eea achieving fiscal & external balance parts 1-4

Important disclosures appear at the back of this document

European Economics Analyst Issue No: 12/01

March 15, 2012

Goldman Sachs Global Economics, Commodities and Strategy Research

at https://360.gs.com

Achieving fiscal and external balance (Part 1): The price adjustment required for external sustainability To a greater or lesser extent, peripheral countries in the Euro area (Greece, Portugal, Ireland, Spain and Italy) face two, interconnected challenges. They need to: (i) regain competitiveness (so as to effect external adjustment) and (ii) correct large public-sector deficits and debts. Countries addressing these ‘twin imbalances’ within a monetary union confront a ‘Catch 22’: dealing with one imbalance is likely to exacerbate the other. Why? With a single currency, regaining competitiveness relies largely on running lower inflation than the Euro area average to adjust the real exchange rate. But stronger nominal GDP growth is needed to address fiscal problems and put public debt on a sustainable path. The low inflation (or deflation) required to regain competitiveness will exacerbate fiscal difficulties.

Given the interconnection between external and fiscal adjustments in the Euro area, it makes sense to consider the challenges of correcting the imbalances together. This is the first of a series of articles—Achieving Fiscal and External Balance—that aims to do just that.

This week, we extend our previous work in the area of external adjustment. We estimate the relative price adjustment required for external adjustment and sustainability. We find that Portugal requires the largest relative price adjustment (around 35%) to achieve external balance, while the equivalent figure is just below 30% for Greece and just above 20% for Spain. On our ‘base-case’ estimate, Italy’s real exchange rate depreciation figure is considerably smaller, at around 10%-15%, while Ireland’s adjustment appears broadly complete.

Huw Pill [email protected] +44(20) 7774 8736 Kevin Daly [email protected] +44 (0)20 7774 5908 Dirk Schumacher [email protected] +49 (0)69 7532 1210 Andrew Benito [email protected] +44(0)20 7051 4004 Lasse Holboell W. Nielsen [email protected] +44(0)20 7774 5205 Natacha Valla [email protected] +33 1 4212 1343 Antoine Demongeot [email protected] +44 (0)20 7774 1169 Adrian Paul [email protected] +44 (0)20 7552 5748

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GRC IRE ESP PRT ITA GER FRA

%Large real exchange rate adjustments are

required within the Euro area*

Current Account balanceStable NIIPNIIP within +/- 25% of GDP

Source: GS Global ECS Research, * nom. growth assumed 2% in GRC and POR, 3% in IRE, ESP and ITA , and 4% in GER and FRA, **incl. tot effects and using ML estimates (Table A2)

Real exchange rate chg.**

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12

18


% of GDPRequired current account adjustments* are

very large in Greece and PortugalCurrent Account balanceStable NIIP**NIIP within +/- 25% of GDP**,***

Source: GS Global ECS Research *Adj. for very large output gaps , ** incl.2001-2007 avg. yearly valuation effects, *** within 20 years

March 15, 2012 Issue No: 12/01 2

European Economics Analyst Goldman Sachs Global Economics, Commodities and Strategy Research

Part 1: The price adjustment required for external sustainability In this first of our series of articles analysing rebalancing in the periphery, we build on our previous work on external adjustment.1,2 In subsequent articles, we plan to discuss how this adjustment to achieve external sustainability will interact with fiscal austerity programmes and broader economic developments as prices are brought down. We will also discuss whether policymakers have the means to improve the trade-off between weak price developments and rising public debt inherent in this analysis.

In our ‘base-case’ scenario, we find that Portugal faces the largest challenge—its required current account adjustment implies a real exchange rate depreciation of the order of 35%, while the equivalent figure is just below 30% for Greece and just above 20% for Spain. While our estimate of the key elasticity parameter is less certain for Italy, the required real exchange rate depreciation in our ‘base-case’ is considerably smaller in Italy (around 10%-15%). Ireland’s external adjustment appears broadly complete. The flipside of a required depreciation in the periphery is a required appreciation in Germany: in our ‘base-case’ scenario, relative prices there need to rise by close to 25%. In France, meanwhile, the price adjustment for achieving sustainability appears large because, while it is running a relatively small current account deficit, France’s tradable sector is small.

This degree of external rebalancing is possible, but it is likely to be long, painful and politically charged, in both the deficit and surplus countries of the Euro area.

Sizable current account adjustments required When is a country’s external position sustainable? A commonly-used metric is a current account balance of

zero. On this basis, the largest adjustments are required in Greece and Portugal, although both have witnessed some improvement recently (Chart 1).3

However, because a current account balance of zero says nothing of the outstanding stock of external debt, it is not clear that it is either necessary or sufficient to secure external sustainability. An alternative requirement—which takes account of both stocks and flows—is for the current account to adjust to a level that would imply a stabilisation in the net international investment position (NIIP) as a share of GDP.

Looking at the development of stocks rather than flows, the NIIP for many peripheral countries has deteriorated sharply over the past ten years and currently stands at about –100% of GDP in Greece, Ireland, Spain and Portugal (Chart 2). Italy stands out among peripheral countries in that its net external debt is only 25% of GDP. Stabilising the periphery’s NIIP at these levels would require less of an adjustment compared with returning the current account to balance (Table A1, upper panel).

We view the stabilisation of NIIP-to-GDP ratios as a minimum requirement for achieving external sustainability, as it would still leave large existing stocks of external debt in many states. A third (and our preferred) gauge of external sustainability is for current accounts to adjust to the point where NIIPs return to within +/-25% of GDP over a period of 20 years (Table A1, lower panel).

Chart 3 summarises the required current account improvement on these three measures of sustainability.4,5

Current account adjustment and real exchange rates How does this current account adjustment translate into

1. For a previous discussion of these issues, see, in particular, “Rebalancing: Current account adjustment and real exchange rate depreciation”, European Weekly Analyst 11/44, and “Rebalancing: Current accounts and how to stabilise net debt”, European Weekly Analyst 11/39.

2. We consider the dynamics of the key peripheral countries facing a significant adjustment requirement—Greece, Ireland, Spain, Portugal and Italy—as well as the flipside of the adjustment: Germany’s revaluation requirement. We also include France in our analysis, which thus covers the bulk of the Euro area’s economic output.

3. Accounting for a temporary compression of domestic demand owing to the large output gap, we consider the ‘structural’ current account to be about 2ppt of GDP worse in Greece, Ireland, Spain, Portugal and Italy. See “Spain’s Rebalancing Act”, European Weekly Analyst 11/26, for details on the impact of large output gaps on the current account.

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% of GDPChart 1: Greece, Ireland and Spain have seen a 5ppt current account shift since 2007

Current Account balance, 2007Current Account balance, 2011*

Source: Eurostat, Nat. source * 4qtr. avg. from last available obs.

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GER FRA ITA ESP GRC IRE PRT

% of GDPChart 2: Peripheral economies accumulated

large net external debt positions

NIIP 2001NIIP 2007NIIP 2010

Source: IMF

March 15, 2012 Issue No: 12/01 3


price adjustments? We use the Obsfeld-Rogoff framework to quantify the implications for the real exchange rate.6 External adjustment requires a real exchange rate depreciation in the periphery and an appreciation in Germany. We abstract, for now, from supply-side changes and cyclical factors, and consider a current account adjustment based on switching within-country demand between tradables (i.e., goods and services that can be traded internationally) and non-tradables.7 Such a current account improvement requires a reduction in the periphery’s demand for tradables and a similar increase in demand for tradables in the rest the world. For such a switch to occur (and abstracting from terms of trade effects), the price of non-tradables in the periphery needs to decline, while the price of non-tradables in the rest of the world needs to increase, thus depreciating the periphery’s real exchange rate. What determines the size of the required price adjustment? The size of the current account adjustment shown in Chart 3 is, of course, a crucial factor. But other factors also matter:

The country’s share of tradables in production: If the share of the economy that produces tradable goods and services is relatively large, then the adjustment burden can be borne by a larger part of the economy. For instance, Greece’s current account deficit-to-GDP ratio is about four times larger than that of France (10% vs. 2%-3%). However, because the share of the Greek economy producing tradable goods and services is much higher than that of France, the relative price adjustment required by the tradable sector in Greece is much less than four times (Chart 4).8

The country’s share of non-tradables in consumption: Similarly, if the share of non-tradables in consumption is high, the impact of relative price changes will be larger (Chart 4).

The within-country price elasticity between non-tradables and tradables: If small changes in relative prices induce large changes in relative demand, then the required price change will be commensurately lower. Rather than assuming specific values for these elasticities—as much of the previous literature in this area has done—we estimate individual elasticities for each of the countries (Table A2).9

Quantifying the real exchange rate depreciation requirement in the Euro area In deriving the price adjustment required to achieve external sustainability, our ‘base-case’ scenario considers the current account adjustment required to secure a NIIP within +/-25% of GDP (Chart 3, black column), and takes account of the cross-country variance in each of the three factors discussed above. We also take account of terms of trade effects, although the impact of these is small.10 On this basis, we calculate the following required real exchange rate adjustments:

The largest adjustment is required by Portugal, which, on our estimates, needs a real exchange rate depreciation of around 35% to achieve external sustainability. The figures for Greece and Spain are around 30% and 20%, respectively. Italy’s price adjustment is about 10%-15%, while Ireland’s is 0%-5%. Germany requires an ‘opposite’ adjustment, i.e., an appreciation, of around 25%, while France’s adjustment is similar to that of Spain (Chart 5).

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% of GDP

Current Account balanceStable NIIP**NIIP within +/- 25% of GDP**,***

Source: GS Global ECS Research *Adj. for very large output gaps , ** incl. 2001-2007 avg. yearly valuation effects, ***within 20 years

Chart 3: Required current account adjustment* very large in Greece and Portugal

4. In calculating the required current account adjustment, we also consider the impact of having the price of a country’s net assets rise or decline relative to the price of the country’s net liabilities. Box 1 explores these valuation effects in more detail. See also Lane and Milesi-Feretti (2005): “Financial globalisation and exchange rates”, IMF WP 05/03, for an analysis emphasising the NIIP.

5. We pick 20 years as a ‘reasonable’ period of time for rebalancing to occur, although we would note that a 10-year adjustment period would increase the required current account surplus (excluding valuation effects) for Greece, Ireland, Spain and Portugal by an order of 2 to 3 times.

6. See European Weekly Analyst 11/44 for more details on this framework. 7. See “Time to focus on productivity and competitiveness”, European Weekly Analyst 12/10 for a discussion of productivity and rebalancing. 8. We account for tradable services using the goods/service share in exports as a proxy for the tradable goods/tradable services share of GVA. 9. See European Weekly Analyst 11/44 for a calculation of price adjustment as a function of an assumed elasticity. 10. See European Weekly Analyst 11/44 for more details on terms of trade effects. As the countries in our analysis are relatively small compared with

global output, the terms of trade effects are small.

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Share of GVA

Chart 4: Greece and Ireland have high tradable production and consumption

Tradable servicesTradable goodsConsumption of tradables, (rhs)

Source: Eurostat, Nat. sources, GS Global ECS Research

Share of tot. cons.

March 15, 2012 Issue No: 12/01 4


Box 1: Valuation effects and measuring elasticities of substitution

Table A1: Current account requirements as a function of growth and valuation effects

N o m. no val. w. va l. no val. w. va l. no val. w. va l. no val. w. val. no val. w. val. no val. w. val. no val. w. val.

0.5 -0.5 4.1 -0.5 -0.7 -0.4 4.1 -0.5 1.2 -0.1 1.5 0.2 1.0 -0.1 1.92.0 -1.8 2.7 -1.9 -2.1 -1.8 2.8 -2.1 -0.4 -0.5 1.1 0.7 1.5 -0.2 1.83.0 -2.7 1.8 -2.9 -3.0 -2.6 2.0 -3.2 -1.4 -0.7 0.9 1.1 1.9 -0.3 1.74.0 -3.6 1.0 -3.8 -4.0 -3.4 1.1 -4.2 -2.4 -1.0 0.6 1.5 2.3 -0.4 1.6

0.5 3.1 7.6 3.4 3.2 2.9 7.5 3.9 5.6 -0.1 1.5 -0.5 0.3 -0.1 1.92.0 2.2 6.8 2.5 2.3 2.1 6.7 2.9 4.7 -0.5 1.1 0.0 0.8 -0.2 1.83.0 1.7 6.2 1.9 1.8 1.6 6.2 2.3 4.1 -0.7 0.9 0.3 1.1 -0.3 1.74.0 1.2 5.7 1.4 1.2 1.1 5.7 1.8 3.5 -1.0 0.6 0.5 1.3 -0.4 1.6

Source: GS Global ECS Research. * Within 20 years

France- - - - - - - - - - - - - - - - - - - - - - C urrent acco unt required to stabilise N IIP at current levels , with and witho ut valuat io n effect - - - - - - - - - - - - - - - - - - - - - - - - -

- - - - - - - - - - - - - - - - - - - - - - - - - - C urrent acco unt required to have |N IIP |<25% o f GD P *, with and witho ut valuat io n effect - - - - - - - - - - - - - - - - - - - - - - - - - - - -

ItalyGreece Ireland Spain Portugal Germany

1A. See European Weekly Analyst 11/39 for details on the valuation effect, and Lane (2011): “The Dynamics of Ireland’s Net External Position”, paper prepared for SSISI meeting, November 14, 2011, for details on the Irish case.

2A. See Obsfeld and Rogoff. (2007): “The Unsustainable U.S. Current Account Position Revisited”, NBER volume “G7 Current Account Imbalances: Sustainability and Adjustment”, University of Chicago Press.

3A. Lai and Trefler (2002): “The gain from trade with monopolistic competition: specification, estimation and mis-specification”, NBER WP 9169. 4A. An often cited reference is Stockman and Tesar (1995), who in a 30-country sample for the year 1975 find an elasticity of 0.44. Mendoza (1992),

using the same data, but restricting the analysis to developed economies, finds an elasticity of 0.74.

The necessary current account surplus/deficit for stabi-lising the NIIP relative to GDP, or having the NIIP within +/-25% of GDP, is a function of nominal growth, the length of the adjustment period and the size of the average yearly valuation effect (Table A1 summarises).

Valuation effects matter. Even within the Euro area, where individual country assets and liabilities tend to be denominated in the same currency, valuation effects are sizable as net asset prices develop differently from net liability prices.1A We thus list the required current ac-count for external sustainability with and without valua-tion effects in Table A1.

While both pre-crisis and crisis developments are char-acterised by unusual circumstances, the pre-crisis period seems more ‘normal’ and suitable for gauging future developments. Thus, the valuation effect included in Table A1 and used in our ‘base-case’ refers to the pre-crisis (2001-2007) average yearly valuation effect. Rela-tive to using the average crisis period effect, this would tend to make the adjustment appear bigger in Greece and Spain, but smaller in Ireland.1A Recent changes to the net asset position in Greece and Spain (which has now shifted to being long net equity), suggest that the 2001-2007 period average for Greece and Spain should be considered an upper bound.

We map these current account requirements into relative price adjustments using the framework developed in Obsfeld and Rogoff (2007). Using this model, the total impact on the real exchange rate can de decomposed into (i) a terms of trade effect and (ii) relative price ef-fect2A:

The size of the terms of trade effect depends on the degree of substitution between home and foreign tradables. Here we using the macro elasticity estimate from Lai and Trefler (2002), but adjust it for each country using Lai and Trefler’s industry specific elas-ticities (GVA weighted). We assume a 0.5 elasticity for tradable services.3A

The relative price effect depends on the degree of within-country substitution between tradables and non-tradables. The literature on this is limited and a unit elasticity is often assumed.4A We estimate this, employing a time series approach for each of the in-dividual countries in our analysis (Table A2). Our results should be cautioned by the short sample; how-ever, the coefficient appears to be significant. Maxi-mum Likelihood coefficients generally range be-tween 0.4 and 1.1. Italy and Germany are outliers, with ML estimates of 2.2 and 0.2, respectively, nota-bly different from the OLS estimates.

Table A2: Estimated relative price elasticity of substitution between non-tradables and tradables, 1995-2010

OLS M L OLS M L OLS M L OLS M L OLS M L OLS M L OLS M L

0.610** 0.753*** 1.052*** 0.753*** 0.750*** 1.077*** 1.110*** 1.119*** 0.604 2.213** 0.432** 0.238** 0.390*** 0.595***(0.175) (0.166) (0.282) (0.166) (0.084) (0.117) (0.020) (0.004) (0.616) (0.692) (0.189) (0.110) (0.034) (0.121)

Constant in LR relation Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes

Trend in LR relation No No Yes Yes No No No No Yes Yes Yes Yes No NoDickey-Fuller t-statistic* / Trace test p-value**

-2.17 0.56 -4.06 0.00 -2.36 0.03 -3.00 0.00 -2.14 0.26 -1.67 0.01 -3.48 0.06

Sample2002- 2010

2002- 2010

1998- 2010

1998- 2010

1995- 2010

1995- 2010

1998- 2010

1998- 2010

1995-2010

1995- 2010

1995- 2010

1995- 2010

1995- 2009

1995- 2009

Source: GS Global ECS Research, std. error in parenthesis, OLS referes to the Engell-Granger procedure, ML refers to Johansen's maximum likelihood estimator * Null hypothesis: unit root in residuals, ** Null hypothesis: No cointegrating relations

Germany France

Elasticity of substitution, Non-Tradables/Tradables

Greece Ireland Spain Portugal Italy

March 15, 2012 Issue No: 12/01 5


What is driving this cross-country variation? The required current account adjustment is largest in Greece and Portugal (about 18% and 15% of GDP, respectively); Spain’s required current account adjustment is around 12%, Italy’s is around 6% and France’s is around 4%-5%. Germany’s required adjustment is also 4%-5% but with the opposite sign.

However, if we measure the required adjustment relative to the size of the tradable sector rather than to GDP, the ordering changes. Because the size of the tradable sector appears to be relatively small in France (in both goods and services), the requirement rises by as much as 5 to 6 times if it is scaled in this way; the required adjustment increases by an order of 3 to 4 times in Spain, Portugal, Italy and Germany, but only doubles in Greece and Ireland.

Adjusting for differences in price elasticity changes the ordering further. Our estimated elasticity for Portugal and Spain is just above 1; for Greece and Ireland it is close to ¾; France is just below this, while Germany's elasticity seems very low, at around ¼. Italy’s estimated price elasticity, meanwhile, appears very high, at close to 2. Thus, while Italy’s and France’s required current account adjustments are similar (when measured relative to tradables), the estimated relative price adjustment required by France is close to four times as large. However, the ‘confidence bounds’ around our estimates of price elasticity in Italy are relatively large (Chart 6).11

Finally, the countries’ share of tradables in consumption differ. Portugal and Italy appear to have a relatively lower consumption share of tradables goods. This exacerbates the real exchange rate deprecation in these two countries.

A long and arduous adjustment process How are these price adjustments likely to come about and how long will they take? As the individual Euro area countries do not have exchange rate flexibility, the adjustment will have to come through relative price changes and internal devaluations.12 With Euro area average inflation of 2%, zero inflation in the deficit countries implies an adjustment of around 15 years in Portugal and Greece, 10 years in Spain and France, and 5-10 years in Italy. (Ireland’s external adjustment already appears complete.) Zero inflation in these economies would translate into a required inflation rate in the rest of the Euro area, including Germany, of more than 4%. At this rate, Germany’s real exchange rate appreciation would be completed in about 5-10 years.

The applied framework is useful for identifying the elements that contribute to the real exchange rate’s overall adjustment requirement. Certain factors are fixed, such as net debt levels. But other factors can change to facilitate an easier adjustment. One such example is expanding the size of the tradable sector. Broadening the Euro area internal market for services is one way of doing this.

As we have noted in previous work, a less painful way of rebalancing is through improving productivity, particularly in the tradables sector. However, gains here may be uncertain, and would take time to have an impact. In the meantime, output is likely to suffer as prices are forced down and public debt is likely to increase as nominal GDP remains subdued. We will consider these issues in more detail in the coming weeks.

Lasse Holboell W. Nielsen

11. Two factors in our calculation are particularly uncertain: (i) Our base-case uses pre-crisis (2001-2007) average valuation effects. However, these effects vary over time. Using the full period (2001-2010) gives a figure closer to a ‘no valuation effect’ (or slightly positive) for in particular Greece, Spain, Portugal and Italy, but a notably negative effect for Ireland. (ii) Our base-case uses the Maximum Likelihood (ML) estimates of the degree of substitution between non-tradables/tradables. The results are relatively close to the OLS estimates (Table A2) —except for in the case of Italy and Germany. We therefore combine the choices of the sample length for valuation effects and the estimator for the elasticity in such a way that produces the largest and smallest price adjustment. The range is largest for Italy, with our base-case estimates closest to the lower bound. On the other hand, our base-case for Portugal and Germany comes close to the upper bound of adjustment (Chart 6).

12. As the aggregate Euro area is broadly balanced, reflected in Germany needing the opposite adjustment to that in the periphery, real exchange rate adjustment needs to occur through relative price moves. Were the Euro area to have an aggregate imbalance, e.g., a 5% of GDP current account deficit across all countries, then the Euro exchange rate could adjust to facilitate the rebalancing.

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% Chart 6: Range of estimated elasticities and valuation effects quite large in Italy

Source: GS Global ECS Research, *|NIIP|<+/-25% of GDP within 20 years, ML estimate, pre-crisis avg. valuation effect

Real exchange rate chg.*

Lower bound (using high estimates of elasticity and small val. effects)

Upper bound (using low estimates of elasticity and larger val. effects)

'Base-case'estimate*

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%Chart 5: Required real exchange rate

adjustment sizable within the Euro area*

Current Account balanceStable NIIP* **NIIP within +/- 25% of GDP

Source: GS Global ECS Research, * nom. growth assumed 2% in GRC and POR, 3% in IRE, ESP and ITA , and 4% in GER and FRA, **incl. tot effects and using ML estimates (Table A2)


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March 15, 2012 Issue No: 12/01

Key European Indicators

...and our Current Activity Indicator suggests positive GDP growth in the UK.

Our survey-based GDP tracker points to positive growth in the Euro area...

We expect a significant convergence in Euro area and UK inflation in 2012.

Data releases have surprised on the upside in recent months.

Business sentiment improves, moving away from 2011Q4 troughs.

European financial conditions are easy, with the exception of Switzerland.

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European financial conditions

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Source: GS Global ECS Research

TighterConditions

Index Jul. 2008=100

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Euro area Composite PMI

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Source: Markit, SVME, Swedbank, GS Global ECS Research

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Source: Markit, Eursotat, GS Global ECS Research

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Source: Eurostat, ONS, GS Global ECS Research

GS Forecast

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% qoq UK GDP and our Current Activity Indicator

Actual GDP

UK CAI (Implied Growth)

Source: ONS, GS Global ECS

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Main Economic Forecasts GDP Consumer Prices Current Account Budget Balance

(Annual % change) (Annual % change) (% of GDP) (% of GDP)2011 2012(f) 2013(f) 2011 2012(f) 2013(f) 2011 (f) 2012(f) 2013(f) 2011(f) 2012(f) 2013(f)

Euro area 1.5 -0.4 0.7 2.7 2.0 1.5 -0.3 -0.1 -0.1 -4.7 -4.0 -3.2Germany 3.1 0.9 1.5 2.5 1.5 1.7 5.3 4.1 3.9 -1.5 -1.0 -0.7France 1.7 0.3 1.0 2.3 2.0 1.7 -2.3 -0.8 -0.9 -5.4 -5.0 -4.0Italy 0.5 -1.3 0.0 2.9 2.3 1.3 -3.2 -1.2 -0.8 -4.1 -3.2 -2.2Spain 0.7 -1.2 -0.1 3.1 1.7 1.1 -3.7 -2.9 -2.4 -8.2 -6.8 -6.0

UK 0.8 1.2 2.3 4.5 2.4 1.8 -2.4 -1.8 -2.3 -7.9 -6.8 -5.2Switzerland 1.9 0.1 1.4 0.2 0.4 0.7 16.0 15.6 15.4 -0.3 -0.2 -0.1Sweden 4.6 2.2 2.4 2.6 2.0 2.2 7.9 8.3 8.1 0.3 0.8 1.3Denmark 0.9 -0.1 1.4 2.6 1.0 1.6 5.5 5.6 3.5 -3.9 -5.7 -5.5Norway* 2.5 1.9 2.5 1.3 1.1 1.6 15.8 20.2 20.4 - - -Poland 4.3 2.6 3.4 4.3 4.1 2.8 -4.1 -3.9 -4.1 -5.2 -3.3 -3.0Czech Republic 1.7 0.6 2.5 1.9 3.1 1.6 -2.5 -2.5 -2.6 -3.9 -3.0 -2.8Hungary 1.7 -0.5 1.8 3.9 5.7 5.7 1.2 2.2 1.9 2.0 -3.5 -3.0

*Mainland GDP grow th. We are ceasing regular country coverage of Greece and Netherlands. These countries w ill no longer form part of our calculated aggregations

of economics indicators. We w ill continue to analyse these and other Euro area countries on a more thematic basis. Source: GS Global ECS Research.



March 22, 2012



Achieving fiscal and external balance (Part 2): The price of competitiveness The Euro area peripheral economies (Greece, Portugal, Ireland, Spain and Italy) face two, interconnected challenges: (i) regaining competitiveness (to effect external adjustment) and (ii) correcting large public sector deficits. Addressing one of these ‘twin imbalances’ within a monetary union is likely to exacerbate the other and, given their interconnectedness, it makes sense to consider the challenges jointly. This is the second of a series of articles which does that.

In the first article in this series, we estimated the relative price adjustment required in peripheral economies to establish ‘external sustainability’. We found that Portugal requires the largest relative price adjustment (around 35%), while the equivalent figure is just below 30% for Greece and just above 20% for Spain. On our ‘base-case’ estimate, Italy’s real exchange rate depreciation figure is considerably smaller, at around 10%-15%.

In Part 2, we consider how much ‘pain’ is likely to be required in peripheral economies to achieve the required price adjustments estimated in Part 1. We base this assessment on estimated ‘sacrifice ratios’—which relate reductions in inflation to output losses (or rises in unemployment). Assuming a ten-year adjustment period, the implied additional output losses, relative to trend, are large in Greece and Portugal (with estimates ranging from 5% to 10% of GDP). That reflects both the scale of adjustment required in those countries and their high estimated sacrifice ratios. In Italy and Spain, where inflation is already at or below the Euro area average, much of the adjustment in output relative to trend already appears complete. In Germany, a sustained period of above-trend output growth is required to drive inflation higher.

Huw Pill [email protected] +44 (0)20 7774 8736 Kevin Daly [email protected] +44 (0)20 7774 5908 Dirk Schumacher [email protected] +49 (0)69 7532 1210 Andrew Benito [email protected] +44 (0)20 7051 4004 Lasse Holboell W. Nielsen [email protected] +44 (0)20 7774 5205 Natacha Valla [email protected] +33 1 4212 1343 Antoine Demongeot [email protected] +44 (0)20 7774 1169 Adrian Paul [email protected] +44 (0)20 7552 5748

-2

0

2

4

6

8

10

12

14

Greece Ireland Spain Portugal Italy France

Far higher 'required' output losses in Greece and Portugal than elsewhere

Curr account balance

NIIP stable

NIIP within +/- 25% GDP


Output loss relative to trend (%)

Note: NIIP is the net international investment (net foreign asset) position

-40

-30

-20

-10

0

10

20

30

40


%Required real exchange rate adjustment

sizable within the Euro area*

Current Account balance

Stable NIIP* **

NIIP within +/- 25% of GDP

Source: GS Global ECS Research, * nom. growth assumed 2% in GRC and POR, 3% in IRE, ESP and ITA , and 4% in GER and FRA, **incl. terms of trade effects.


March 22, 2012 Issue No: 12/02 2


The price of competitiveness

Achieving fiscal and external balance The Euro area peripheral economies (Greece, Portugal, Ireland, Spain and Italy) face two, interconnected challenges: (i) regaining competitiveness (to effect external adjustment) and (ii) correcting large public sector deficits and debts. Addressing these ‘twin imbalances’ within a monetary union presents a ‘Catch 22’: dealing with one imbalance is likely to exacerbate the other, because weak demand and low inflation make fiscal adjustment more difficult. Given their interconnectedness, it makes sense to consider the challenge of correcting these imbalances jointly. This is the second of a series of articles—‘Achieving Fiscal and External Balance’—which aims to do just that.

In the first article in this series, we estimated the relative price adjustment required in peripheral economies to establish ‘external sustainability’.1 We found that Portugal requires the largest relative price adjustment (around 35%), while the equivalent figure is just below 30% for Greece and just above 20% for Spain. On our ‘base-case’ estimate, Italy’s real exchange rate depreciation figure is considerably smaller, at around 10%-15% (Chart 1).

In Part 2 of our series, we consider how much ‘pain’ is likely to be required in peripheral states to achieve the required price adjustments estimated in Part 1. We base this assessment on estimated ‘sacrifice ratios’—which relate reductions in inflation to output losses (or rises in unemployment). Assuming a ten-year adjustment period, the implied additional output losses, relative to trend, are large in Greece and Portugal (with estimates ranging from 5% to 10% of GDP). That reflects both the scale of adjustment required in those countries and their high estimated sacrifice ratios. In Italy and Spain, where inflation is already at or below the Euro area average, much of the adjustment in output relative to trend already appears complete. In Germany, a sustained period of above-trend output growth is required to drive inflation higher.

The costs of restoring competitiveness The sacrifice ratio measures the output loss required to reduce trend inflation by 1ppt. It summarises the relationship (as seen in historical data) between trend inflation (as the denominator) and associated output loss (the numerator).2 A high sacrifice ratio implies that a relatively large amount of ‘pain’ is required (in terms of lost output or higher unemployment) in order to bring about an adjustment in inflation.

Sacrifice ratios are based on empirical relationships. They do not capture deeper structural features of an economy. How they vary from country to country and over time will depend on what has caused inflation and output to vary, and on how these initial impulses are transmitted through an economy. As a general principle, however, economic ‘flexibility’ across two dimensions appears to be a key determinant of sacrifice ratios:

Whether wage rates or profit margins are flexible in the face of a fall in output.

-40

-30

-20

-10

0

10

20

30

40







1. ‘Achieving fiscal and external balance (Part 1): The price adjustment required for external sustainability’, European Economics Analyst, March 15, 2012.

2. We define trend inflation as a nine-quarter moving average of inflation (the GDP deflator); the end of the disinflation period (for output) is defined as four quarters after inflation reaches its trough. In doing so, we follow the methodology set out by Ball, L (1994), ‘What determines the sacrifice ratio?’, NBER.

Table 1: Estimated sacrifice ratios in the Euro area from the Great Recession

Country Fall in trend inflation (pp)

Fall in output (%)

Output-based sacrifice ratio

Alternative estimates of

sacrifice ratio

Rise in unemployment (pp)

Unemployment-based sacrifice ratio

Germany 0.6 1.5 2.3 2.9 -1.3 -2.0France 1.9 2.1 1.1 0.8 1.5 0.8Italy 2.3 5.1 2.2 1.7 2.1 0.9Spain 3.0 2.2 0.7 0.9 10.4 3.5Greece 1.9 10.9 5.7 - 5.5 2.9Portugal 1.8 4.3 2.3 - 3.6 2.0Ireland 5.0 11.6 2.3 0.7 8.2 1.7Euro area 1.5 3.3 2.2 - 2.4 1.6

Note: Alternative estimates of the sacrif ice ratio come from a study by Ball (1994). Where possible, w e take Ball’s estimates based on quarterly data.Sources: GS Global ECS Research and Ball (1994).

March 22, 2012 Issue No: 12/02 3


Whether there is flexibility in reallocating unused resources (such as unused labour or capital) to alternative uses when demand weakens.

Table 1 provides our estimates of the sacrifice ratio for each country, based on their experience during the ‘Great Recession’ that began in 2008. Charts 2-5 outline the performance of inflation (as measured by the GDP deflator) in each of the economies discussed.

For the Euro area, trend inflation fell by 1.5ppt during the Great Recession, while output fell by 3.3%. That implies a sacrifice ratio for the Euro area as a whole of 2.2: i.e., a 2.2% fall in output is required to reduce (trend) inflation by 1ppt. But this estimate masks considerable variation across countries, reflecting cross-country structural differences.

Despite marked falls in output during the 2008/09 recession, Greece and Portugal have seen a relatively modest fall in trend inflation. Ireland stands out as having seen a substantial fall in its ‘trend’ inflation, and has moved into outright deflation territory (note the different scales in Charts 2-5). Spain, meanwhile, has seen a larger

moderation in its inflation rate than Italy, and France rather more so than Germany. Inflation in Germany has remained low throughout this period.

Greece has the highest sacrifice ratio (at 5.7), while Spain has the lowest (at only 0.7). But the relatively low sacrifice ratio in terms of output losses seen in Spain may disguise considerable hardship in terms of rising unemployment. Looking at an unemployment-based ratio helps reflect the particular social costs associated with rising unemployment. These are also reported in Table 1.

Indeed, although Spain has the lowest output-based sacrifice ratio, it has the highest unemployment-based sacrifice ratio (at 3.5) in our set of countries. This highlights the Spanish economy’s main structural problem: its labour market, which has generated a high cost in terms of rising unemployment when inflation or output fall. In the 2008/09 recession, Spain’s unemployment rate rose by over 10ppt. This large cyclical response partly reflects two factors: a) a structural shift away from the construction sector, which has accounted for 1.4m of the 2.4m lost jobs in Spain, and b) a high cyclical sensitivity of employment to output, with wages

Charts 2-5: Trend inflation in the Euro area

0.0

0.5

1.0

1.5

2.0

2.5

3.0

01 02 03 04 05 06 07 08 09 10 11 12

% qoq, annualised

Chart 2: A moderate fall in Euro area inflation implies a high sacrifice ratio

Source: Eurostat

Euro area

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

01 02 03 04 05 06 07 08 09 10 11 12

% qoq, annualised

Chart 4: A larger fall in inflation in Spain than in Italy

Source: Eurostat

Italy

Spain

0.0

0.5

1.0

1.5

2.0

2.5

3.0

01 02 03 04 05 06 07 08 09 10 11 12

% qoq, annualised

Chart 3: Low inflation in Germany throughout monetary union

Source: Eurostat

Germany

France

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

01 02 03 04 05 06 07 08 09 10 11 12

% qoq, annualised

Chart 5: A marked fall in inflation in Ireland contrasts with Greece and Portugal

Source: Eurostat

Ireland

Portugal

Greece

March 22, 2012 Issue No: 12/02 4


seeming to take less of the burden of adjustment. Structural reforms aimed at enhancing wage flexibility should help reduce the cyclical response of employment and unemployment to output falls (see European Weekly Analyst 12/05, ‘Avoiding austerity and inflexibility in a Keynesian labour market’).

Our estimates of the sacrifice ratio are generally in line or a little higher than previous estimates based on earlier disinflation episodes (Table 1 also displays estimates derived by the economist Laurence Ball (1994)). However, we think the experiences following the 2008/09 recession are likely to provide a better guide to the sacrifice ratios at low inflation rates, and so prefer to use our (generally higher) estimates.

The price of regaining competitiveness is far higher in Greece and Portugal than elsewhere We can combine our estimates of the required gain in competitiveness set out in Chart 1 and the sacrifice ratios in Table 1 to provide an estimate of the output loss required to restore competitiveness in each of these economies (Table 2). In deriving these calculations, we assume:

The adjustment in competitiveness takes place over a period of ten years. Assuming countries have ten years to adjust is somewhat arbitrary, although consistent with Chancellor Merkel’s suggestion that it will take a decade to recover from the financial crisis. The output and unemployment costs are proportional to the adjustment period, so would be raised or lowered accordingly from those shown in Table 2 (e.g., assuming instead that countries have just five years to make the adjustment doubles the output costs).

The ECB targets Euro area wide inflation of 2% for consumer prices (which implies a somewhat lower outcome for inflation under the GDP deflator).

The Euro area as a whole is taken to be in external balance and, with the ECB targeting 2% inflation, there is no loss in aggregate output relative to supply. In other words, we focus on intra-Euro area adjustment on the basis that the consolidated position relative to the rest of the world is broadly in balance.

The range of estimates set out in Table 2 correspond to the different criteria of external sustainability set out in last week’s European Economics Analyst, i.e., i) a zero current account balance, ii) stabilising the net external debt position, or iii) reducing the net external debt position to 25% of GDP.

On this basis, the estimated required output losses are high in some cases. Consider the countries with the largest required gains in competitiveness first: Greece and Portugal. Greece would have to incur an additional output cost of between 7-12% and Portugal an output cost of 3-6% in order to achieve external sustainability. These estimates are relative to trend output, although for Greece and Portugal, where trend growth appears low, this is not such an important distinction.

Spain has the next-largest required gain in competitiveness. But its output-based sacrifice ratio is relatively low and its inflation rate has already fallen significantly. So, provided it has ten years to make the adjustment, Spain’s additional output losses relative to trend should be small. With an unemployment rate of more than 20%, the labour market cost to Spain of the adjustment has already been extremely high. More recent signs of a significant moderation in wage pressure in Spain, alongside labour market reforms, may help moderate this high unemployment cost.

The required gains in competitiveness for France and Italy are not very different to that for Spain. France’s additional output cost is around 1-1½%. Italy’s is close to zero since its inflation rate is already close to the required level. Ireland’s adjustment, meanwhile, appears to be essentially complete.

Higher inflation required in the core In order for Euro area inflation to average 2% over the adjustment period, German inflation would need to average significantly more than this. In the calculations in Table 2, Germany’s inflation rate averages between 3.3% and 4.7% over a 10-year period. The German public and policymakers may resist such elevated inflation, highlighting the scope for tensions in both the core and the periphery of the Euro area.

Were the ECB to bow to German pressure in this scenario and target a lower inflation rate for the Euro area as a whole, then the consequence would be even higher output losses in the periphery than the estimates set out in Table 2. Assuming an implicit ECB target of 1% inflation for Euro area wide consumer prices would see the range of country inflation rates as shown in Table 3. German inflation in these scenario averages between 2.3% and 3.7%, which may prove more palatable in Germany. But this implies Greece and Portugal would experience outright deflation under the three criteria of external sustainability. More notably, those countries are joined by France, Italy and Spain—all of which experience outright

Table 2: Estimated Output losses for required gains in competitiveness

% Greece Ireland Spain Portugal Italy Germany France

Curr account balance 7.2 0.0 0.2 3.5 -0.1 n.a. 0.9

NIIP stable 9.1 0.0 0.4 3.3 0.2 n.a. 1.4NIIP within +/- 25% GDP 11.9 0.0 0.8 5.6 0.2 n.a. 1.4


March 22, 2012 Issue No: 12/02 5


deflation under each of the three criteria of sustainability. This pattern of inflation implies the range of output costs shown in Table 4—much higher than those under an ECB target of 2% inflation. In this situation, France and Italy face output losses, relative to trend, of over 2%, whilst Spain’s would be slightly lower.

It is tempting to conclude that the output costs could be lowered further if the ECB targeted higher inflation, perhaps effectively allowing its target to drift to 2.5% or 3% inflation. On our arithmetic that would, after all, imply smaller output losses in peripheral economies. It would, however, also involve still higher inflation rates in Germany than the 3.3-4.7% base case. Moreover, allowing inflation to drift up in that way would involve significant further costs by subsequently forcing the ECB to tighten policy significantly and presumably at a time when higher inflation expectations had become embedded. Although we cannot quantify the costs of implicitly targeting higher inflation here—and then being forced into subsequently tighter policy—we believe those costs would be large.

Improving the output-inflation trade-off Deriving estimates of this type is far from being an exact science and it is worth emphasising some limitations that apply to the calculations set out above:

First, we assume linearity throughout the calculations, extrapolating the output and unemployment costs of one recent episode to the costs implied over a ten-year period. In practice, the costs may be more non-linear than this assumption allows for.

Second, our focus in these calculations has been on demand reduction, implying that the structural features of each of these economies will remain unchanged throughout the 10-year adjustment period. However, as we discussed in the introduction, the sacrifice ratio is not a fixed feature of an economy: its value will depend on both structural features and the range of influences that caused output and inflation to change

in a particular way. By changing these responses, economic policy should be able to change the value of the sacrifice ratio.

With the right structural reforms, the peripheral economies could achieve gains in competitiveness with lower output costs. Appropriately designed reforms could raise the economy’s potential output and also make pricing (and competitiveness) more responsive to what slack there is in the economy. In our exercise we have focused on weak demand as the means of delivering gains in competitiveness. We do that as a way of presenting a benchmark for calculating the cost of adjustment. In future work, we will turn our attention to the likely contribution of structural reforms, and what precise structural reforms would work best to achieve that aim.

Structural reforms in Germany could also help the adjustment and reduce the burden on inflation differentials in the Euro area to achieve that. The key area of reform in Germany is the liberalisation of its non-traded sector (e.g., services) to make it ‘more tradable’.

Our message from this exercise is a fairly bleak one for Greece and Portugal, and underscores just how important making the right structural reforms is for those economies. Elsewhere, a more optimistic tone emerges—at least for Spain and Italy, where output losses seem much smaller, although by no means negligible. The message for Germany is rather more subtle and, in some sense, also quite stark. Although Germany does not face an output loss given its established competitiveness, in order to achieve external adjustment, Germany may need to tolerate higher inflation than it has been used to, at least if most of the Euro area is to avoid outright deflation. Germany will also need to play an important role in ensuring that peripheral countries have enough time, at least ten years on our calculations, to restore their competitiveness.

Andrew Benito

Table 3: Inflation rates that ensure sustainability if ECB targets 1% inflation

Greece Ireland Spain Portugal Italy Germany France

Curr account balance -0.9 0.5 -0.3 -1.5 0.0 3.7 -0.4

NIIP stable -1.3 0.9 -0.5 -1.4 -0.2 2.3 -0.9

NIIP within +/- 25% GDP -1.8 0.3 -1.1 -2.4 -0.2 2.8 -0.9


Table 4: Output costs under a lower (1%) ECB inflation target

% Greece Ireland Spain Portugal Italy Germany France

Curr account balance 12.9 0.0 0.9 5.8 2.1 n.a. 2.0

NIIP stable 14.8 0.0 1.1 5.6 2.4 n.a. 2.5NIIP within +/- 25% GDP 17.6 0.0 1.5 7.9 2.4 n.a. 2.5


6




...and our Current Activity Indicator suggests positive GDP growth in the UK.

Our survey-based GDP tracker points to positive growth in the Euro area...

We expect a significant convergence in Euro area and UK inflation in 2012.


Business sentiment softens. European financial conditions are easy, with the exception of Switzerland.

92

94

96

98

100

102

104

106

108

110

112



Euro area

UK

Switzerland

Sweden

Norway


TighterConditions

Index Jul. 2008=100

30

35

40

45

50

55

60

65

70

05 06 07 08 09 10 11 12


Euro area Composite PMI

UK Composite PMI

Switzerland Manuf. PMI

Sweden Manuf. PMI


-3.0

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

99 00 01 02 03 04 05 06 07 08 09 10 11 12

% qoq

Actual GDP




-1

0

1

2

3

4

5

6

99 00 01 02 03 04 05 06 07 08 09 10 11 12 13



UK Headline CPI


GS Forecast

-0.5

-0.4

-0.3

-0.2

-0.1

0.0

0.1

0.2

0.3

05 06 07 08 09 10 11 12


Euro area (3m mav.)

UK (3m mav.)


-3.0

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

99 00 01 02 03 04 05 06 07 08 09 10 11 12


Actual GDP


Source: ONS, GS Global ECS Research

7



We, Andrew Benito and Antoine Demongeot, hereby certify that all of the views expressed in this report accurately reflect personal views, which have not been influenced by considerations of the firm’s business or client relationships. Global product; distributing entities The Global Investment Research Division of Goldman Sachs produces and distributes research products for clients of Goldman Sachs on a global basis. Analysts based in Goldman Sachs offices around the world produce equity research on industries and companies, and research on macroeconomics, currencies, commodities and portfolio strategy. This research is disseminated in Australia by Goldman Sachs Australia Pty Ltd (ABN 21 006 797 897); in Brazil by Goldman Sachs do Brasil Corretora de Títulos e Valores Mobiliários S.A.; in Canada by Goldman Sachs Canada & Co. regarding Canadian equities and by Goldman Sachs & Co. 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UK 0.8 1.2 2.3 4.5 2.4 1.8 -2.4 -1.8 -2.3 -7.9 -6.8 -5.2Switzerland 1.9 0.1 1.4 0.2 0.4 0.7 16.0 15.6 15.4 -0.3 -0.2 -0.1Sweden 4.0 0.9 2.3 2.6 2.0 2.2 7.2 6.2 6.0 0.3 0.1 0.6Denmark 1.0 0.2 1.4 2.7 1.1 1.6 5.6 5.6 4.0 -3.7 -5.6 -5.4Norway* 2.7 2.3 2.5 1.3 1.2 1.6 14.6 15.0 15.0 - - -Poland 4.3 2.6 3.4 4.3 4.1 2.8 -4.1 -3.9 -4.1 -5.2 -3.3 -3.0Czech Republic 1.7 0.6 2.5 1.9 3.1 1.6 -2.5 -2.5 -2.6 -3.9 -3.0 -2.8Hungary 1.7 -0.5 1.8 3.9 5.7 5.7 1.2 2.2 1.9 2.0 -3.5 -3.0

*Mainland GDP grow th.

Source: GS Global ECS Research.



March 29, 2012



Achieving fiscal and external balance (Part 3): External adjustment, weaker prices and public debt Peripheral countries in the Euro area (Greece, Portugal, Ireland, Spain and Italy) face two, interconnected challenges. They need to: (i) regain competitiveness (so as to effect external adjustment) and (ii) correct large public-sector deficits and debts. But dealing with one imbalance is likely to exacerbate the other. Why? With a single currency, regaining competitiveness relies largely on running lower inflation than the Euro area average to adjust the real exchange rate. But stronger nominal GDP growth is needed to address fiscal problems and put public debt on a sustainable path. The low inflation (or deflation) required to regain competitiveness will exacerbate fiscal difficulties.

Given the interconnection between external and fiscal adjustments in the Euro area, it makes sense to consider these challenges jointly. This is the third in a series of articles—‘Achieving Fiscal and External Balance’—that aims to do just that.

In Part 3, we consider the impact on public debt dynamics of our estimates of the required real depreciation (derived in Part 1) and output loss (from Part 2). Over 10 years, these two effects imply an increase in the debt-to-GDP ratio of around 35ppt in Portugal, 30ppt in Greece, 10ppt-15ppt in Spain and France, 5ppt in Italy, but zero in Ireland. Expressed in terms of the required fiscal primary deficit, Greece and Portugal need an improvement of 1.5ppt-2ppt, France and Spain 0.5ppt, and Italy around ¼ppt.

Weak potential growth exacerbates these adjustment challenges. Given the limits to fiscal consolidation, our calculations highlight the need for structural reforms if the peripheral rebalancing is to succeed.


0

2

4

6

8

10

12

POR ITA IRE GRC FRA ESP GER

pt of GDP

Weaker* potential growth raises debt-to-GDP by 5-10ppt by 2020

Impact on debt-to-GDP in 2020 from weaker-than-base-case growth

Source: GS Global ECS Research, *Relative to IMF base-case for POR, IRE and GRC and EWA 12/06 base-base for ITA, FRA and ESP with growth assumed 1ppt lower in POR;0.5ppt lower in elsewhere (excl. GER)

-15

-5

5

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25

35

45

POR GRC ESP FRA ITA IRE GER

ppt of GDP Impact on debt-to-GDP in 2020 from weaker price developments*

Source: GS Global ECS Research, *Relative to base-case with weaker potential growth. GRC includes additional output loss required toachieve full real depreciation

Real exchange rate depreciation and internal devaluation raise debt-to-GDP in periphery

There will be no European Economics Analyst next week. The next issue will be published on April 12.

March 29, 2012 Issue No: 12/03 2


Part 3: External adjustment, weaker prices and public debt To a greater or lesser extent, peripheral countries in the Euro area (Greece, Portugal, Ireland, Spain and Italy) face two, interconnected challenges. They need to: (i) regain competitiveness (so as to effect external adjustment) and (ii) correct large public-sector deficits and debts. Countries addressing these ‘twin imbalances’ within a monetary union confront a ‘Catch 22’: dealing with one imbalance is likely to exacerbate the other. Why? With a single currency, regaining competitiveness relies largely on running lower inflation than the Euro area average to adjust the real exchange rate. But stronger nominal GDP growth is needed to address fiscal problems and put public debt on a sustainable path. The low inflation (or deflation) required to regain competitiveness will exacerbate fiscal difficulties.

Given the interconnection between external and fiscal adjustments in the Euro area, it makes sense to consider the challenges of correcting the imbalances jointly. This is the third in a series of articles—‘Achieving Fiscal and External Balance’—which aims to do just that.

In the first article in the series, we estimated the relative price adjustment that peripheral economies need to make in order to return their economies to ‘external sustainability’.1 In the second article, we looked at how much ‘pain’ will be required (in terms of output gaps and cyclical weakness) in order for these adjustments in price competitiveness to take place.2 This week, we look at how the process of regaining competitiveness will interact—both directly and indirectly—with fiscal adjustment in these economies. This analysis builds on our previous work in the area of fiscal adjustment and debt sustainability.3

The interaction between the adjustment to external and fiscal sustainability takes place across two dimensions:

There is a direct interplay between the downward price adjustment and the effect this has on nominal GDP (and thus on deficit- and debt-to-GDP dynamics).

There is an indirect interplay between the negative output gap required to bring about the relative price adjustment and the effect this cyclical weakness has on fiscal ratios.

Debt dynamics 101 To understand the interplay between the factors driving the government debt-to-GDP ratio, note that the numerator, public debt in Euros, evolves by adding interest cost to and subtracting the primary balance4 from the previous period’s debt stock (see Box).

The denominator of the ratio is nominal GDP in Euros, reflecting the size of the economy and its tax base. These measures provide a gauge of the government’s ability to service its debt. Nominal GDP growth, g, is given as the sum of real GDP growth, r, and inflation (given by the GDP deflator), π. Thus the debt ratio depends negatively on both real growth and inflation.

The direct effect from internal devaluation works by lowering nominal growth, g, via a lower inflation rate, π. But in order to achieve lower prices, real GDP growth must decline. Hence, an indirect effect also exists that reduces g via a lower r. Lower real GDP would most likely also affect the primary balance directly through the automatic stabilisers (higher expenditures from unemployment benefits and lower tax receipts). In our calculation, however, we assume that such shortfalls are corrected. This creates a feedback loop to the real economy, where austerity further depresses real GDP and prices. We consider the ‘reduced form’ outcome of combinations of the primary balance, prices and growth, although it may be the case that primary balance targeting results in an ‘overshoot’ of the output loss.

This illustrates that in order to make up for a smaller denominator (lower nominal GDP), the numerator must fall via: (i) a rise of the primary surplus, (ii) a decline of the debt cost, and / or (iii) a write-down of the existing debt stock.

Of course, lower nominal growth can also in itself be countered by improving the supply side of the economy through structural reforms. As noted previously1,2, in this exercise we calculate a benchmark for rebalancing assuming the absence of such reforms.5

1. See ‘European Economics Analyst: 12/01 - Achieving fiscal and external balance (Part 1): The price adjustment required for external sustainability’ March 15, 2012.

2. See ‘European Economics Analyst: 12/02 - Achieving fiscal and external balance (Part 2): The price of competitiveness’ March 22, 2012. 3. See ‘European Weekly Analyst: 12/06 - Fiscal adjustment: Primary deficits and debt sustainability’ February 9, 2012. 4. Costs or receipts from privatisations, bank recapitalisations and recognitions of contingent liabilities are usually not included in the primary

balance. However, from a debt dynamics perspective, these flows can be considered part of the primary surplus, which thus may spike in certain years as e.g. sales of government assets are recorded. Other stock-and-flow adjustments are usually small when excluding debt restructurings.

5. As the empirical evidence on fiscal devaluations is uncertain (see IMF Fiscal Monitor Sep. 2011, Appendix 1), we abstract from this channel.

Box: Debt dynamics 101 Denote public debt at the end of period t, Bt, the interest on public debt i and the government’s primary balance in period t, Pt. Thus Bt = (1+ i)Bt-1 - Pt. Let nominal GDP be given as Yt = (1+g)Yt-1, where g denotes the nominal growth rate. Then Bt / Yt = (1+ i)Bt-1 / Yt - Pt / Yt. Let the lower-case denote that the variable is scaled relative to nominal GDP and rearrange to obtain the debt-to-GDP ratio as: Bt / Yt ≡ bt = [(1+i) / (1+g)]bt-1 - pt. Decomposing g into real GDP growth, r, and inflation, π, means that bt = [(1+i) / (1+ r + π)] bt-1 - pt.

March 29, 2012 Issue No: 12/03 3


The impact of price adjustments on public debt In Part 1 of this series we found that the largest required real exchange rate depreciation is in Portugal and Greece (about 35% and 30%, respectively). Sizable adjustments are needed in Spain and France (around 20%), with more limited depreciation required in Italy (10%-15%) and, in particular, in Ireland (close to zero). In Part 2, reflecting these differences as well as country-specific sacrifice ratios, we found that the required output loss to generate lower prices is greatest in Greece, somewhat smaller in Portugal and more muted elsewhere (Table 1, upper row).

Our point of departure is the base-case scenario in the published IMF reviews in the three programme countries. For Italy, Spain and France, we use our own base-case.6

These base-case scenarios assume there is an impact from structural reforms on potential output. But, as noted above, we calculate a benchmark for the required adjustment absent such reforms. We adjust the IMF’s and our own base-case so that growth converges to just 1% in Greece, Portugal, Italy and Spain, to about 1.5% in France and to 2% in Ireland. This lower growth path (by 1ppt in Portugal, for example) should mimic a situation in which the structural reform process stalls. Based on this path for potential growth from 2010, actual output would be about 8% lower than potential in 2020 in Greece and Portugal. Other notable losses would have occurred in Italy and Spain, while the loss would be small in France and Ireland (Table 1, lower row). Compared with the required output losses calculated in Part 2, these base-cases already contain sufficient output declines to force prices down sufficiently—with the exception of Greece.

While the output adjustment implicit in these base-cases is mostly sufficient, prices need to fall more than assumed. With aggregate Euro area inflation of 2%, the IMF base-case for 2010 to 2020 would see the price level for Greece and Portugal move ‘only’ 11% and 4% lower, respectively, relative to the rest of the Euro area—much below the requirement identified in Part 1.

Adding the weaker potential growth assumption (and in the case of Greece, a further output loss) to the price adjustment, we can simulate the denominator effect on the debt-to-GDP paths relative to the base-case (Charts 1-7).

For Portugal and Greece, the debt-to-GDP ratio is around 35ppt and 30ppt higher, respectively, than in the IMF base-case, due to the price adjustment. While this increase

is entirely driven by the weaker GDP deflator in Portugal, further output compression accounts for around a third of the increase in Greek debt (Charts 1-2).7

As the real exchange rate depreciation requirement is also sizable in Spain and France, adjustment implies their debt-to-GDP ratios rise by around 10ppt-15ppt by 2020 (Charts 3-4).

The smaller adjustment requirement in Italy, and notably in Ireland, implies that the debt-to-GDP increase is limited (5ppt in Italy and about zero in Ireland). Indeed, prices should rise slightly faster in Ireland compared with the IMF’s base-case in order for the real exchange rate depreciation not to be larger than needed (Charts 5-6).

Lastly, the flipside of the internal devaluation in the Euro area periphery is a real exchange rate appreciation in Germany. Accounting for higher inflation in Germany lowers the public debt-to-GDP ratio by an order of 10ppt-15ppt relative to our base-case scenario (Chart 7).8

While the weaker nominal GDP raises debt ratios, the trajectory is still downward-sloping in Greece, Italy and Ireland. For Portugal and Spain, debt-to-GDP rises notably in the 10-year adjustment period, while France sees a modestly upward-sloping debt path. From the completion of the adjustment in 2020, debt-to-GDP declines in Portugal and France, but not in Spain.

Finally, our lower potential growth assumption raises the debt ratio 10ppt by 2020 in Portugal, and 5ppt elsewhere.

How to make up for the lost denominator As we noted above, the denominator effect from lost nominal output can be mitigated through the numerator. Excluding the debt write-down option, in order to maintain the required debt ratio, a primary balance improvement is needed to make up for lost nominal GDP (as debt servicing costs are neither government determined nor likely to decrease).

This raises two questions: (i) How much does the primary balance need to adjust to make up for the weaker prices and growth identified in Part 1 and Part 2? And, (ii) how much does the primary balance need to adjust to make up for lower potential growth in the absence of structural reforms?

(i) Relative to current targets, the primary balance needs to rise by around 1.5ppt-2ppt in Portugal and Greece, and by around 0.5ppt in Spain and France to make up

6. We use the base-case assumptions from IMF country report 12/59 (Greece), 11/353 (Portugal) and 12/48 (Ireland). Our base-case assumptions for Italy, Spain and France are taken from European Weekly Analyst 12/06, February 9, 2012.

7. The larger price decline in the IMF base-case for Greece relative to Portugal explains why the impact of lower prices on debt seems disproportionally larger in Portugal than in Greece.

8. Our base-case scenario for Germany has real GDP growth at 1.5% and a primary surplus of 2.5% of GDP from 2015.

Table 1: Output lossesGreece Ireland Spain Portugal Italy Germany France

Estimated loss to regain competitiveness* 11.9% 0.0% 0.8% 5.6% 0.2% n.a. 1.4%

Projected loss in base-case** 8.1% 0.3% 5.8% 9.0% 5.9% n.a. 2.7%

Source: GS Global ECS Research, *See EEA 12/02 for more details. **From 2010 to 2020 and relative to potential grow th. Real grow th assumed 0.5ppt low er than in IMF's base-case for GRC, IRE, and 1ppt for POR from 2012; real grow th 0.5ppt low er than our base-case from 2012 (see EWA 12/06 ) for ITA, ESP and FRA. Potential grow th assumed 1% for GRC, POR, ITA and ESP, 1.4% for FRA and 2% for IRE.

March 29, 2012 Issue No: 12/03 4


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140

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1999 2004 2009 2014 2019 2024 2029

Gov. debt, % of GDP

Chart 1: Portugal

IMF base-case (with weaker growth)*IMF base-casePrice and output adj. in 10 yr**

Projections

10 years

Source: GS Global ECS Research, *IMF assump. on infl., avg. int. rate, prim. bal. and priv. receipts. Real GDP growth 1ppt. lower than IMF path. **Assump. as in IMF base-case (with weaker growth) after 2020

Effect from weaker-than-'base-case' inflation

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1999 2004 2009 2014 2019 2024 2029

Gov. debt, % of GDP

Chart 2: Greece

IMF base-case (with weaker growth)*IMF base-case Price and output adj. in 10 yr** Price adj. in 10 yr**

Source: GS Global ECS Research, *IMF assump. on infl., avg. int. rate, prim. bal. and priv. receipts. Real GDP growth 0.5ppt. lower than IMF path. ** Assump. as in IMF base-case (with weaker growth) after 2020

Projections


10 years

Effect from weaker-than-base-case inflation and output

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1999 2004 2009 2014 2019 2024 2029

Gov. debt, % of GDP

Chart 3: Spain

Base-case (with weaker growth)**Base-case*Price and output adj. in 10yr***

Projections

10 years

Source: GS Global ECS Research, *Base-case assump. from EWA 12/06, **with 0.5ppt lower growth. *** with price adj.; assump. as in base-case (with weaker growth) after 2020.

Effect from weaker-than-base-case inflation

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1999 2004 2009 2014 2019 2024 2029

Gov. debt, % of GDP

Chart 4: France

'Base-case' (with weaker growth)**'Base-case'*Price and output adj. in 10yrs ***

Projections10 years



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1999 2004 2009 2014 2019 2024 2029

Gov. debt, % of GDP

Chart 5: Italy

Base-case (with weaker growth)**Base-case*Price and output adj. in 10yrs ***

Projections

10 years


Effect from weaker-than-base-case inflation

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140

1999 2004 2009 2014 2019 2024 2029

Gov. debt, % of GDP

Chart 6: Ireland

IMF base-case (with weaker growth)*IMF Base-casePrice and output adj. in 10 yr**

Projections

10 years

Source: GS Global ECS Research, *IMF assump. on infl., avg. int. rate, prim. bal. Real GDP growth 0.5ppt. lower than IMF path. ** Assump. as in IMF base-case (with weaker growth) after 2020

Greece’s base-case already has price declines, but further output losses would raise debt-to-GDP by 30ppt.

In Portugal, a 35% internal devaluation would see debt-to-GDP rise by 35ppt by 2020 relative to the base-case.

Italy’s price adjustment is more limited, lifting the debt-to-GDP ratio by just 5ppt.

Prices in Ireland are already projected to be weak enough to account fully for its limited depreciation need.

...and in France. But unlike Spain, France has a downward sloping debt-to-GDP after the adjustment period.

The smaller required price adjustment raises the debt-to-GDP ratio by ‘only’ 10ppt-15ppt in Spain...

March 29, 2012 Issue No: 12/03 5


for the lower prices. Italy’s requirement is about half that of Spain and France, and it is zero for Ireland.

(ii) An increase of around 1ppt in the primary balance is required in Portugal, and about 0.5ppt elsewhere, to reverse the impact of lower potential growth.

But even correcting for weaker prices and lower potential growth, the base-case may not be sustainable in some cases. Assuming that the 60% debt-to-GDP threshold is to be reached over 20 years, the primary balance would, subject to the government’s financing cost, need to be tightened by around a further 1ppt in Spain and 0.5ppt in Greece. Elsewhere, no further consolidation seems necessary.

So in the absence of structural reforms and accounting for both weaker inflation and weaker potential growth, achieving a 60% debt-to-GDP ratio would represent quite a challenge. Summing up the different effects, the primary

balance needs to rise in addition to the base-case path by 3ppt in Greece and Portugal and by 2ppt-2.5ppt in Spain. Elsewhere, the required adjustment is smaller: about 1ppt in France, 0.5ppt-1ppt in Italy and just 0.5ppt in Ireland.

As the pace of austerity across the periphery is already close to the ‘speed limit’ we have identified in previous research9, there is little scope for improving the budget balance in the short run through fiscal consolidation. With the exception of Spain, the targeted primary balances are already quite high, and thus the scope for major improvements here are limited. (Table 2 summarises, as a function of nominal growth and interest rates, the primary balance required if we depart from the base-case debt peak in 2013/14, either to (i) stabilise debt-to-GDP or (ii) reach the 60% threshold). In particular, it appears to be difficult for Greece and Portugal to make up these primary balance improvements.

The market may, of course, be willing to finance these debt-to-GDP paths, particularly if debt-to-GDP is on a fairly rapid downward-sloping trajectory. But a reasonably quick public debt reduction only occurs in Greece, Portugal, Spain and France if the denominator effect is reversed by sizable primary balance improvements. And in Spain, more is needed for the base-case debt-to-GDP path to decline reasonably rapidly.

This highlights the role of structural reforms as a less ‘painful’ way of reversing these upward pressures on public debt. As we highlighted in Part 1, structural reforms aimed at raising output in the tradables sector seems particularly fruitful, as this would reduce the initial real exchange rate adjustment requirement, and thus the initial ‘Catch 22’ between external adjustment and public-sector debt sustainability.

Lasse Holboell W. Nielsen

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1999 2004 2009 2014 2019 2024 2029

Gov. debt, % of GDP

Chart 7: Germany: Inflation above 2% implies primary balance can be lowered 2ppt

Base-case*Price adj. 10 yrs**

Projections

10 years

Source: GS Global ECS Research, *Using GS f'cast to 2013; from 2015, nom growth at 3.5%, prim. bal at 2.5% of GDP and debt issuance cost of 3.5%. **Assump. as in base-case after 2020

Effect from higher-than-base-case inflation

9. See “The Speed Limit of Fiscal Consolidation” Global Economics Paper 207 and “Peripheral consolidation: Probable but painful” European Weekly Analyst 11/27, July 29, 2011.

Nom. interest rate (i) / Nom. growth (g): i: 4.0% 5.0% 6.0% 4.0% 5.0% 6.0% 4.0% 5.0% 6.0% 4.0% 5.0% 6.0% 4.0% 5.0% 6.0% 4.0% 5.0% 6.0% 4.0% 5.0% 6.0%

g:

0.0% 6.7 8.4 10.0 4.7 5.9 7.1 3.3 4.1 4.9 4.7 5.9 7.1 5.0 6.2 7.5 3.2 3.9 4.7 3.7 4.6 5.5

1.0% 5.0 6.6 8.3 3.5 4.7 5.9 2.4 3.3 4.1 3.5 4.7 5.8 3.7 4.9 6.2 2.3 3.1 3.9 2.7 3.7 4.6

2.0% 3.3 4.9 6.6 2.3 3.5 4.6 1.6 2.4 3.2 2.3 3.5 4.6 2.4 3.7 4.9 1.5 2.3 3.1 1.8 2.7 3.6

3.0% 1.6 3.2 4.9 1.1 2.3 3.4 0.8 1.6 2.4 1.1 2.3 3.4 1.2 2.4 3.6 0.8 1.5 2.3 0.9 1.8 2.7

4.0% 0.0 1.6 3.2 0.0 1.1 2.3 0.0 0.8 1.6 0.0 1.1 2.3 0.0 1.2 2.4 0.0 0.8 1.5 0.0 0.9 1.8

5.0% -1.6 0.0 1.6 -1.1 0.0 1.1 -0.8 0.0 0.8 -1.1 0.0 1.1 -1.2 0.0 1.2 -0.8 0.0 0.8 -0.9 0.0 0.9

0.0% 10.3 11.6 13.0 6.7 7.7 8.7 4.0 4.8 5.5 6.7 7.7 8.7 7.2 8.2 9.2 3.8 4.5 5.3 4.8 5.6 6.4

1.0% 9.0 10.2 11.5 5.7 6.7 7.6 3.3 4.0 4.8 5.7 6.6 7.6 6.1 7.1 8.1 3.1 3.8 4.5 4.0 4.7 5.6

2.0% 7.7 8.9 10.2 4.7 5.7 6.6 2.5 3.3 4.0 4.7 5.6 6.6 5.1 6.1 7.1 2.3 3.0 3.7 3.1 3.9 4.7

3.0% 6.5 7.7 8.9 3.8 4.7 5.6 1.8 2.5 3.2 3.8 4.7 5.6 4.2 5.1 6.1 1.6 2.3 3.0 2.4 3.1 3.9

4.0% 5.4 6.5 7.7 2.9 3.8 4.7 1.1 1.8 2.5 2.9 3.8 4.7 3.2 4.2 5.1 0.9 1.6 2.3 1.6 2.4 3.1

5.0% 4.3 5.4 6.5 2.1 2.9 3.8 0.4 1.1 1.8 2.1 2.9 3.8 2.4 3.2 4.1 0.3 0.9 1.6 0.9 1.6 2.4Source: GS Global ECS Research, * Does not include privitisation receipts. For Greece, the receipts are expected to average about 2ppt of GDP through 2022. ** IMF base-case for GRC, POR and IRE and EWA 12/06 'base-case' for ITA, FRA and ESP. Current government targets for the primary balance (in % of GDP) after 2013/14 are: 4.5% in GRE (falling to 3.5% by 2030), 3% in POR (rising to 4.1% by 2030), 0.8% in IRE (rising to 3% by 2016), about 5.5% in ITA, 1% in ESP, 2% in FRA and 2.5% in GER.

--------------------------------------- Government primary balance needed to stabilise debt at 2013/14 levels ----------------------------------------

--------------------------- Government primary balance needed to obtain public debt at 60% in 20 years from 2013/14 ----------------------------

------ Germany ------------ Portugal ------------ Greece ------ ------ Ireland ------ ------ Spain ------ ------ Italy ------ ------ France ------

Table 2: Required primary balance* from base-case debt peak in 2013/14** as a function of nom. interest rate and growth

6




...and our Current Activity Indicator suggests positive growth in the UK.

Our survey-based GDP tracker points to very modest positive growth in the Euro area...

We expect a significant convergence in Euro area and UK inflation in 2012, to rates below 2%.


Business sentiment softens. European financial conditions are easy, with the exception of Switzerland.

92

94

96

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112



Euro area

UK

Switzerland

Sweden

Norway


TighterConditions

Index Jul. 2008=100

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Euro area Composite PMIUK Composite PMISwitzerland Manuf. PMISweden Manuf. PMI


-3.0

-2.5

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% qoq

Actual GDP




-1

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UK Headline CPI


GS Forecast

-0.5

-0.4

-0.3

-0.2

-0.1

0.0

0.1

0.2

0.3

05 06 07 08 09 10 11 12


Euro area (3m mav.)

UK (3m mav.)


-3.0

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

99 00 01 02 03 04 05 06 07 08 09 10 11 12


Actual GDP



7



We, Lasse Holboell W. Nielsen and Adrian Paul, hereby certify that all of the views expressed in this report accurately reflect personal views, which have not been influenced by considerations of the firm’s business or client relationships. Global product; distributing entities The Global Investment Research Division of Goldman Sachs produces and distributes research products for clients of Goldman Sachs on a global basis. Analysts based in Goldman Sachs offices around the world produce equity research on industries and companies, and research on macroeconomics, currencies, commodities and portfolio strategy. This research is disseminated in Australia by Goldman Sachs Australia Pty Ltd (ABN 21 006 797 897); in Brazil by Goldman Sachs do Brasil Corretora de Títulos e Valores Mobiliários S.A.; in Canada by Goldman Sachs Canada & Co. regarding Canadian equities and by Goldman Sachs & Co. (all other research); in Hong Kong by Goldman Sachs (Asia) L.L.C.; in India by Goldman Sachs (India) Securities Private Ltd.; in Japan by Goldman Sachs Japan Co., Ltd.; in the Republic of Korea by Goldman Sachs (Asia) L.L.C., Seoul Branch; in New Zealand by Goldman Sachs New Zealand Limited; in Russia by OOO Goldman Sachs; in Singapore by Goldman Sachs (Singapore) Pte. (Company Number: 198602165W); and in the United States of America by Goldman, Sachs & Co. Goldman Sachs International has approved this research in connection with its distribution in the United Kingdom and European Union. European Union: Goldman Sachs International, authorised and regulated by the Financial Services Authority, has approved this research in connection with its distribution in the European Union and United Kingdom; Goldman, Sachs & Co. AG, regulated by the Bundesanstalt für Finanzdienstleistungsaufsicht, may also distribute research in Germany. General disclosures This research is for our clients only. Other than disclosures relating to Goldman Sachs, this research is based on current public information that we consider reliable, but we do not represent it is accurate or complete, and it should not be relied on as such. We seek to update our research as appropriate, but various regulations may prevent us from doing so. Other than certain industry reports published on a periodic basis, the large majority of reports are published at irregular intervals as appropriate in the analyst's judgment. Goldman Sachs conducts a global full-service, integrated investment banking, investment management, and brokerage business. We have corporate advisory, corporate finance and other business relationships with a substantial percentage of the companies covered by our Global Investment Research Division. Goldman Sachs & Co., the United States broker dealer, is a member of SIPC (http://www.sipc.org). Our salespeople, traders, and other professionals may provide oral or written market commentary or trading strategies to our clients and our proprietary trading desks that reflect opinions that are contrary to the opinions expressed in this research. Our asset management area, our proprietary trading desks and investing businesses may make investment decisions that are inconsistent with the recommendations or views expressed in this research. The analysts named in this report may have from time to time discussed with our clients, including Goldman Sachs salespersons and traders, or may discuss in this report, trading strategies that reference catalysts or events that may have a near-term impact on the market price of the equity securities discussed n this report, which impact may be directionally counter to the analysts’ published price target expectations for such stocks. Any such trading strategies are distinct from and do not affect the analysts’ fundamental equity rating for such stocks, which rating reflects a stock’s return potential relative to its coverage group as described therein. We and our affiliates, officers, directors, and employees, excluding equity and credit analysts, will from time to time have long or short positions in, act as principal in, and buy or sell, the securities or derivatives, if any, referred to in this research. This research is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. Clients should consider whether any advice or recommendation in this research is suitable for their particular circumstances and, if appropriate, seek professional advice, including tax advice. The price and value of investments referred to in this research and the income from them may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Fluctuations in exchange rates could have adverse effects on the value or price of, or income derived from, certain investments. Certain transactions, including those involving futures, options, and other derivatives, give rise to substantial risk and are not suitable for all investors. Investors should review current options disclosure documents which are available from Goldman Sachs sales representatives or at http://www.theocc.com/about/publications/character-risks.jsp. Transaction costs may be significant in option strategies calling for multiple purchase and sales of options such as spreads. Supporting documentation will be supplied upon request. In producing research reports, members of the Global Investment Research Division of Goldman Sachs Australia may attend site visits and other meetings hosted by the issuers the subject of its research reports. In some instances the costs of such site visits or meetings may be met in part or in whole by the issuers concerned if Goldman Sachs Australia considers it is appropriate and reasonable in the specific circumstances relating to the site visit or meeting. All research reports are disseminated and available to all clients simultaneously through electronic publication to our internal client websites. Not all research content is redistributed to our clients or available to third-party aggregators, nor is Goldman Sachs responsible for the redistribution of our research by third party aggregators. For all research available on a particular stock, please contact your sales representative or go to http://360.gs.com. Disclosure information is also available at http://www.gs.com/research/hedge.html or from Research Compliance, 200 West Street, New York, NY 10282. © 2012 Goldman Sachs. All rights reserved. No part of this material may be (i) copied, photocopied or duplicated in any form by any means or (ii) redistributed without the prior written consent of The Goldman Sachs Group, Inc.









April 12, 2012



Achieving Fiscal and External Balance (Part 4): Escaping the vicious circle This is the final article in a series assessing the challenge faced by Euro area countries in achieving external and fiscal balance. The story we have told so far is predominantly one of cyclical adjustment within constraints imposed by the structural parameters of these economies. Our results suggest that, for some Euro area countries—notably Greece and Portugal, but arguably Spain as well—the task of regaining fiscal and external balance through cyclical adjustment alone appears large, to the point of being insurmountable.

But the story does not end here. Well-designed structural reform could change the structural parameters of these economies in ways that would alleviate the trade-off that they face. Indeed, such is the severity of the ‘all else equal’ scenario set out in Parts 1-3 of this series that, for a number of these economies, structural reform provides the only realistic prospect of making the adjustment work. The need for reform is not exclusive to the periphery: Germany and France also have important work in this area.

The implementation of structural reform is also painful and the alternative—which could come about through choice or by default—would be to allow the break-up of EMU. Our own view remains that the likelihood of this outcome is low because the political commitment to EMU (and to structural reform) is strong and the cost of break-up would be high.

The good news is that in some of the peripheral economies—notably Portugal, Spain and Italy—progress has been made in implementing structural reforms. But these countries are still closer to the beginning of this journey than to the end, and the road ahead is likely to remain difficult.


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Achieving Fiscal and External Balance (Part 4): Escaping the vicious circle Achieving Fiscal and External Balance To a greater or lesser extent, peripheral countries in the Euro area (Greece, Portugal, Ireland, Spain and Italy) face two, interconnected challenges. They need to: (i) regain competitiveness (so as to effect external adjustment) and (ii) correct large public-sector deficits and debts. Countries addressing these ‘twin imbalances’ within a monetary union confront a ‘Catch 22’: dealing with one imbalance is likely to exacerbate the other. Why? With a single currency, regaining competitiveness relies largely on running lower inflation than the Euro area average to adjust the real exchange rate. But stronger nominal GDP growth is needed to address fiscal problems and put public debt on a sustainable path. The low inflation (or deflation) required to regain competitiveness will exacerbate fiscal difficulties.

Given the interconnection between external and fiscal adjustments in the Euro area, it makes sense to consider the challenges of correcting the imbalances together. This is the fourth (and final) article in a series—Achieving Fiscal and External Balance—that aims to do just that.

A summary of our results: A demanding benchmark In the first article in this series, we estimated the relative price adjustment that peripheral economies will be required to make in order to return their economies to ‘external sustainability’.1 We found that Portugal requires the largest relative price adjustment (around 35%) to achieve external balance, while the equivalent figure is just below 30% for Greece and just above 20% for Spain (Chart 1). On our ‘base-case’ estimate, Italy’s real exchange rate depreciation figure is considerably smaller,

at around 10%-15%, while Ireland’s adjustment appears broadly complete.

In the second article, we considered how much ‘pain’ is likely to be required in peripheral economies—in terms of output and employment sacrificed—to achieve the required price adjustments estimated in Part 1.2 We based this assessment on estimated ‘sacrifice ratios’—which relate reductions in inflation to output losses (or rises in unemployment). Assuming a ten-year adjustment period, the implied additional output losses relative to trend (i.e., over and above those already suffered) are large in Greece and Portugal (with estimates ranging from 5% to 10% of GDP; Chart 2). That reflects both the scale of adjustment required in those countries and their high estimated sacrifice ratios. In Italy and Spain, where inflation is already at or below the Euro area average, much of the adjustment in output relative to trend already appears complete. In Germany, sustained above-trend output growth is required to drive inflation higher.

In the third article, we described how the process of regaining competitiveness through relative price adjustment interacts with the fiscal adjustments that are also underway in these economies.3 We considered the impact on public debt dynamics of our estimates of the required real depreciation (derived in Part 1) and output loss (from Part 2). Over 10 years, these two effects imply an increase in the debt-to-GDP ratio of around 35ppt in Portugal, 30ppt in Greece, 10ppt-15ppt in Spain and France, 5ppt in Italy, but zero in Ireland (Chart 3). Expressed in terms of the required primary deficit to stabilise the fiscal situation, Greece and Portugal need an improvement of 1.5ppt-2ppt, France and Spain 0.5ppt, and Italy around 0.25ppt.

1. “Achieving Fiscal and External Balance (Part 1): The price adjustment required for external sustainability”, European Economics Analyst, March 15, 2012.

2. “Achieving Fiscal and External Balance (Part 2): The price of competitiveness”, European Economics Analyst, March 22, 2012. 3. “Achieving fiscal and external balance (Part 3): External adjustment, weaker prices and public debt”, European Economics Analyst, March 29, 2012.

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April 12, 2012 Issue No: 12/04 3


How do these results compare with financial markets’ perception of each country (as reflected, for instance, in government bond spreads)? Greece—perhaps unsurprisingly—emerges relatively badly from this analysis. More surprising is that Portugal performs just as poorly as Greece on a number of metrics. Our analysis also suggests that the challenge faced by Spain to regain fiscal and external balance is significantly more arduous than that faced by Italy (something that has been reflected in the recent trading recommendations from our markets group). Ireland comes out relatively well: while its fiscal challenge remains large, the task of regaining external balance is complete. Finally, while France’s fiscal and internal imbalances are significantly smaller than those in the peripheral economies, the small size of its tradables sector implies that large relative price adjustments are needed to re-establish a sustainable external balance.

Escaping the vicious circle Our focus in this article is on whether policymakers—at the national and Euro area level—have the means to ease the painful adjustment that they currently face. For some Euro area countries—notably Greece and Portugal, but arguably Spain as well—the task of regaining fiscal and external balance implied by our analysis (so far) appears large, to the point of being insurmountable. Were our analysis to end here, it would suggest that—at best—these peripheral economies face a prolonged period of exceptional economic weakness while the required adjustments take place.

However, this is not the end of the story. The estimates provided in Parts 1-3 of this series provide a realistic benchmark of the challenge that Euro area countries face on an ‘all else equal’ basis. The story we have told so far

is predominantly one of cyclical adjustment within the constraints imposed by the structural parameters of these economies. But all else need not be equal: well-designed structural reform could change the structural parameters of these economies in ways that could alleviate the trade-off that they face. Indeed, such is the severity of the ‘all else equal’ scenario set out in Parts 1-3 that, for a number of these economies, structural reform provides the only realistic prospect of making the adjustment work.

What can Euro area countries do to reduce the ‘pain’ of these adjustments implied by our analysis? Specifically, what are the parameters that need to change and what are the structural reforms that can deliver the required changes to those parameters? We focus on the task of regaining external competitiveness, as it is the negative feedback from this to deficit and debt dynamics which exacerbates the task of regaining fiscal balance.4

We set out the parameters of the problem using a standard Phillips curve relationship that links the size of the output gap (or the level of unemployment) to inflation (Chart 4). Inflation tends to fall when an economy is cyclically weak (i.e., there is a negative output gap), and it tends to rise when an economy is operating above capacity. However, for most economies, the relationship between spare capacity and inflation that the Phillips curve describes is not linear: even if the output gap turns significantly negative, inflation typically struggles to fall below zero. This downward price rigidity at large negative output gaps reflects the importance of the 0% nominal threshold in the setting of prices and the fact that nominal wages, in particular, are rigid downwards (i.e., workers are less prepared to accept a 1% decline in nominal wages when inflation is zero than a 1% rise in wages when inflation is 2%).5 In economies where there

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4. This leaves aside the question of how the fiscal correction should be designed in order to minimise the damage that it inflicts on the economy. Cross-country evidence suggests that growth tends to fare better in fiscal corrections driven by reductions in current spending rather than those driven by higher taxes or cuts in investment. See, “Limiting the fall-out of fiscal adjustment”, Global Economics Paper No. 195, April 14, 2010.

5. Because economies face sectoral and regional shocks over time that necessitate relative adjustments in real wages, the reluctance of all workers to accept nominal wage cuts results in overall inflation stickiness kicking in at a level above 0% (put another way, the truncation of the distribution at zero results in the mean of the distribution becoming sticky at a rate well above zero). The evidence of the 0% bound exists in both micro and macro data. For instance, in a cross-sectional distribution of pay-settlements data, there is typically a large clumping together of results at 0%. For a review of the empirical evidence in this regard, see Holden and Wulfsberg, 2007, “Are Real Wages Rigid Downwards?”, CESifo Working Paper Series No. 1983.

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Source: GS Global ECS Research, *Relative to IMF base-case for POR, IRE and GRC, and EWA 12/06 base-base for ITA, FRA and ESP, with growth assumed 1ppt lower in POR;0.5ppt lower in elsewhere (excl. GER)

April 12, 2012 Issue No: 12/04 4


is a high degree of flexibility in the setting of wages and other prices, the importance of the 0% threshold typically appears less pronounced.6

That the Phillips curve tends to be flat at large negative output gaps is one reason why the task of regaining external competitiveness through cyclical forces alone is very difficult. Starting off from Point A in Chart 4, the decline in inflation implied by the transition to Point B starts the process of regaining competitiveness. But, as the output gap turns increasingly negative (Point C), the additional benefit in terms of lower inflation is small. No matter how weak the economy becomes, it takes a long time for competitiveness to be regained if inflation does not turn negative.

The Phillips curve sets out—in a stylised sense—the structural parameters of the adjustment problem. How can these parameters be altered to ease the adjustment process? There are two ways this can occur:

Adjusting the slope of the Phillips curve: Chart 5 shows how the situation would differ if the Phillips curve did not flatten out as the output gap turns negative. If wage growth is responsive to labour market weakness, then unemployment will need to rise by less to bring about the required competitiveness adjustment. (In Chart 5, as the economy weakens, it transitions to Points B’ and C’, where inflation is lower than B and C and, thus, the ‘pain’ required to regain competitiveness is less.) The example of Ireland—where inflation and nominal wages both turned negative during the recession—showed that this is possible given sufficient flexibility in the setting of wages and other prices. Labour market reform can improve the unemployment-inflation trade-off in this way, if it increases flexibility and increases the labour market’s ability to adjust to negative shocks once they occur.

And, as Andrew Benito argued in a recent piece, a more flexible labour market also implies a reduced impact from fiscal austerity on growth.7

Shifting the position of the Phillips curve: A shift in the Phillips curve to the right—displayed in Chart 6—would imply an improved trade-off between the output gap and inflation at all points along the curve. Such a move would imply higher output, for a given inflation rate. What could induce such a shift? Labour market reform, in addition to increasing the ability to adjust to shocks once they occur, can also bring about such a move by pushing up average employment rates. An increase in whole-economy productivity growth would also result in a rightward shift in the Phillips curve. However, while there is a fairly direct link between well-designed labour market reforms and labour market outcomes, productivity growth is more difficult for governments to influence directly. An added complication is that, while higher whole-economy productivity growth would clearly improve the trade-off that the peripheral countries face, higher productivity growth in the ‘wrong’ sectors could have the effect of exacerbating external imbalances.8 As we discussed in Part 1 of this series, the peripheral economies require a rebalancing in output from the non-traded to the traded sectors, while Germany requires the converse adjustment. To increase the elasticity between traded and non-traded sectors in peripheral economies and Germany alike, structural reform in the peripheral states should focus on the traded sectors, while reform in Germany should focus on non-traded sectors, such as services. In this respect, reforming Germany’s retail sector, for example, could play just as important a role in rebalancing the Euro area economy as improving productivity in the periphery’s traded sector.

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6. Different labour market structures create their own individual complexities. In Spain, for instance, the dual labour market structure results in a sharp ‘kink’ in the Phillips curve: a fall in employment in the ‘flexible sector’ influences wage dynamics up to the point where most/all of these workers lose their jobs, leaving only ‘protected sector’ employees who are resistant to wage changes.

7. “Avoiding Austerity and Inflexibility in a ‘Keynesian’ Labour Market: Some Good and Bad News”, European Weekly Analyst, February 2, 2012. 8. In this respect, the challenges of correcting external and fiscal imbalances are distinct. Stronger productivity growth would improve the fiscal

imbalance but, depending on the sector in which it is located, it would not necessarily improve the external imbalance.

April 12, 2012 Issue No: 12/04 5


9. “Next steps for the Euro area—A primer”, European Weekly Analyst, September 15, 2011.

Optimising structural reform With this framework and these parameters in mind, how are Euro area member states progressing in implementing structural reforms that would improve the terms of the trade-off? The discussion here is brief—we will look at individual countries in more detail in future research—and our focus is on the implementation of structural reform (rather than on the implementation of fiscal adjustment). Considering each of the countries in turn:

Greece implemented important labour market legislation in mid-2010 but its subsequent progress in implementing structural reform to labour and product markets has been disappointing. Notably, the liberalisation of regulated professions (lawyers, auditors, engineers, etc.) has been delayed.

While the challenge that Portugal faces is daunting, it has already made significant progress. The government, unions and employers have reached agreement on a set of labour market reforms that make it easier for companies to hire and fire, and that reduce compensation for redundancy and holiday entitlements. Earlier this month, EU/IMF assessors declared that Portugal’s programme of economic reforms was “on track”.

For Ireland, given that labour and product markets are already relatively flexible and external competitiveness has been regained, there is less need for structural reform (i.e., the primary focus is on regaining fiscal balance).

For Spain, labour market reform is the key area where urgent progress is required. The Spanish authorities have successfully implemented some reforms—such as allowing firms to opt out of centralised pay-setting—and these should help to facilitate greater pay flexibility over time. However, even with these changes, Spain’s labour market is less flexible than elsewhere in the Euro area.

For Italy, with most inflation measures already running below the Euro area average and a primary fiscal surplus, the key challenge is to raise potential growth. In this regard, some of the reforms introduced by the Monti government are likely to have helped but significant work remains. Important labour market reforms remain in the balance: while the government recently announced compromises to proposed legislation, the substance of the measures remains intact. If the government succeeds in implementing the legislation in its current form—against union opposition—it would represent an important development in the liberalisation of Italy’s labour market.

While there has been much less focus on the need for reform in ‘core’ Euro area economies, changes are necessary here too:

For France, the small size of its tradables sector implies that large relative price adjustments are needed to re-establish a sustainable external balance. It will be difficult to bring about such an adjustment without shifting resources from the domestically-oriented public sector into the externally-oriented parts of the private sector. Ahead of the Presidential election, progress in this regard has been limited.

Germany also has an important role to play in the adjustment process (and not only in underwriting the system financially as others readjust). As already discussed, reforming Germany’s services sector would aid the adjustment process in the Euro area periphery. However, proposed changes in this area appear to have fallen off the agenda. And, while relatively high inflation may be politically unpopular in Germany, it is difficult to see how the periphery’s return to external competitiveness can take place without it.

Accepting the obligations of Euro membership The analysis set out in Parts 1-3 of this series of articles suggests that, for some Euro area countries, the task of regaining fiscal and external balance through cyclical adjustment alone is likely to prove exceptionally difficult. Such is the severity of the problem that, for a number of economies, structural reform provides the only realistic prospect of making the adjustment work. The need for reform is not exclusive to the periphery: Germany and France also have important work in this area.

Of course, the implementation of structural reform is itself difficult. But, if the members of the Euro area want the Euro to survive, they need to accept the obligations that this entails and the implementation of structural reform represents a necessary part of those obligations.

The alternative—which could come about either through choice or by default—would be to allow the break-up of the Euro area. Our own view remains that the likelihood of this outcome is low because the political commitment to EMU (and to structural reform) is strong and the cost of break-up would be high.9 While the reintroduction of exchange rate flexibility would bring some clear advantages, it would also involve substantial costs (widespread public-sector defaults and the collapse of banking systems around Europe, to name just two likely outcomes) and a great deal of uncertainty.

The good news is that in some of the peripheral economies—notably Portugal, Spain and Italy—progress has been made in implementing structural reforms. But these countries are still closer to the beginning of this journey than to the end, and the road ahead is likely to remain difficult.

Kevin Daly

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April 12, 2012 Issue No: 12/04


...and our UK Current Activity Indicator picked up in March.

Our survey-based GDP tracker points to very modest positive growth in the Euro area...

We expect a significant convergence in Euro area and UK inflation in 2012, to rates below 2%.


Business sentiment softens in the Euro area, while the UK improves.

European financial conditions are easy, with the exception of Switzerland.

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April 12, 2012 Issue No: 12/04

We, Kevin Daly and Antoine Demongeot, hereby certify that all of the views expressed in this report accurately reflect personal views, which have not been influenced by considerations of the firm’s business or client relationships. Global product; distributing entities The Global Investment Research Division of Goldman Sachs produces and distributes research products for clients of Goldman Sachs on a global basis. Analysts based in Goldman Sachs offices around the world produce equity research on industries and companies, and research on macroeconomics, currencies, commodities and portfolio strategy. This research is disseminated in Australia by Goldman Sachs Australia Pty Ltd (ABN 21 006 797 897); in Brazil by Goldman Sachs do Brasil Corretora de Títulos e Valores Mobiliários S.A.; in Canada by Goldman Sachs Canada & Co. regarding Canadian equities and by Goldman Sachs & Co. (all other research); in Hong Kong by Goldman Sachs (Asia) L.L.C.; in India by Goldman Sachs (India) Securities Private Ltd.; in Japan by Goldman Sachs Japan Co., Ltd.; in the Republic of Korea by Goldman Sachs (Asia) L.L.C., Seoul Branch; in New Zealand by Goldman Sachs New Zealand Limited; in Russia by OOO Goldman Sachs; in Singapore by Goldman Sachs (Singapore) Pte. (Company Number: 198602165W); and in the United States of America by Goldman, Sachs & Co. Goldman Sachs International has approved this research in connection with its distribution in the United Kingdom and European Union. European Union: Goldman Sachs International, authorised and regulated by the Financial Services Authority, has approved this research in connection with its distribution in the European Union and United Kingdom; Goldman, Sachs & Co. AG, regulated by the Bundesanstalt für Finanzdienstleistungsaufsicht, may also distribute research in Germany. General disclosures This research is for our clients only. Other than disclosures relating to Goldman Sachs, this research is based on current public information that we consider reliable, but we do not represent it is accurate or complete, and it should not be relied on as such. We seek to update our research as appropriate, but various regulations may prevent us from doing so. Other than certain industry reports published on a periodic basis, the large majority of reports are published at irregular intervals as appropriate in the analyst's judgment. Goldman Sachs conducts a global full-service, integrated investment banking, investment management, and brokerage business. We have corporate advisory, corporate finance and other business relationships with a substantial percentage of the companies covered by our Global Investment Research Division. Goldman Sachs & Co., the United States broker dealer, is a member of SIPC (http://www.sipc.org). Our salespeople, traders, and other professionals may provide oral or written market commentary or trading strategies to our clients and our proprietary trading desks that reflect opinions that are contrary to the opinions expressed in this research. Our asset management area, our proprietary trading desks and investing businesses may make investment decisions that are inconsistent with the recommendations or views expressed in this research. The analysts named in this report may have from time to time discussed with our clients, including Goldman Sachs salespersons and traders, or may discuss in this report, trading strategies that reference catalysts or events that may have a near-term impact on the market price of the equity securities discussed n this report, which impact may be directionally counter to the analysts’ published price target expectations for such stocks. Any such trading strategies are distinct from and do not affect the analysts’ fundamental equity rating for such stocks, which rating reflects a stock’s return potential relative to its coverage group as described therein. We and our affiliates, officers, directors, and employees, excluding equity and credit analysts, will from time to time have long or short positions in, act as principal in, and buy or sell, the securities or derivatives, if any, referred to in this research. This research is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. Clients should consider whether any advice or recommendation in this research is suitable for their particular circumstances and, if appropriate, seek professional advice, including tax advice. The price and value of investments referred to in this research and the income from them may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Fluctuations in exchange rates could have adverse effects on the value or price of, or income derived from, certain investments. Certain transactions, including those involving futures, options, and other derivatives, give rise to substantial risk and are not suitable for all investors. Investors should review current options disclosure documents which are available from Goldman Sachs sales representatives or at http://www.theocc.com/about/publications/character-risks.jsp. Transaction costs may be significant in option strategies calling for multiple purchase and sales of options such as spreads. Supporting documentation will be supplied upon request. In producing research reports, members of the Global Investment Research Division of Goldman Sachs Australia may attend site visits and other meetings hosted by the issuers the subject of its research reports. In some instances the costs of such site visits or meetings may be met in part or in whole by the issuers concerned if Goldman Sachs Australia considers it is appropriate and reasonable in the specific circumstances relating to the site visit or meeting. All research reports are disseminated and available to all clients simultaneously through electronic publication to our internal client websites. Not all research content is redistributed to our clients or available to third-party aggregators, nor is Goldman Sachs responsible for the redistribution of our research by third party aggregators. For all research available on a particular stock, please contact your sales representative or go to http://360.gs.com. Disclosure information is also available at http://www.gs.com/research/hedge.html or from Research Compliance, 200 West Street, New York, NY 10282. © 2012 Goldman Sachs. No part of this material may be (i) copied, photocopied or duplicated in any form by any means or (ii) redistributed without the prior written consent of The Goldman Sachs Group, Inc.







eea achieving fiscal & external balance parts 1-4

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