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This is the end game for "flexible" labour markets in Europe

8/26/2013

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Wages need to fall to Eastern European levels, or else production will be moved. Italian firm shifts production to Poland in the night. Coming soon to entire Eurozone. (my thanks to Dan for the link)
Editors note: Brent in his comment below correctly points out that it is productivity adjusted real wages to which I refer. Moreover, for Germany pairwise comparisons with other countries make these wages lower than they would be if they had their own currency because the Euro is an average currency, whose value is lower than the DM would be. For the periphery countries the effect is the opposite and this is what has lead to them importing at an accelerated pace from Germany (exporting their jobs) for much of the last decade. What is more, for good stretches of the last decade real wages in Germany have been declining (exhibiting much of the vaunted labour market flexibility despite an economy with significant union representation). Finally, in trade models with imperfect competition the lowest cost producer may be kept out of the market because an established player prevents them from getting down the cost curve to a an economic level of efficiency. One more potential hurdle confronting the PIIGS wrt to German competition.
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Italy, interest rates, western economies and westerns

11/15/2011

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There is going to be a shoot out, worthy of any classic western, in the global credit markets.

The major world economies are going through a debt crisis, the euro area is struggling to find a sustainable path, and political brinksmanship in the US congress contributed to a downgrade to the US credit rating. 
  
Despite some optimism about recent US economic numbers (I want to do a post on this topic, but I am currently focused on writing a PhD paper) the western economies seem headed for a recession and for some countries this will slip into a 
depression.
 
The basic formula for interest rates that we teach to undergraduates is nominal (money) interest rate = the real interest rate +
inflation. This can be rearranged so that real interest rate =nominal (money) interest rate – minus inflation. Real interest rates are often thought of as stable or relatively unchangeable over time, so most of economic analysis  is  often concerned with inflation
rates. Normally, real interest rates go up if a country experiences deflation. I have, of course, argued on these pages that prolonged deflation is necessary for countries in the euro zone to become competitive. 
 http://www.economicpresence.com/4/post/2011/09/i-guess-i-am-overdue-for-a-eurozone-post.html
 
However, I believe that deflation is not a necessary requirement for real interest rates to go up in this era of  sovereign debt crises and unstable political arrangements. It is hard to imagine that the sovereign risk of the world’s largest economies (including Germany) will not rise substantially over the next decade and with it will be a rise in real rates. With many countries defaulting or printing money to escape their real debts it is difficult to see how creditors will not demand a higher risk premium.
 
Adjustments of real rates are mainly a question of changing perceptions as we are now seeing with Italian bonds. Italian 10 year bonds have averaged 4.46%, since 2001, while inflation has averaged 2.2%, leaving a real interest rate of 2.26%. Last week, global investors woke up and (accurately, but two years late IMO) perceived Italy to be much riskier than before and the 10 year rate rose to 7.48%, forcing the resignation of Berlusconi. Italian inflation is currently around 3.07%. The real rate of interest being charged rose to 4.40% an increase of 95% above the average.

This, of course, creates a severe negative feedback loop which can turn into a viscous cycle as higher rates make it more difficult for a country to regain a sustainable economy path due to rising debt service costs necessitating more cuts and tax increases which in turn are negative for growth. 
 
It is unlikely Monti will be able to deal with Italy’s problems any better than his predecessor. Adjustments for Italy within the Euro area will either come through Germany or deflation. It matters little who is at the helm in Italy. After the resignation, the 10 year rate fell, but it is once again on the rise, up today 37 basis points, to 7.07%. To quote Tuco, from the Italian made (spaghetti) western, ‘The Good, Bad and the Ugly’:
 
“Who the hell is that? One bastard goes in, another one comes out.”
 
What is happening in Italy, will eventually happen for all western economies, until systematic and sustainable changes are made to restore internal and external balance to global economies. This will have a significant negative impact on global growth because so many borrowers, consumers and businesses, are on the short end of the yield curve. On the inevitability of such real interest rate increases, I quote Ben Wade, from a more recent western, ‘3:10 to Yuma’:
 
“Oh, they're coming, Dan. Sure as God's vengeance, they're  coming."  


Investors better get out of Dodge or grab a gun.
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