Domino Effect in Southern Europe? Subjecting Greece, Portugal, and Spain to a Crisis Test

 Press Release January 25, 2012

Greece is far from having overcome its economic and financial crisis. On the contrary, it is becoming increasingly clear that it could end up bankrupt. Even the Greek government is now threatening to let the country go bankrupt. But Greece has not been the only country in the EU to be considered susceptible to bankruptcy. Many think that a Greek bankruptcy could have a domino effect on other Southern European countries such as Portugal and Spain. Could the crises in Portugal and Spain really become as acute as the crisis in Greece? The Kiel Institute economists Klaus Schrader and Claus-Friedrich Laaser examine the real economic causes of the crises in Greece, Portugal, and Spain in their new Kiel Discussion Paper (No. 500/501) entitled “Die Krise in Südeuropa oder die Angst vor dem Dominoeffekt – Griechenland, Portugal und Spanien im Krisentest” (The Crisis in Southern Europe and Fears of a Domino Effect: Subjecting Greece, Portugal, Spain to a Crisis Test). They compare economic developments in these three countries and find that there is little reason, from a real economic perspective, to expect that there will be a domino effect. The nature and history of the crisis in each of the countries is too different, as are the means that the countries have at their disposal to deal with the crises. The crisis test that Schrader and Laaser apply does, however, indicate that all three countries will nevertheless have to implement painful structural reforms in order to overcome their crises.

The worldwide economic and financial crisis brutally brought long-standing structural problems in Greece, Portugal, and Spain as well as a questionable solvency of at least two of these countries to the fore. The “markets” have thus now stopped assuming that merely because a country is in the euro zone it has a healthy economy that is subject to strict stability criteria. For a long time, the structural problems in these countries were ignored and they were given more trust than they deserved, but now the economic realities in these are being scrutinized very closely.

Schrader and Laaser’s crisis test shows that Greece, Portugal, and Spain suffer to some degree from very different crisis symptoms, the causes of which are also to some degree very different. The situation in Greece is unquestionably the worst. Its economic and financial policies not only need to be completely redefined, there also has to be a change in its political and societal mindset. The situation in Portugal is not as bad as in Greece, but nevertheless requires fast and decisive turn-around measures. The economic situation in Spain is also strained, but as much as in Greece or Portugal.

Greece has not been able to develop any competitive employment structures since joining the EU 1981. In particular, there is a lack of jobs for the highly qualified. Its dominant public sector and partially closed private sector are out of step with globalization. It thus does not have the types of economic structures that a highly developed industrialized country has. Its relatively strong growth in the last ten years has been based largely on public and private consumption financed by borrowing, which has resulted in an uncontrolled amassment of debt. The disappearance of cheap money and the fall in demand it generated have brought about record unemployment in Greece, unemployment that will be very difficult to remedy because Greece has failed to engage in structural change for decades.

Portugal was able to attract numerous businesses after joining the EU in 1986, but it neglected to implement structural changes necessitated by the opening of markets in Central and Eastern Europe. It is better integrated into international production networks than Greece, but it has become too expensive for the labor-intensive type of production that once boomed there. Thus, export-driven growth has increasingly tapered off. Further, a lack of highly qualified workers, poor productivity, and public and private debt have slowly led to a crisis.

Spain> joined the EU in the same year as Portugal. Its joining the EU triggered a catching up process that was buttressed by its solid industrial base. The temptation to make fast money during the real estate boom, however, put an end to this process. After the real estate bubble burst, unemployment in Spain increased to more than 20 percent. Further, rigid labor market institutions and a high level of private debt have acted as a drag on economic recovery.

What all three countries have in common is that they need to create sustainable growth to get out of their crises. Such growth can, however, no longer be created by increasing public or private consumption, as cheap credit is no longer available. It will have to be export driven, which will require radical structural reform that promises to sustainably increase the countries’ competiveness. This would restore confidence in these countries in international financial and capital markets, which would in turn make structural reform easier.

Greece will have the largest number of reforms to implement to remedy its productivity problems and also finally generate export-driven growth. It will have to radically reform its labor market, develop a consensus culture in wage negotiations, launch an educational offensive to improve education throughout life, privatize government-owned enterprises and infrastructure, open up its goods and services markets, do away with bureaucratic obstacles to domestic and foreign investment, turn the government into an investment-friendly provider of services, compete for investment, particularly in high-value production, and modernize its tourism sector.

Portugal will have to reduce its unit labor costs to become internationally competitive again. Further, it will have to make working more worthwhile again to bring down the increasing number of unemployed. It also needs to provide training at all levels to increase productivity, and to attract high-value production that is part of international value-added chains.

Spain needs to get back to its export-driven growth model and, in doing so, utilize its unquestionable industrial potential better. It also needs to radically reform its labor market to make it more flexible, while establishing competitive wages to bring mass unemployment down. At the same time, it needs to deregulate its economy to make it more competitive and to make it attractive to high-tech industries other than just the automobile industry.

Schrader and Laaser maintain that it would be a great mistake if the IMF and the EU, in the course of this year, were to lift the pressure for reforms. If the countries were to be given the impression that they could bank on basing their growth on transfers of whatever kind, their willingness to engage in structural reforms would fade rapidly: such reforms would initially cause incomes to drop, making politicians keen to accept any alternative that is less painful. Schrader and Laaser urge financial and capital market actors to take into account the differences between the real economies in these countries. Hysterically lumping all of them together would only hurt the markets. The need for structural change has been glossed over for years, and the costs of doing so are already high enough.

The full study (in German)

Contact: Dr. Klaus Schrader and Dr. Claus Friedrich Laaser