Tuesday, November 8, 2011
Let’s take a moment to sort out the euro mess.
First, there are two problem areas that have to be addressed. The immediate trigger, as it usually is, is finance: big borrowers can’t service their debt, and this puts their creditors at risk too. The underlying issue, however, is imbalances—large, persistent current account surpluses in some countries and offsetting deficits in others that created today’s debt problems and will create tomorrow’s with near certainty.
The financial crisis is a matter of arithmetic. Here are the numbers to keep in mind:
1. Debt service as a function of total debt outstanding and interest rates. Yes, there are maturity complications, but at a first approximation, and assuming payments are made only on interest and not principal, you can multiply the first by the second and get a rough idea of what borrowers have to come up with.
2. Debt service and a sustainable Debt/GDP ratio. Since this is most immediately a sovereign debt crisis, the core question is whether it is possible for debtor governments to run a large enough primary surplus to finance payments to creditors while also preventing debt from exploding. In the analysis that follows we will assume that the stock of outstanding debt is altered only by running fiscal deficits or surpluses; there is no effect operating through changes in the price level. (This is a reasonable simplification given that inflation is very low in the peripheral European economies, and the ECB is determined to keep it this way.) Specifically, and again assuming debtors pay only interest, the condition for servicing debt while maintaining debt stability is:
Debt service - primary surplus = total outstanding debt x growth rate of GDP
As a special case, if GDP remains constant, the entire interest payment must be financed by a primary surplus. Plug in the numbers from individual countries and see how that works.
3. GDP and primary fiscal surpluses. Unless offsetting changes in either consumer spending or business investment are triggered by fiscal austerity, increases in the primary fiscal surplus will reduce GDP. In theory, private spending could exhibit either positive or negative feedbacks, but as a starting point, assume a fiscal multiplier of one, i.e. no feedback. In that case, and maintaining the assumptions of price stability and debt service consisting only of interest payments, the sustainability constraint is:
primary surplus = debt service x 1/(1-d)
where d is the ratio of outstanding debt to GDP. Note that the primary surplus must always exceed debt service, and that it reaches infinity (fails to achieve sustainability) as d approaches 1. In other words, heavy debtors, whose debt load approaches or even exceeds GDP, cannot achieve sustainability without economic growth.
4. Debt relief and creditor solvency. If you do the arithmetic on sovereign debtors and find they need a reduction in debt service—a relaxation of terms or a reduction in principal—to remain viable, it is still an open question whether their creditors can sustain this haircut. Some creditors are public, such as the ECB and IMF, so set them aside. The critical issue is whether the banks that have made these loans can afford to write off as much as the sovereigns require. Banks within the debtor countries are most exposed but, in general, least systematic. (This does not apply to Santander.) Core country banks present deep system risk. There is arithmetic for this, but it is difficult to apply because there is little transparency regarding equity buffers and full (direct and indirect) exposure of creditor banks. If we find out, it will be in the actual course of events.
The second issue, imbalances, poses the question of adjustment. What will it take for persistent (current account) deficit countries to return to approximate balance? Let’s separate a few strands.
1. Devaluation is the most direct route, but it is blocked by adoption of a common currency.
2. Internal devaluation—deflation—is theoretically possible, but extremely costly and may fail due to the interaction between debt service sustainability and GDP. If the economy is shrunk to achieve deflation, this increases d in (3) above and requires even more austerity on the part of fiscal authorities. This can become a doom loop under plausible parameters.
3. Surplus country adjustment is far more feasible economically, but politically unlikely. Large wage and price increases in Germany, the Netherlands and Finland would do the trick, but how can they be induced to accept? There is no financial gun pointed to their head, nor is there any mechanism in the eurozone machinery for this sort of lifting. Note the preponderant influence of the surplus countries in ECB policy, for instance. It should also be remembered that exporters like Germany also face competition from outside the eurozone, and price inflation that balances the first set of accounts may put the second into deficit.
4. That leaves “structural reform”. This is the linchpin of troika conditionality: deficit countries must deregulate, liberalize their labor markets, privatize, modernize, etc. This perspective is echoed in media coverage of negotiations in Greece and Italy, where the question is understood to be, can the dysfunctional political regimes of these countries get their act together and meet the stern but reasonable demands for reform? The honest response, however, should be that there is minimal evidence that the reforms on the table will actually lead to rebalancing.
The most dubious demand is that labor markets be deregulated. While economists disagree about specific labor market institutions, it is fair to say that the consensus emerging from the last decade or so of research is that no general conclusion can be drawn from such simple notions as labor market flexibility. Different regulations function differently and in different national contexts. To take just one case: can you think of a less flexible labor market than Germany’s? There is an elaborate system for certifying who is permitted to perform which job. Most wages are set in centralized bargaining. The consent of unions and works councils is required for business decisions entailing layoffs, changes in work organization, etc. As mentioned in earlier posts, Germany also “suffers” from a largely public banking system that channels subsidized funds through politically influenced channels to firms. It persists in maintaining public and nonprofit ownership stakes in large parts of its economy, from housing to professional sports (Bayern München) to manufacturing (VW). According to conventional standards, Germany should be first in line to get reformed, but they are the ones who have the trade surpluses and are dictating terms to the peripherals. (Yes, I know about Hartz I-III, but this has left most of German labor market regulation intact; in fact, that was largely its purpose, to keep the core institutions through strategic trimming.)
Incidentally, the poverty of the “reform” discourse should be apparent from the now-indisputable failure of structural funds. These funds were supposed to bring the less productive regions of the EU up to the leaders, but the current crisis showed they have not done this. Whether the money was not enough, whether it was misspent, or whether the entire idea was an illusion is a topic worth discussing. The one thing we can be certain about is that Europe has a track record in pursuing futile remedies for its imbalances. (The funds may have accomplished other purposes, of course. I run along a nice canal path financed by my benefactors in Brussels.)
Adjustment is needed; the problem is that the eurozone honchos do not have a recipe for it. For now, the only reasonable conclusion is that adjustment will remain out of reach for the foreseeable future. Either Europe recycles surpluses through transfers, or the euro is toast.