To preserve most of the fiscal stimulus now in place, in our forecasts we have assumed that today's tax rates and credits (excluding the Making Work Pay credit) would be extended for lower- and middle-income taxpayers, that rates on capital gains and dividends would be raised to 20%, and that Congress would enact a fix for the estate tax and an AMT patch.
Rising uncertainty. But delay on those extensions has started to undermine that assumption. The debate around taxes is already fierce, with Democrats and Republicans each arguing that the other side will raise taxes on January 1, thus imperiling the economy. Partisan divisions, a limited Congressional calendar, and a difficult legislative process all add up to either gridlock or kicking the can down the road. In our view, that's a recipe for deferring decision, so a one-year extension of all provisions prior to the mid-term elections in November now seems to be the most likely outcome. While that would temporarily preserve stimulus, it would also leave tax and fiscal policy unusually uncertain for an extended period. Such policy uncertainty could blunt the intended impact of maintaining the stimulus.
Quantifying expiring tax cuts. The debate around required action by the end of this year involves far more than whether to extend the Bush tax cuts enacted in 2001 and 2003 under EGTRRA and JGTRRA; nearly one hundred provisions of the tax code will expire at the end of 2010. Extending the Bush tax rate and bracket cuts and maintaining the tax rate on dividends and capital gains would cost the Treasury roughly $120 billion in FY 2011 compared with their expiration under current law. In his FY2011 budget, President Obama proposed ending the individual income tax cuts begun under EGTRRA and JGTRRA only for upper-income taxpayers. Under the President's proposal, the top marginal tax rates for married couples filing jointly with incomes above $250,000 would go from 33% and 35% to 36% and 39.6%, levels last seen in 2000. Married couples with incomes below that threshold would continue to enjoy current tax rates. The current 10% tax bracket would be maintained, compared with the lowest tax rate of 15% prior to 2001, preserving for 88 million taxpayers an average of $503 in lower taxes next year. The Congressional Budget Office (CBO) estimates that this proposal would cost the Treasury $67 billion in FY2011 relative to current law.
Extending today's middle-income tax rates isn't controversial and would not require Congress to find ‘pay fors' required for other fiscal actions under the PAYGO rules Congress adopted at the start of 2010. In contrast, extending the rate cuts and deductions for upper-income taxpayers is a hot issue: All Republicans favor it, but Democrats are divided. Some Democrats favor temporary extension until the economy is on firmer ground, but most, including the Administration, oppose any extension. And while increasing the rates on capital gains and dividends taxes would not net much revenue, here, too, there is division among Democrats. Treasury Secretary Geithner would equalize both at 20% to minimize distortions between debt and equity financing, but some Democrats favor boosting both.
Other expiring provisions. In addition, in order to limit the increase in taxes, Congress would have to fix the estate and gift tax laws that revert back to 2000 levels at year-end, extend relief from the marriage penalty, and extend a patch for the Alternative Minimum Tax. Moreover, key tax credits such as the child credit and the earned income tax credit will sunset at the end of 2011. Finally, the Making Work Pay tax credit, part of last year's American Recovery and Reinvestment Act (ARRA), will expire at the end of this year, removing $60 billion in fiscal stimulus. Although President Obama proposed a one-year extension in his FY2011 budget, we assume the credit will expire under current law.
At the 11th hour, kicking the can down the road. As noted above, Congress is unlikely to settle the tax issue decisively soon; a one-year extension before the mid-term elections in November is the most likely outcome. Most important, the divisions between Democrats and Republicans seem to be widening daily. Sensing an advantage, for example, House Republicans are proclaiming that the Democrats' ticking "Tax Bomb" threatens the economy. Procedure is also a hurdle: Senate Democrats lack the 60 votes needed to pass their agenda, because Congress was unable to agree on and pass a budget resolution for the current fiscal year.
Moreover, the clock is running out, favoring a one-year extension: Congress will recess again in August, return to Washington for three weeks in September, and then hit the campaign trail. Action in the weeks following the election makes little sense politically; neither side would benefit from postponing decisions until a lame-duck session following the election. And lawmakers may see benefit in keeping the real debate alive as the Presidential election campaign begins in 2011.
Risks to our forecast. If Congress fails to act on the expiring Bush-era tax provisions alone, income taxes would rise by $125 billion more than we've assumed in FY2011 and by more than that in out years. The resulting fiscal drag likely would trim growth in 2011 by half a percentage point or more from our 3% baseline. In contrast, extending all the expiring provisions (excluding the Making Work Pay credit) would add fiscal stimulus relative to our assumptions.
However, the way in which lawmakers extend or sunset the provisions matters both for revenue and for economic impact. Regarding revenue, CBO estimates the cost of extending the middle-income tax cuts at $67 billion in FY2011 and at $1.169 trillion during the 10-year window budgeteers use for apples-to-apples comparisons.
Correspondingly, theory suggests that permanent tax actions have bigger and more lasting effects than temporary ones. In addition, extending the middle-income tax ‘cuts' would benefit lower- and middle-income consumers, who would likely spend more of the savings than would those in upper tax brackets. We also believe that multipliers from fiscal actions vary depending on other circumstances. For example, in the heat of the crisis in early 2009, wary consumers saved more of their income, but as financial conditions and wealth improved, they opened up their wallets a bit more. With market healing likely to be even more advanced in 2011 than it is today, extending the tax cuts for middle-income taxpayers would probably get substantial traction. The combination of more dollars and more bang for each buck means that such action would offer meaningful stimulus in the short to medium term.
In contrast, the effects of a temporary extension would be somewhat smaller, depending on which taxes are affected. Here theory suggests two opposing effects. A temporary extension of some tax cuts could accelerate certain income and economic activity to the present at the expense of out years as people seek to minimize taxes. Think accelerated bonus depreciation and cash for clunkers as extreme examples. In contrast, the overall impact of a temporary extension is less than that for a permanent one because consumers and businesses would plan on higher and less certain taxes in the future.
Broader debate. The 2010 debate around tax rates and other expiring tax provisions is merely the opening salvo in a broader narrative. Congress and the Administration will need to reconcile maintaining near-term stimulus with longer-term fiscal sustainability by committing to a credible, long-term fiscal exit strategy. Such a combination would assure the most bang for the buck from any near-term extension of expiring provisions. Both taxes and spending will have to be on the table to achieve that goal, so broadening the tax base and reforming the tax system must be part of the discussion, especially because there is no realistic level of tax rates alone that can bring the deficit down to sustainable levels. Most important, the debate ultimately will have to confront the tough choices required to pare and thus preserve the essential benefits of our healthcare and other safety nets by shrinking them back to their original purpose.
The Treasury market posted strong 5-year and 7-year gains over the past week and smaller upside at the short and long ends as investors continued to put money to work in the most attractive areas of the curve from a carry and rolldown perspective. Economic data were mixed on the week, which left investors comfortable that the Fed is not going to do anything for quite some time, keeping the ongoing grab for yield and collapse in volatility running full steam through the week's run of auctions and into an added boost from Friday's month-end portfolio adjustments. In an extended further period of the Fed being on hold, 5s entered the week as the most attractive part of the curve followed by 7s, driving money from longer maturities into this area through much of the week and supporting a blowout 5-year auction on Wednesday followed by only a brief market setback Thursday afternoon before a move to new highs Friday after a much softer 7-year auction Thursday when market enthusiasm temporarily got a bit ahead of itself in a good rally right into the 7-year bidding. Even after a big week of outperformance and seeming richness versus 2s and 10s, the 5-year area is still the most attractive part of the curve on a carry and rolldown basis (outright and volatility adjusted) according to our interest rate strategy team (see the July 29 report, US Interest Rate Strategist: A Risk Case for Rising Yields: UST 10y 3.10% to 3.25% by Jim Caron and team). As well as the Treasury market performed on the week, it again lagged within the broader interest rate space, with swap spreads coming down and current coupon mortgage yields moving to new record lows (though with higher coupon MBS underperforming significantly on investor worries about the policy changes that could sharply accelerate stalled refis in these issues), which was most shockingly seen in 3.5% MBS rallying moving above par after surging more than a half point on the week. Swap spread narrowing was supported by a sizable further improvement in interbank lending conditions, with Libor and Libor/fed funds spreads on a spot and forward basis moving significantly lower, while the continued run of mortgage market strength was helped by an extension of the renewed collapse in volatility, which mostly has now reversed back down to post-2007 lows previously seen in March after a modest move higher in April and May during the height of concern about European fiscal issues.
Of course, a carry and rolldown based investment strategy only ends up working out well if rates actually roll down the yield curve and there isn't a hawkish shift in expectations about the medium-term path for policy. And while there was nothing in the past week's run of mixed data to make anyone think the Fed will be anything but firmly on hold for a good while longer, we continue to think the market is being too complacent about the prospects for a reversal in policy next year. The market is already acting increasingly as if the US is moving towards a prolonged Japan-type morass (making warnings about this from St. Louis Fed President Bullard the past week unhelpful in guiding expectations), continuing to price out Fed tightening for longer and longer. There wasn't much additional movement in the latest week (but then there really isn't much space to move at this point), but after small additional gains, fed funds futures are pricing in no change in rates through mid-2011, only a move up to 0.50% or 0.75% at the end of next year, and just a 1% fed funds target in mid-2012. Correspondingly, as such a policy scenario has been priced in, excess carry was first wrung out of 2s and now 5s and perhaps next 7s, and volatility has been grinding persistently lower in what looks like the start of a repeat of what happened in Japan (see the January 14, 2003 note Japan Economics: Evaporating Yield Curve by Takehiro Sato). There is unlikely to be anything to derail these expectations for now - though a major mortgage refinancing wave that looks imminent to us could certainly shake things up from a market flows perspective - but we continue to think that investors are too bearish on the growth and inflation outlook for the next couple years and too complacent about the risks of a quicker return towards the policy exit strategy that was starting to move forward in the spring before the recent modest soft patch in the data in the wake of the European turmoil. For sure, overall GDP growth in 2Q was a bit disappointing, but domestic demand growth posted its strongest gain in four years, as expected, which spilled over into a surge in imports that depressed GDP. And while consumption growth was sluggish in 2Q and revised lower the past few years, with income growth adjusted up to show less weakness during the recession and an acceleration to robust 4.4% growth in 2Q, the personal savings rate is now shown to be at a generational high, a couple points above what was previously being reported for 2Q, so consumer rebalancing is more advanced. We continue to see 2H growth on pace for a rise near +3 1/4%, close to the first half pace. Meanwhile, we continue to believe that core inflation has bottomed and will gradually turn up in the months ahead, with the significant ongoing acceleration in rental costs across the country a key driver. This component is more important for the core CPI turn than core PCE, but revised core PCE inflation is now already higher than expected, with the year-on-year pace in 2Q coming in a quarter point higher than expected at +1.5%, making the Fed's forecast of a 0.9% gain in all of 2010 unlikely. Looking to the near-term data flow, the second round of regional surveys released the past week were much better than the previously released Philly and Empire reports and supported our expectations for a strong ISM report for July. We'll probably see a somewhat sluggish gain in private sector payrolls in the July employment report, but the last couple jobless claims reports suggest some notable renewed underlying improvement beneath the recent auto sector led volatility.
For the week, benchmark Treasury yields fell 4-17bp led by the 5-year. The old 2-year yield fell 5bp to 0.53%, 3-year 12bp to 0.82%, old 5-year 17bp to 1.56%, old 7-year 14bp to 2.28%, 10-year 9bp to 2.90%, and 30-year 4bp to 3.98%. TIPS had a great week, outperforming the rally in nominals to slightly extend a rebound in inflation breakevens from the lows of the year hit a couple weeks ago. Month-end-related buying was particularly helpful to TIPS on Friday with the big new 10-year having been sold this month, but the strong relative performance on the week without any support from energy prices, which were flat, is consistent with the underlying nature of the recent decline in rates as being focused more on expectations of lower real rates for longer rather than rising deflation concerns. The 5-year TIPS yield plunged 20bp to 0.10%, 10-year 11bp to 1.11%, and 30-year 7bp to 1.85%. The benchmark 10-year inflation breakeven fell to 1.69% on July 19, low since last September, but has since rebounded to 1.79% as a 17bp drop in the TIPS yield over the time has outpaced a 6bp decline in the nominal yield. Swaps outpaced Treasuries on the week, with the benchmark 10-year spread falling 2.5bp to -1bp, while the benchmark 2-year spread plunged 4.5bp (accounting for the roll into the new 2-year Treasury) to 18bp. Major further movements towards normalization in dollar interbank lending markets after the strains caused by European bank funding issues in the spring supported the spread narrowing. Spot 3-month Libor fell 4bp on the week to 0.453%, low since mid-May after twelve straight declines. The spot Libor/OIS spread fell 5bp to 26bp and more improvement was priced in for coming months as the Sep 10 eurodollar futures contract gained 6bp to 0.41%, Dec 10 7.5bp to 0.445%, and Mar 11 8.5bp to 0.51%. This lowered the forward Libor/OIS spread for September, which peaked above 70bp in the spring episode, by 7bp to 22bp, December 9bp to 24bp, and March 9bp to 22bp.
There was substantial divergence along the mortgage coupon stack on the week, as lower coupon issues surged in a further outperformance of Treasuries - potentially pushing the market towards a big refinancing acceleration - while the super-premium higher coupon issues lagged significantly. Higher coupons were hurt as investors reassessed the risk/reward of the small extra carry that can be earned in these issues versus the possibility of a big price adjustment if policy changes are implemented (see the July 27 note US Economics: Slam-Dunk Stimulus by David Greenlaw for our recommendations) to allow more refinancing of these issues. Much tighter credit standards and lower prices since the mortgages underlying 5.5%, 6%, 6.5% MBS have resulted in much slower rates or refinancings in the mortgages underlying these pools than was expected, as average 30-year mortgage rates plunged to current record lows near 4.5%, about 150-225bp less than the rates on mortgages underlying these high coupon MBS. Surprisingly low prepay rates as mortgage rates plunged allowed these securities to surge to unprecedented dollar prices, almost 8 points over par for Fannie 5%, 8 1/2 points over par for 6%, and 9 1/2 points over par for 6.5%. At such levels, our desk thinks that there could be a quick drop of a couple points if policy measures were taken to make it easier for homeowners stuck in these high mortgage rates and currently unable to refi under current tight standards to do so. As this possibility became a much greater market focus over the past week, these issues lagged the rally substantially (though they didn't actually lose much ground in absolute terms). Fannie 5% MBS lagged Treasuries on the week by 5 ticks, 6% by 22 ticks, and 6.5% by 10 ticks. On the other hand, lower coupon issues substantially extended their upside through most of the week before giving up some relative ground Friday when the move became big enough that it made a major refi wave an imminent possibility. Current coupon yields were down about 15bp on the week to near 3.45%, a record low. As MBS yields have plunged to new lows the past several weeks, the spread between MBS yields and mortgage rates has been holding at unusually high levels, with average 30-year mortgage rates stuck at 4 1/2%. With this latest market rally, this should start increasingly setting down to 4 3/8% and 4 1/4%, at which point the large amounts of 4.5% MBS (with underlying mortgage rates around 5 1/8%) should start to see a significantly accelerated pace of refinancings. These are mostly very high credit quality mortgages since they were written largely last year at the worst of the credit crunch and the lows in home prices, so there won't be the same issues that have sharply slowed high coupon refis. Interestingly, the Fed owns a ton of 4.5% MBS, so a big pickup in refis in those issues could actually result in a noticeable decline in the size of the Fed's balance sheet and a corresponding drop in excess bank reserves if the FOMC continues with its current policy of not reinvesting mortgage maturities.
The past week's economic data flow was mixed. New home sales surged in June, but May was so weak that June's level was still the second worst ever, even after a 24% rebound. Consumer confidence was soft in July, as survey respondents expressed more pessimism about the labor market and about the prospects for economic growth over the next six months. The durable goods report was much weaker than expected on a headline basis, largely as a result of big drop in the volatile aircraft category. Underlying capital goods orders and shipments remained quite robust. This was very clear in the GDP report, with the biggest gain in equipment and software investment in twelve years leading to the biggest gain in overall domestic demand in four years. This demand spurt ended up being met by a surge in imports to a large extent, however, leading to a somewhat disappointing gain in GDP in 2Q. There wasn't anything in the GDP report that changed our outlook for continued moderate growth near 3 1/4% in the second half and 3% in 2011. Looking to next week's key data, after pretty dismal results from the early regional manufacturing surveys, the second round of reports out of Richmond, Kansas City, and Chicago were much better, and we raised our ISM forecast a half point to 55.5 as a result. Jobless claims also showed a surprising decline in the latest week that brought the 4-week average down to its lowest level since early May. This was too late in the month to impact our July employment forecast, but if it continues would point to some improvement next month.
Real GDP grew 2.4% annualized in 2Q, with final domestic demand surging 4.1%, high in four years, and inventory accumulation (+1.1pp) providing a further boost, but net exports (-2.8pp) plunging as a spike in imports (+29%) far outpaced a good gain in exports (+10%). The unusually big estimated drag from net exports incorporated BEA's assumption of a very large widening in the trade gap in June, so there could be an upward revision if the results aren't as bad as that. Growth was revised up a point to +3.7% in 1Q - which left 1H growth of +3.1% a quarter point better than we were estimating before this release - but adjusted down a quarter point to +0.2% annualized from 4Q06 to 1Q10 and to -2.8% from -2.5% during the recession from 4Q07 to 2Q09. Demand upside in 2Q was led by a surge in investment, as expected. Overall business investment rose 17%, with equipment and software at +29%, high since 1998, and structures at +5% after a run of seven straight declines cumulating to a 32% collapse. Residential investment was also strong, rising 28%, the biggest gain since 1984. Underlying new home building activity rose 16%, and there was sizable additional upside in home improvements as homeowners took advantage of the ‘cash for appliances' incentives and in brokers' commissions as home sales surged ahead of the homebuyers' tax credit expiration. Government spending accelerated to +4.5%, with the smaller and more volatile federal government component jumping 9.1% and state and local government spending gaining 1.3% after one of the worst declines on record in 1Q. A sharp pickup in state and local government construction spending as infrastructure spending from the 2009 stimulus bill finally started to materialize accounted for the improvement. On the softer side, consumption was sluggish at +1.6% and there were sizable downward revisions back through 2009 on significantly lower spending on services. Consumer fundamentals looking forward, however, looked better, thanks to upward revisions to income growth over the past few years that lifted to personal savings rate in 2Q to +6.2% from less than 4% in the pre-revision monthly results for April and May. Outside of a temporary bump in 2Q09 after the stimulus bill was implemented, this was the highest quarterly savings rate since 1992.
Core inflation numbers were revised a bit higher, likely putting the FOMC's mid-year forecast for a deceleration by 4Q in core PCE inflation to a range of +0.8% to +1.0% out of reach. Core PCE inflation was up 1.5%Y in 2Q after previously reported monthly results of +1.2% for April/May. The June monthly result that will be released Tuesday will probably show a +1.5%Y rate and muted comparison with a year ago (the average sequential gain in the three months of 3Q09 was only +0.08%) points to move up another couple tenths in the next few months. Full underlying details on the GDP revisions won't be released until Tuesday's personal income report, but there wasn't anything in these results that pointed to a significant adjustment to our medium-term outlook. We had been looking for GDP growth of 3.4% in 3Q, 3.3% in 4Q, and 3.0% in 2011 on a 4Q/4Q basis and that is unlikely to change much at this point.
There is a busy economic calendar in the coming week, as we get the initial run of key data for July - manufacturing ISM Monday, motor vehicle sales Tuesday, nonmanufacturing ISM Wednesday, chain store sales results Thursday, and the employment report Friday. In addition to this run of key data releases, Treasury's quarterly refunding announcement will be Wednesday morning. We look for a $33 billion 3-year ($2 billion smaller than last month), $24 billion 10-year (unchanged), and $16 billion 30-year (unchanged) to be announced for auction the following week. At the announcement, we will be looking for any additional guidance from the Treasury about goals for average maturity of the outstanding debt and the related question of bill sector paydowns. Treasury's previously persistent series of moves towards extending the average maturity of outstanding Treasury debt after it fell to an unusually low level at the end of fiscal year 2009 has been scaled back somewhat in recent months with the paring back of 2-year, 3-year, 5-year and 7-year sizes (but not 10s or bonds) and some corresponding slowing in the rate of debt paydowns in the T-bill sector. With yields where they are, however, and the recent experience in Europe highlighting the advantages of terming out debt to lower rollover risk, we wonder if there might be thoughts of shifting back towards more intermediate and longer-end issuance. On the auction calendar, the main shift we see as likely at some point will be to introduce a second 5-year TIPS issue each year, which with one reopening would fill in the TIPS auction schedule to one a month. Currently, a new 5-year TIPS is auctioned in April and reopened in October, and the likely move we expect next year would be to have new issues in April and October that are reopened in June and December (the two months that currently have no TIPS auctions). This would probably not need to be announced until the November refunding, however. Data releases due out this week include ISM and construction spending Monday, auto sales and personal income Tuesday, and employment Friday:
* We look for the ISM to decline slightly in July to 55.5. The regional surveys were all over the map this month. On an ISM-weighted basis, Empire, Philly and Richmond registered declines while Dallas, KC and Chicago posted gains. We believe that it is no coincidence that the districts with the most exposure to the auto sector showed the best performance. As we have been highlighting, assembly schedules point to about a 15% jump in motor vehicle production during July. However, this may not be enough to offset some moderation in other industries, so we look for a slight dip in the overall diffusion index this month (relative to the 56.2 seen in June). Finally, the price gauge is expected to edge down a point to 56.0.
* We forecast a flat reading for June construction spending. The housing starts data point to a further pullback in the residential category, but this is expected to be just about offset by another gain in the public sector. Indeed, over the past few months, infrastructure spending has started to show some signs of life - likely a reflection of stimulus dollars finally being put to put work.
* We look for 0.1% gains in personal income and spending in June. The labor market report points to only a fractional rise in personal income. Meanwhile, the retail sales data imply a similar advance in consumer spending. Finally, the CPI results point to a 0.16% rise in the core PCE price index for June. But, the annual revisions should contribute to a higher year-on-year rate of +1.5% in June (versus the previously reported reading of +1.3% for May).
* We forecast a jump in July motor vehicle sales to a 12.1 million unit annual rate. The June selling rate was 11.1 million units, which matched the average seen during the entire 1H10. Although there are widespread indications that lean inventories are acting as a significant restraint on sales volume at the point, industry surveys point to a solid pick-up in the July selling rate. Indeed, if we exclude the cash-for-clunkers spike seen in August 2009, the sales pace this month should be the best since September 2008.
* We forecast a 5,000 dip in nonfarm payrolls in July, with ex census jobs expected to be up 135,000. During 1H10, payrolls rose an average of about 100,000 per month (excluding the impact of census workers). We look for a pick-up to a monthly pace of close to +200,000 during 2H10. This type of acceleration would be consistent with the recent improvement in federal government withheld tax collections, the steady rise in temp help hires, and the sharp decline in layoff announcements. In July, payrolls and the average workweek should get a modest boost from the situation in the auto sector (where some plants avoided the typical summer shutdowns). Also, as we noted last month, there appears to be a historical tendency for private payrolls to show at least a slight elevation as census workers depart. And government data point to a further 140,000 drop in the number of census workers in July. On a related front, we are skeptical about the recent jump in federal government non-census employment and there might be some pullback in this sector. Interestingly, climate data show that average temperatures across the US were much, much hotter than usual around the time of the July labor market survey. While unusual weather events can have important effects on payroll employment in certain months, we do not detect a noticeable correlation for the month of July. Finally, the unemployment rate is expected to tick up slightly to 9.6% - however, it's worth noting that we have unusually low confidence in our short-term forecast of the unemployment rate at this point due to the historically unprecedented volatility in the labor force participation rate experienced during the past few months.
Viewed from 2020, events over the past three years and events over the coming years may still be debated. Charles Goodhart, emeritus consultant of Morgan Stanley, looks back in his old age at the difficult events of 2009-13.
Looking back now with the benefit of hindsight, the European collapse of 2013 appears from the vantage point of 2020 to have had a certain grim inevitability. Yet at the time, and in the years leading up to this debacle, it was far from clear what the future would hold, and many protagonists, especially in the policymaking arena, continued to contend that all would turn out alright, especially if their own policy proposals were followed.
Although much was made at the time of the failure of Greece to get its public finances under control, even before 2008, many of the countries with construction booms, e.g., Ireland and Spain, had been running public sector surpluses. It was not so obvious in 2007/8 that these countries would be in any future difficulty. Yet such booms, and imbalances, cannot go on forever. It should have been clear that, once the housing/finance boom (as marked in the UK as anywhere else) was punctured, it would not be easy for the countries involved to grow their output and exports sufficiently to pay off their external/internal debts without distress.
The Build-Up to Collapse
Cause of the Break-Up: Two Chief Policy Failures
The collapse was mainly caused by two key failures among European leaders. The first was the assumption that the unbalanced pattern of intra-European growth that had persisted from 1999 until 2008 could, and would, last indefinitely. The second was that these leaders could not agree on an over-arching vision for the longer-term future of the eurozone.
1. Assuming debt-fuelled growth could persist:
Imbalances that were a natural result of the construction of the eurozone were allowed to persist far too long.
• Low interest rates = construction boom: The entry of the southern European and peripheral countries, such as Ireland, into the eurozone (and the prospective entry of Eastern European economies) had led to a housing and construction boom in those countries as nominal interest rates fell sharply; at the same time interest rates converged to a euro area ‘norm' in the build up to the euro's launch.
• Accelerated by bank lending: Accelerating the boom, housing and construction sectors were enthusiastically financed by banks (and their shadows) both within and outside their own country.
• Result = Private indebtedness and a loss of competitiveness... The result in these countries was a massive increase in private sector indebtedness, largely matched by increasing capital inflows (from banks in Germany, France, etc.), and by the same token a large current account deficit. The construction boom of 1999-2007 in the peripheral European countries had been partly responsible for unit labour costs rising faster there than in Germany; indeed, this was part of the adjustment process in response to the boom.
• ...leading to almost insoluble problems when the boom turned to bust... By the time the boom broke in 2007/8, several eurozone economies had seen major losses in competitiveness over that boom. If a recovery in competitiveness was to be the chosen route to salvation, then this required wage/price declines (relative to Germany), i.e., internal devaluation, of eye-popping intensity. Some succeeded (Latvia - not a eurozone member, but pegged to the euro); some made a good attempt (Ireland); but in others it was beyond the capacity of the body politic. The shift of national indebtedness from the private to the public sectors in 2008-10 deferred, but did not resolve, this issue.
• ...and a weakened banking system: As economies had become over-indebted during the preceding boom, their banks were in particular difficulties. These banks held claims on local property, now fallen in value, and with liabilities (e.g., via the interbank market) to banks elsewhere in Europe.
2. The lack of a unified vision
The second main policy failure was that the European political leaders could not agree on an over-arching vision for the longer-term future of the eurozone, for the ultimate end-game.
One set of leaders continued to hanker for a more centralised, federal Europe with a shift of fiscal competences to a central budget, and enhanced political unification. A second set of leaders felt that the eurozone, and to a lesser extent also the single market, should comprise a narrower grouping of nation states with similar economies, and between whom labour and capital could flow very freely.
Group 1: Stick together at all costs: For this group, even the weakest member of the eurozone (Greece) had to be propped up, kept intact. Restructuring their debt, even if done in an orderly way, if that was feasible, would be a disaster and unthinkable. Entry into the euro system should be a one-way street with no exit. But in return for continuing (fiscal) support, all the member nation states should increasingly lose their independence to set their own fiscal policies, becoming more like US states in this respect. Given the difficulties that the periphery would have in regaining growth and competitiveness, that vision of the European end-game implied (fiscal) transfers from the stronger members of the eurozone of an unlimited and potentially unbounded (both in time and amount) extent.
Group 2: No ‘transfer union': Many countries, notably Germany and the Netherlands inside the eurozone, and the UK outside, were not prepared to sign up for such a ‘transfer union'. They had a different vision of the longer-term development of the eurozone. Their end-game was that the eurozone should be a narrower grouping of nation states with similar economies, and between whom labour and capital could flow very freely, more akin to the optimal currency area of theory, rather than the more inclusive eurozone of 1999-2012. In their view, fiscal transfers were a wasted subsidy to bad behaviour and replete with ‘moral hazard'. If other countries could not match up to the German example, they should be encouraged to restructure, not prevented. As countries' economic conditions changed, they should have (and utilise) the option of leaving, and possibly then subsequently rejoining, the eurozone. The eurozone should be a voluntary union of similarly minded and similar-economic nation states, not a mélange of differing economies herded together within a nascent federal United States of Europe.
The Consequences of Policy Failure...
The main consequences of these policy failures was 1) an almost inevitable over-focus on austerity measures post-recession. 2) An open debate about the European ‘end-game' that caused the markets to become, and remain, unsettled.
1) Policymakers focused excessively on austerity: Given lost competitiveness and over-indebtedness, a major focus of economic policy should have been on the questions of how to enable these countries to meet their debts through enhanced competitiveness and growth. Instead, the focus was almost entirely on additional public sector austerity. This focus was largely forced upon the politicians by the developing Greek crisis of 2009-10, whereby a vicious spiral ensued. Market doubts about the ability of the Greek government to meet its debt commitments led to higher risk premia, which led to further doubts about solvency. And such worries about Greece soon led to contagious overspills into the risk premia of other over-indebted eurozone countries.
2) Open political disagreement and so unsettled markets: Once the European crisis began to unfold, in 2010, the incompatibility of these differing visions began to cause difficulties. At each stage in the crisis, the federalists would insist that some way of helping Greece, or Spain, or Portugal must be found, and that such help would soon be on its way. But in each case, such help meant putting cash on the table, and in almost every instance those opposed to a ‘transfer union' would then express doubts about whether they could/would/should put up the money. The backing and filling, the internal debate about the European end-game among the political elite was a major factor causing markets to become, and to remain, unsettled.
When the crisis did reach a local climax in spring 2010, there were hopes that the combined IMF/EU support for Greece, and the wider and bigger European Stabilisation Fund, could assuage market fears. But both of these were perceived as temporary financing measures, not a means of resolving or removing the underlying problem of over-indebtedness in these countries. Moreover, there were valid concerns that such temporary measures would not give sufficient time for readjustment in the peripheral countries, and would not be extended should there still seem to be a continuing need for that.
Response to the Crisis: Shooting the Messenger?
There were several measures employed to counter the crisis. One of the most important was the weight political leaders put on attempting to limit the capacity of the markets to destabilize the eurozone.
The Lehman collapse in September 2008 punctured the European housing/construction boom. A combination of automatic fiscal stabilisers and Keynesian stimuli led to sharply increasing fiscal deficits and rising debt ratios. Whereas in October 2008 most fiscal authorities could credibly support their own banking systems, by mid-2010 in many countries the fiscal system and the banks were struggling. The worse the fiscal position, the more threatened was the solvency of the banking system, and vice versa.
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