Nouriel Roubini is cofounder and chairman of Roubini Global Economics, a global macroeconomic and market strategy research firm. More ›
"Crisis Economics: A Crash Course in the Future of Finance" (Penguin Press, 2010).
"Bailouts or Bail-Ins: responding to Financial Crises in Emerging Markets" by Nouriel Roubini and Brad Setser
The announcement of the most recent EZ rescue package (acceptance of a bigger haircut for Greek private creditors, the recapitalization of EZ banks and the use of guarantees and financial leverage in the hope of preventing Italy and Spain losing market access) led to markets rallying for a day as the tail risk of a disorderly situation in the EZ, temporarily, diminished. By the next day, Italian yields and spreads were still close to their high, serving as a reminder"”as we argued in "The Last Shot on Goal: Will Eurozone Leaders Succeed in Ending the Crisis?," co-authored with Megan Greene"”that the EZ's fundamental problems will not be resolved by this trio of policy actions.
To put the latest package in context, we need to first assess the fundamental problems facing the EZ and the potential scenarios for the monetary union.
EZ Flow Problems
The EZ suffers from both stock and flow problems, which are related to each other. The flow problems were and/or are:
Large fiscal and current account deficits in most members of the EZ periphery (Greece, Ireland, Portugal, Cyprus, Spain and Italy); Economic weakness, manifesting itself in renewed near recession or outright recession and weak actual and potential growth; The periphery's long-term loss of competitiveness, driven by three factors: Loss of export market share to emerging markets (EMs) in traditional labor-intensive low-valued-added sectors; real appreciation, driven by wages growing more than productivity since the inception of the EZ; and the relative strength of the value of the euro in the past decade.EZ Stock Problems
The stock problems are the large and possibly unsustainable stock of liabilities of: The government (in most of the periphery with the exception of Spain); the private non-financial sector (mostly in Spain, Ireland and Portugal); the banking and financial system (in most of the periphery); and the country (external debt), especially in Greece, Spain, Portugal, Cyprus and Ireland.
Stock vulnerabilities are the result of flow imbalances: A big fiscal deficit results in a growing and large stock of public debt (Greece, Italy, Ireland, Cyprus, Portugal) and in a large stock of foreign debt when private sector savings-investment imbalances are also large; a wide current account deficit"”whether driven by private sector imbalances (like in Spain and Ireland) or public sector ones (Greece, Cyprus, Portugal)"”leads to a build-up of foreign debt. In some cases, the excesses started in the private sector (housing boom and then bust in Ireland and Spain); so, initially it was a buildup of private debts and of foreign debts driven by large current account deficits. In other cases, the excesses started in the public sector (Greece, Italy, Portugal, Cyprus), leading to a large stock of public debt and of foreign debt"”via current account deficits"”in the subset of countries with fragile savings-investment imbalances in their private sectors (Greece, Portugal, Cyprus).
Until recently, Italy had a public debt problem but not current account and foreign debt problems as the high savings of the household sector prevented the fiscal deficit from turning into a current account deficit. But now, the sharp fall in private savings has led to the emergence of a current account deficit even there. In Spain and Ireland, the flow and stock imbalances started in the private sector leading to large current account deficits and foreign debts, but once the Spanish and Irish housing sectors went bust and resulted in sharp fiscal deficits"”in part, due to the socialization of private losses"”the ensuing rise in public debt created a sovereign debt sustainability problem.
Recent Policy Actions Start to Deal With Some Stock Vulnerabilities
The recent EZ package starts to deal with some"”but by no means all"”of the stock imbalances in the EZ periphery. First, public debt"”in some (Greece) but not all of the countries where it is unsustainable (Portugal, Ireland, Cyprus, Italy)"”will be reduced (50% haircut on private creditors, though the July plan will have to be completely scrapped, and the new details are lacking at this point). Second, the excessive amount of debt relative to the equity/capital of EZ banks will be partly addressed"”to prevent insolvency"”by recapitalizing EZ banks (both in the periphery and the core). These banks suffer from low capital ratios and potential erosion of their capital through losses, given exposures to sovereigns, busted real estate and rising non-performing loans as a result of the growing recession. But the capital needs of EZ banks, given these tail-risk losses, are much larger than the â?¬100 billion of recapitalization needs that the EZ has identified. Third, illiquidity"”of banks and sovereigns"”risks turning illiquidity into insolvency as self-fulfilling bad equilibria of runs on short-term liabilities of banks and governments are possible. Thus, the ECB's full allotment policy would prevent such a run on bank liabilities in principle only for banks that are illiquid but solvent, but in practice even possibly for insolvent banks.
For sovereigns that have lost market credibility"”and whose spreads could blow to an unsustainable level"”"catalytic finance" to use the traditional IMF terminology (see my book "Bailouts vs. Bail-Ins") or the "big bazooka" of the financial equivalent of Powell's doctrine of "overwhelming force" is necessary to provide time and financing for the flow adjustment"”fiscal and structural"”to restore market confidence and reduce spreads to sustainable levels. In each case, assumptions need to be made about whether a country is a) illiquid but solvent given financing to prevent loss of market access, time and enough adjustment/austerity (possibly Italy and Spain); b) illiquid and insolvent (Greece, clearly); or c) illiquid and near insolvent and already needing conditional financing given that market access has already been lost (Portugal, Ireland and Cyprus).
But even if Italy and Spain were illiquid and solvent given time, financing and adjustment, the big bazooka that the EZ needs to backstop banks and sovereigns in the periphery is at least â?¬2 trillion and possibly â?¬3 trillion rather than the fuzzy â?¬1 trillion that the EZ vaguely committed to at the recent summit. So, on all three counts, the recent EZ plan falls short of addressing the stock problems of highly indebted sovereigns, the capital needs of EZ banks and the liquidity needs of EZ banks and sovereigns; it also does little or nothing to restore competitiveness and growth in the short run.
Critical Role of Flow Factors in Resolving Stock Sustainability Issues
To make stocks sustainable, it is crucially important to address flow imbalances, for several reasons. First of all, without economic growth, you have a dual problem: a) The socio-political backlash against fiscal austerity and reforms becomes overwhelming as no society can accept year after year of economic contraction to deal with its imbalances; b) more importantly, to attain sustainability, flow deficits (fiscal and current account) and excessive debt stocks (private and public, domestic and foreign) need to be stabilized and reduced, but if output keeps on falling, such deficit and debt ratios keep on rising to unsustainable levels.
Second, restoring growth is also important because, without growth, absolute fiscal deficits become larger rather than smaller (given automatic stabilizers). Third, restoring external competitiveness is key as that loss of competitiveness led"”in the first place"”to current account deficits and the accumulation of foreign debt and to lower economic growth as the trade balance detracts from GDP growth when it is in a large and growing deficit. So, unless growth and external competitiveness are restored, flow imbalances (fiscal and current account deficits) persist and stabilizing domestic and external deficits becomes "mission impossible." Finally, note that, unless growth and competitiveness are restored, even dealing with stock problems via debt reduction will not work as flow deficits (fiscal and current account) will continue and, eventually, even reduced debt ratios will rise again if the denominator of the debt ratio (debt to GDP), i.e. GDP, keeps on falling. Growth also matters as credit risk"”measured by real interest rates on public, private and external debt, which measures the default risk"”will be higher the lower the economic growth rate. So, for any given debt level, a lower GDP growth rate that leads to a higher credit spread makes those debt dynamics more unsustainable (as sustainability depends on the differential between real interest rates and growth rates times the initial debt ratio).
The Current Account Flow Deficit Problem in the EZ Periphery
While the issue of fiscal deficits and public debt has been overemphasized in the recent policy debate about the problems of the EZ, one should not underestimate the role of external"”current account"”imbalances. These imbalances are now becoming unsustainable as the "sudden stop" and "reversal of private capital inflows" that the periphery has suffered implies that such deficits are now not financeable in the absence of official finance. These deficits are the result of savings-investment imbalances in both the private (Spain, Ireland, Portugal) and public sectors (Greece, Portugal, Cyprus, Italy); they are also the result of the real appreciation of these countries following a decade of declining export market share, the growth of wages in excess of productivity growth and the strength of the euro. Some of these deficits are now cyclically lower given that the collapse of output/demand has led to a fall in imports. But, on a structural basis, unless the real appreciation is reversed, the restoration of growth to its potential level would result in the resumption of large"”and now not financeable"”external deficits.
So, the modest reduction in current account deficits in the periphery that has been seen since 2009 is deceptive: It doesn't"”for the most part"”reflect an improvement in competitiveness; it is only the result of a severe and persistent recession. Real depreciation is required to restore such competiveness while ensuring sustained economic growth. An inability to restore competitiveness and thus growth would eventually undermine the monetary union as private creditors are now"”after a sudden stop"”unwilling to finance such deficits. So, eliminating the external current account deficit is as critical to restoring debt sustainability as reducing flow fiscal deficits. And fiscal deficits are not the only explanation of the external deficits as real appreciation and loss of competitiveness are as important, if not more important, than fiscal imbalances, in explaining such external imbalances.
The Recent EZ Package Does Little or Nothing to Restore, in the Short Term, Growth and Competitiveness, Which Are the Key to Sustainability
The latest economic data"”such as the EZ PMIs"”strongly suggest that the EZ"”not just the periphery, but also the core"”are falling back into a recession. This is very clear in the periphery where some countries never got out of their first 2008 recession, while the others are plunging back into recession after a very moderate recovery. But even in the core of the EZ, the latest data suggest that a recession is looming.
The recent EZ package (a bigger Greek haircut, bank recaps and a levered European Financial Stability Facility (EFSF), together with more fiscal austerity and a push toward structural reforms) does nothing to restore competitiveness and growth in the short run. In fact, it actually exacerbates the risk of a deeper and longer recession. Fiscal austerity is necessary to prevent a fiscal train wreck, but, in the short run (as recent IMF studies suggest), raising taxes, reducing transfer payments and cutting government spending (even inefficient/unproductive expenditure) has a negative effect on economic growth, as it reduces aggregate demand and disposable income. Moreover, even structural reforms that will eventually boost growth via higher productivity growth have a short-run negative effect: You need to fire unproductive public employees; you need to fire workers in weak firms and sectors; you need to shut down unprofitable firms in declining sectors; you need to move labor and capital from declining sectors to new sectors in which the country may have a comparative advantage. This all takes time and, in the absence of a rapid real depreciation, what are the sectors in which a periphery country has a new comparative advantage? Even necessary structural reforms"”like fiscal austerity"”reduce output and GDP in the short run before they have beneficial medium-term effects on growth.
To restore growth and competitiveness: The ECB would have to rapidly reverse its policy hikes, sharply reduce policy rates toward zero and do more quantitative and credit easing; the value of the euro would have to sharply fall toward parity with the U.S. dollar; and the core of the EZ would have to implement significant fiscal stimulus if the periphery is forced into necessary but contractionary fiscal austerity (which will have a short-term drag on growth).
Options for Dealing with Stock and Flow Problems
Stock imbalances"”large and potentially unsustainable liabilities"”can be addressed in multiple ways: a) high economic growth can heal most wounds, especially debt wounds given that fast growth in the denominator of the debt ratio (i.e. GDP) can lead over time to a lowering of debt ratios; b) low spending and higher savings in the private and public sectors can lead to lower fiscal deficits and lower current account deficits (lower flow imbalances) that, over time, reduce the stocks of public and external debt relative to GDP; c) inflation and/or forms of financial repression can reduce the real value of debts; the same can occur with unexpected depreciation of the currency if the liabilities are in a domestic currency; d) debts can be reduced via debt restructurings and reductions, including the conversion of debt into equity. The last option is key: If growth remains anemic in the EZ; if savings lead to the paradox of thrift (a more severe short-term recession) and if monetization, inflation or devaluations are not pursued by the ECB, the only way to deal with excessive private and public debts becomes some orderly or disorderly reduction of such debts and/or their conversion into equity.
Flow imbalances are more difficult to resolve as they imply a reduction of fiscal and current account deficits that are consistent with sustainable growth and with the restoration of competitiveness, which requires real depreciation. To reduce external current account deficits"”the key to restoring competitiveness and growth"”you need both decreases in expenditure (private and public) and expenditure-switching through a real depreciation. Such real depreciation can occur in four ways: a) a nominal depreciation of the euro large enough to lead to a sharp real depreciation in the periphery; b) structural reforms that increase productivity growth while keeping a lid on wage growth below productivity growth and thus reduce unit labor costs over time; c) real depreciation via deflation"”a cumulative persistent fall in prices and wages that achieves a sharp real depreciation; and d) exit from the monetary union and return to a national currency that leads to a nominal and real depreciation. The key issue here is"”as we will discuss in detail below"”that achieving the real depreciation via route a) is unlikely, as there are many reasons why the euro will not weaken enough; getting it via b) may take way too long"”a decade or more"”when the sudden stop requires a rapid turnaround of the external deficit; achieving it via c) may also take too long and would be associated with a persistent recession, while leading to massive balance-sheet effects; thus the d) option"”exit from EZ"”becomes the only available one if the other three are not feasible/desirable.
Additionally, if growth and competitiveness are restored in short order, this is the best way"”on top of decreased expenditure via fiscal austerity"”to reduce both the fiscal and current account imbalances as well as the relative ones (i.e. as a share of GDP). In other terms, fiscal austerity and structural reforms eventually restore growth and productivity, but they are, in the short run, recessionary. Thus, other macro policies are needed to restore growth, which is critical to make the adjustment politically and financially feasible. Therefore, macro policies consistent with a rapid return to economic growth are the key to resolving flow problems.
Four Options to Address the Stock and Flow Problems of the EZ
Given the above analysis of the structural and fundamental problems faced by the EZ, there are four possible options to deal with the bloc's stock and flow problems; each option implies a different future for the monetary union. Each reduces unsustainable debts and restores growth and competitiveness and reduces flow imbalances via a different combination of the policies discussed above
1. Growth and Competiveness Are Restored. In this first option, policies are undertaken to rapidly restore growth and competitiveness (monetary easing, a weaker euro, core fiscal easing and the reduction of unsustainable public and private debts in clear insolvency cases), to reduce flow deficits and to restore private, public and external debt sustainability, all while the periphery undertakes continued painful austerity and structural reforms. In this scenario, the EZ survives in the sense that most members"”maybe with the exceptions of Greece and possibly Portugal"”remain in the EZ and most members"”again, with the exceptions of Greece and possibly Portugal"”avoid a coercive restructuring of their public and private debts. This solution requires a nominal and real depreciation of the euro and, for a period of time, higher (lower) inflation in the core (periphery) of the EZ than the current ECB target to restore, via real depreciation, the competitiveness of the periphery and rapidly eliminate its unsustainable current account deficit.
2. The Deflationary/Depressionary Route to the Restoration of Competitiveness. Growth and competitiveness are not restored in the short run as the core/Germany imposes an adjustment based on deflationary and depressionary draconian fiscal austerity and structural reforms that, in the absence of appropriate expansionary macro policies, makes the recession of the periphery severe and persistent and doesn't restore its external competitiveness for many years. This depression/deflationary path becomes politically and socially unsustainable for most"”but possibly not all"”of the EZ periphery as it implies five-ten years of ever-fall
The announcement of the most recent EZ rescue package (acceptance of a bigger haircut for Greek private creditors, the recapitalization of EZ banks and the use of guarantees and financial leverage in the hope of preventing Italy and Spain losing market access) led to markets rallying for a day as the tail risk of a disorderly situation in the EZ, temporarily, diminished. By the next day, Italian yields and spreads were still close to their high, serving as a reminder"”as we argued in "The Last Shot on Goal: Will Eurozone Leaders Succeed in Ending the Crisis?," co-authored with Megan Greene"”that the EZ's fundamental problems will not be resolved by this trio of policy actions.
To put the latest package in context, we need to first assess the fundamental problems facing the EZ and the potential scenarios for the monetary union.
EZ Flow Problems
The EZ suffers from both stock and flow problems, which are related to each other. The flow problems were and/or are:
EZ Stock Problems
The stock problems are the large and possibly unsustainable stock of liabilities of: The government (in most of the periphery with the exception of Spain); the private non-financial sector (mostly in Spain, Ireland and Portugal); the banking and financial system (in most of the periphery); and the country (external debt), especially in Greece, Spain, Portugal, Cyprus and Ireland.
Stock vulnerabilities are the result of flow imbalances: A big fiscal deficit results in a growing and large stock of public debt (Greece, Italy, Ireland, Cyprus, Portugal) and in a large stock of foreign debt when private sector savings-investment imbalances are also large; a wide current account deficit"”whether driven by private sector imbalances (like in Spain and Ireland) or public sector ones (Greece, Cyprus, Portugal)"”leads to a build-up of foreign debt. In some cases, the excesses started in the private sector (housing boom and then bust in Ireland and Spain); so, initially it was a buildup of private debts and of foreign debts driven by large current account deficits. In other cases, the excesses started in the public sector (Greece, Italy, Portugal, Cyprus), leading to a large stock of public debt and of foreign debt"”via current account deficits"”in the subset of countries with fragile savings-investment imbalances in their private sectors (Greece, Portugal, Cyprus).
Until recently, Italy had a public debt problem but not current account and foreign debt problems as the high savings of the household sector prevented the fiscal deficit from turning into a current account deficit. But now, the sharp fall in private savings has led to the emergence of a current account deficit even there. In Spain and Ireland, the flow and stock imbalances started in the private sector leading to large current account deficits and foreign debts, but once the Spanish and Irish housing sectors went bust and resulted in sharp fiscal deficits"”in part, due to the socialization of private losses"”the ensuing rise in public debt created a sovereign debt sustainability problem.
Recent Policy Actions Start to Deal With Some Stock Vulnerabilities
The recent EZ package starts to deal with some"”but by no means all"”of the stock imbalances in the EZ periphery. First, public debt"”in some (Greece) but not all of the countries where it is unsustainable (Portugal, Ireland, Cyprus, Italy)"”will be reduced (50% haircut on private creditors, though the July plan will have to be completely scrapped, and the new details are lacking at this point). Second, the excessive amount of debt relative to the equity/capital of EZ banks will be partly addressed"”to prevent insolvency"”by recapitalizing EZ banks (both in the periphery and the core). These banks suffer from low capital ratios and potential erosion of their capital through losses, given exposures to sovereigns, busted real estate and rising non-performing loans as a result of the growing recession. But the capital needs of EZ banks, given these tail-risk losses, are much larger than the â?¬100 billion of recapitalization needs that the EZ has identified. Third, illiquidity"”of banks and sovereigns"”risks turning illiquidity into insolvency as self-fulfilling bad equilibria of runs on short-term liabilities of banks and governments are possible. Thus, the ECB's full allotment policy would prevent such a run on bank liabilities in principle only for banks that are illiquid but solvent, but in practice even possibly for insolvent banks.
For sovereigns that have lost market credibility"”and whose spreads could blow to an unsustainable level"”"catalytic finance" to use the traditional IMF terminology (see my book "Bailouts vs. Bail-Ins") or the "big bazooka" of the financial equivalent of Powell's doctrine of "overwhelming force" is necessary to provide time and financing for the flow adjustment"”fiscal and structural"”to restore market confidence and reduce spreads to sustainable levels. In each case, assumptions need to be made about whether a country is a) illiquid but solvent given financing to prevent loss of market access, time and enough adjustment/austerity (possibly Italy and Spain); b) illiquid and insolvent (Greece, clearly); or c) illiquid and near insolvent and already needing conditional financing given that market access has already been lost (Portugal, Ireland and Cyprus).
But even if Italy and Spain were illiquid and solvent given time, financing and adjustment, the big bazooka that the EZ needs to backstop banks and sovereigns in the periphery is at least â?¬2 trillion and possibly â?¬3 trillion rather than the fuzzy â?¬1 trillion that the EZ vaguely committed to at the recent summit. So, on all three counts, the recent EZ plan falls short of addressing the stock problems of highly indebted sovereigns, the capital needs of EZ banks and the liquidity needs of EZ banks and sovereigns; it also does little or nothing to restore competitiveness and growth in the short run.
Critical Role of Flow Factors in Resolving Stock Sustainability Issues
To make stocks sustainable, it is crucially important to address flow imbalances, for several reasons. First of all, without economic growth, you have a dual problem: a) The socio-political backlash against fiscal austerity and reforms becomes overwhelming as no society can accept year after year of economic contraction to deal with its imbalances; b) more importantly, to attain sustainability, flow deficits (fiscal and current account) and excessive debt stocks (private and public, domestic and foreign) need to be stabilized and reduced, but if output keeps on falling, such deficit and debt ratios keep on rising to unsustainable levels.
Second, restoring growth is also important because, without growth, absolute fiscal deficits become larger rather than smaller (given automatic stabilizers). Third, restoring external competitiveness is key as that loss of competitiveness led"”in the first place"”to current account deficits and the accumulation of foreign debt and to lower economic growth as the trade balance detracts from GDP growth when it is in a large and growing deficit. So, unless growth and external competitiveness are restored, flow imbalances (fiscal and current account deficits) persist and stabilizing domestic and external deficits becomes "mission impossible." Finally, note that, unless growth and competitiveness are restored, even dealing with stock problems via debt reduction will not work as flow deficits (fiscal and current account) will continue and, eventually, even reduced debt ratios will rise again if the denominator of the debt ratio (debt to GDP), i.e. GDP, keeps on falling. Growth also matters as credit risk"”measured by real interest rates on public, private and external debt, which measures the default risk"”will be higher the lower the economic growth rate. So, for any given debt level, a lower GDP growth rate that leads to a higher credit spread makes those debt dynamics more unsustainable (as sustainability depends on the differential between real interest rates and growth rates times the initial debt ratio).
The Current Account Flow Deficit Problem in the EZ Periphery
While the issue of fiscal deficits and public debt has been overemphasized in the recent policy debate about the problems of the EZ, one should not underestimate the role of external"”current account"”imbalances. These imbalances are now becoming unsustainable as the "sudden stop" and "reversal of private capital inflows" that the periphery has suffered implies that such deficits are now not financeable in the absence of official finance. These deficits are the result of savings-investment imbalances in both the private (Spain, Ireland, Portugal) and public sectors (Greece, Portugal, Cyprus, Italy); they are also the result of the real appreciation of these countries following a decade of declining export market share, the growth of wages in excess of productivity growth and the strength of the euro. Some of these deficits are now cyclically lower given that the collapse of output/demand has led to a fall in imports. But, on a structural basis, unless the real appreciation is reversed, the restoration of growth to its potential level would result in the resumption of large"”and now not financeable"”external deficits.
So, the modest reduction in current account deficits in the periphery that has been seen since 2009 is deceptive: It doesn't"”for the most part"”reflect an improvement in competitiveness; it is only the result of a severe and persistent recession. Real depreciation is required to restore such competiveness while ensuring sustained economic growth. An inability to restore competitiveness and thus growth would eventually undermine the monetary union as private creditors are now"”after a sudden stop"”unwilling to finance such deficits. So, eliminating the external current account deficit is as critical to restoring debt sustainability as reducing flow fiscal deficits. And fiscal deficits are not the only explanation of the external deficits as real appreciation and loss of competitiveness are as important, if not more important, than fiscal imbalances, in explaining such external imbalances.
The Recent EZ Package Does Little or Nothing to Restore, in the Short Term, Growth and Competitiveness, Which Are the Key to Sustainability
The latest economic data"”such as the EZ PMIs"”strongly suggest that the EZ"”not just the periphery, but also the core"”are falling back into a recession. This is very clear in the periphery where some countries never got out of their first 2008 recession, while the others are plunging back into recession after a very moderate recovery. But even in the core of the EZ, the latest data suggest that a recession is looming.
The recent EZ package (a bigger Greek haircut, bank recaps and a levered European Financial Stability Facility (EFSF), together with more fiscal austerity and a push toward structural reforms) does nothing to restore competitiveness and growth in the short run. In fact, it actually exacerbates the risk of a deeper and longer recession. Fiscal austerity is necessary to prevent a fiscal train wreck, but, in the short run (as recent IMF studies suggest), raising taxes, reducing transfer payments and cutting government spending (even inefficient/unproductive expenditure) has a negative effect on economic growth, as it reduces aggregate demand and disposable income. Moreover, even structural reforms that will eventually boost growth via higher productivity growth have a short-run negative effect: You need to fire unproductive public employees; you need to fire workers in weak firms and sectors; you need to shut down unprofitable firms in declining sectors; you need to move labor and capital from declining sectors to new sectors in which the country may have a comparative advantage. This all takes time and, in the absence of a rapid real depreciation, what are the sectors in which a periphery country has a new comparative advantage? Even necessary structural reforms"”like fiscal austerity"”reduce output and GDP in the short run before they have beneficial medium-term effects on growth.
To restore growth and competitiveness: The ECB would have to rapidly reverse its policy hikes, sharply reduce policy rates toward zero and do more quantitative and credit easing; the value of the euro would have to sharply fall toward parity with the U.S. dollar; and the core of the EZ would have to implement significant fiscal stimulus if the periphery is forced into necessary but contractionary fiscal austerity (which will have a short-term drag on growth).
Options for Dealing with Stock and Flow Problems
Stock imbalances"”large and potentially unsustainable liabilities"”can be addressed in multiple ways: a) high economic growth can heal most wounds, especially debt wounds given that fast growth in the denominator of the debt ratio (i.e. GDP) can lead over time to a lowering of debt ratios; b) low spending and higher savings in the private and public sectors can lead to lower fiscal deficits and lower current account deficits (lower flow imbalances) that, over time, reduce the stocks of public and external debt relative to GDP; c) inflation and/or forms of financial repression can reduce the real value of debts; the same can occur with unexpected depreciation of the currency if the liabilities are in a domestic currency; d) debts can be reduced via debt restructurings and reductions, including the conversion of debt into equity. The last option is key: If growth remains anemic in the EZ; if savings lead to the paradox of thrift (a more severe short-term recession) and if monetization, inflation or devaluations are not pursued by the ECB, the only way to deal with excessive private and public debts becomes some orderly or disorderly reduction of such debts and/or their conversion into equity.
Flow imbalances are more difficult to resolve as they imply a reduction of fiscal and current account deficits that are consistent with sustainable growth and with the restoration of competitiveness, which requires real depreciation. To reduce external current account deficits"”the key to restoring competitiveness and growth"”you need both decreases in expenditure (private and public) and expenditure-switching through a real depreciation. Such real depreciation can occur in four ways: a) a nominal depreciation of the euro large enough to lead to a sharp real depreciation in the periphery; b) structural reforms that increase productivity growth while keeping a lid on wage growth below productivity growth and thus reduce unit labor costs over time; c) real depreciation via deflation"”a cumulative persistent fall in prices and wages that achieves a sharp real depreciation; and d) exit from the monetary union and return to a national currency that leads to a nominal and real depreciation. The key issue here is"”as we will discuss in detail below"”that achieving the real depreciation via route a) is unlikely, as there are many reasons why the euro will not weaken enough; getting it via b) may take way too long"”a decade or more"”when the sudden stop requires a rapid turnaround of the external deficit; achieving it via c) may also take too long and would be associated with a persistent recession, while leading to massive balance-sheet effects; thus the d) option"”exit from EZ"”becomes the only available one if the other three are not feasible/desirable.
Additionally, if growth and competitiveness are restored in short order, this is the best way"”on top of decreased expenditure via fiscal austerity"”to reduce both the fiscal and current account imbalances as well as the relative ones (i.e. as a share of GDP). In other terms, fiscal austerity and structural reforms eventually restore growth and productivity, but they are, in the short run, recessionary. Thus, other macro policies are needed to restore growth, which is critical to make the adjustment politically and financially feasible. Therefore, macro policies consistent with a rapid return to economic growth are the key to resolving flow problems.
Four Options to Address the Stock and Flow Problems of the EZ
Given the above analysis of the structural and fundamental problems faced by the EZ, there are four possible options to deal with the bloc's stock and flow problems; each option implies a different future for the monetary union. Each reduces unsustainable debts and restores growth and competitiveness and reduces flow imbalances via a different combination of the policies discussed above
1. Growth and Competiveness Are Restored. In this first option, policies are undertaken to rapidly restore growth and competitiveness (monetary easing, a weaker euro, core fiscal easing and the reduction of unsustainable public and private debts in clear insolvency cases), to reduce flow deficits and to restore private, public and external debt sustainability, all while the periphery undertakes continued painful austerity and structural reforms. In this scenario, the EZ survives in the sense that most members"”maybe with the exceptions of Greece and possibly Portugal"”remain in the EZ and most members"”again, with the exceptions of Greece and possibly Portugal"”avoid a coercive restructuring of their public and private debts. This solution requires a nominal and real depreciation of the euro and, for a period of time, higher (lower) inflation in the core (periphery) of the EZ than the current ECB target to restore, via real depreciation, the competitiveness of the periphery and rapidly eliminate its unsustainable current account deficit.
2. The Deflationary/Depressionary Route to the Restoration of Competitiveness. Growth and competitiveness are not restored in the short run as the core/Germany imposes an adjustment based on deflationary and depressionary draconian fiscal austerity and structural reforms that, in the absence of appropriate expansionary macro policies, makes the recession of the periphery severe and persistent and doesn't restore its external competitiveness for many years. This depression/deflationary path becomes politically and socially unsustainable for most"”but possibly not all"”of the EZ periphery as it implies five-ten years of ever-falling output to restore competitiveness via deflation and eventual structural reforms. And with output falling in the short run and a fall in prices/wages, stock problems worsen for a while (as both nominal and real GDP are falling) until the restoration of growth eventually takes care of the stock imbalances. Since, for most EZ members, Option 2 becomes politically and socially unfeasible, in the absence of a path that leads to Option 1, Option 2 evolves into Options 3 or 4.
3. The Core Permanently Subsidizes the Periphery. If Option 1 does not materialize while Option 2 becomes politically-socially unsustainable, the only other way to avoid Option 4 (EZ break-up) is not just via a reduction of the unsustainable stocks of liabilities in the periphery (a capital levy on the core of creditors), but also via a permanent subsidization of the uncompetitive periphery by the core. Since the lack of a restoration of growth/competiveness implies a permanent external deficit (trade deficit) in the periphery with a trade surplus in the core that implies an unsustainable current account deficit in the periphery, the only way in which the core can prevent the periphery from exiting the EZ (even after a debt reduction that doesn't resolve the current account flow deficit problem) is to make a unilateral permanent yearly transfer payment (of the order of several percentage points of core GDP, possibly as high as 5% of GDP) to the periphery to prevent the trade deficit from turning into an unsustainable current account deficit that in turn leads to the accumulation of even more unsustainable external debt. Such a unilateral transfer sustains the GNP of the periphery while its GDP remains permanently depressed as competitiveness is not restored. So, stock problems are addressed via repeated restructurings, extensions and haircuts of privately held debt (bonds) and bilateral/multilateral loans as well as via recapitalizations of banks that include some conversion of debt into equity. Meanwhile, flow problems are addressed via a permanent yearly subsidy to the periphery from the core.
4. The EZ Experiences Widespread Debt Restructurings. Members of the periphery react to the Option 2 (depression/deflation) that is currently imposed on them by Germany and the ECB by, first, losing market access (or not regaining it) and are thus forced, once official finance runs out (because of political and/or financial constraints in the core), to coercively restructure their public and also their private debts (say, of banks and financial institutions). Even such a debt reduction is insufficient to restore growth and competitiveness as it partially deals with stock problems, but does not deal with flow problems. If, then, the flow problem is not resolved via a permanent subsidization of the income of the periphery by the core (Option 3), then the only other way to restore growth and competitiveness is via exit from the monetary union and a return to the national currency. The EZ can survive the exit of its smaller members (Greece, Portugal, Cyprus), but if debt restructurings and the exit of Italy and/or Spain become necessary/inevitable, the EZ effectively breaks up, with only a small core"”Germany and a few core members"”remaining in a smaller and much damaged monetary union.
An Assessment of the Likelihood of the Four Options
Option 1: Most Desirable But Quite Unlikely as Contrary to the Goals and Constraints of Germany/the ECB
Which one of these four options is most likely? Option 1 appears the most desirable as it leads to the survival and success of the EZ. However, it is not necessarily the most likely option as it would imply radical, rapid and presumably unacceptable changes in the core's macro-policy.
First, the ECB would have to reverse its policy tightening and aggressively cut rates; even that would not be sufficient as aggressive quantitative easing (QE) would be necessary to restore growth and provide unlimited lending of last resort (LOLR) to sovereigns"”such as Spain and Italy"”that are possibly illiquid but solvent if given enough time and liquidity to resolve their problems. Even traditional QE would not be sufficient as unconventional credit easing may be necessary to restore credit growth to smaller firms and households subject to a credit crunch. This is obviously not acceptable to the ECB and Germany as it would require a radical change (maybe via a treaty change) to the ECB's formal mandate (the bank is currently supposed to only pursue the goal of price stability). The ECB"”and eventually Germany as a recap of the ECB would fall to Germany/core"”would also take a significant risk in becoming (for a while) the LOLR for Italy and Spain, which may turn out"”even with massive liquidity"”to be not just illiquid but also insolvent (there are many future paths via which the latter could happen).
Second, the value of the euro would have to fall sharply compared with current levels, possibly toward parity with the U.S. dollar to reverse the loss of competitiveness of the periphery. This would imply that inflation would rise in the core"”starting in Germany"”for a number of years above 2% to allow the real depreciation of the periphery to occur. This doesn't look like being politically acceptable to Germany and the ECB. Also, with Germany being uber-competitive and with a large external surplus, while the U.S. dollar needs to a weaken given the large U.S. current account deficit, it is not obvious that the euro would fall as sharply as the periphery needs, unless the ECB aggressively pursues QE and credit easing and jawbones the euro down with verbal and actual intervention: All very unlikely outcomes given the ECB's current mandate and the German/ECB goal of restoring the periphery's competitiveness via deflation ("internal devaluation").
Third, the core would have to accept and implement a fiscal stimulus to compensate for the recessionary effects of the fiscal austerity of the periphery. But Germany and the core are vehemently against back-loaded fiscal austerity let alone fiscal easing of the type that even the IMF is now suggesting to them. Germany/the core is of the view that the problems of the periphery were self-inflicted even when private imbalances (like in Spain and Ireland) rather than public ones were at the core of financial difficulties. So, austerity and reform are viewed by the core as a must for both the periphery and also for the core.
Option 2: Socially-Politically Unacceptable as Implies a Persistent Recession-Depression in Most of the Periphery
Option 2 is the type of adjustment that the ECB and Germany would like to impose on the periphery, but it would be socially and politically unacceptable for most. It is thus not a stable equilibrium but rather an unstable disequilibrium that would eventually lead to Options 3 or 4. Since fiscal deficits are excessive, they need to be rapidly reduced via front-loaded austerity to make public debts sustainable. Current account deficits will be partly reduced via the reduction of public dis-savings. The rest of the external imbalance will be corrected via deflation (internal devaluation) and via accelerated structural reforms that increase productivity growth, while keeping a lid on wage growth below such higher productivity growth will progressively reduce unit labor costs and restore external competitiveness.
The problems with the German/ECB solution to the growth/competitiveness issue are multiple. First, fiscal austerity is necessary, but if implemented by the entire EZ it makes the periphery recession worse, deeper and longer and thus undermines the restoration of growth that is necessary to make the debts sustainable. Also, such recession damages attempts to reduce fiscal deficits; and it improves external balances only temporarily via a compression of imports, not via a true restoration of competitiveness; structural external deficits mostly remain.
Second, reducing unit labor costs via accelerated reforms that increase productivity growth"”while keeping a lid on wage growth below such rising productivity growth"”is easier said than done. It took 10 to 15 years for Germany to achieve its reduction of unit labor costs via that route. And since German unit labor costs have fallen by 20% since the inception of the EZ, while they have risen by 30% in the EZ periphery, the unit labor cost gap between Germany and periphery is now about 50%. So, if the EZ periphery were to accelerate reforms that actually depress output in the short run, the benefits will start to show up after five years or so; and no country can accept five years of recession or depression before it returns to growth. Also, a reduction in unit labor costs via a rise in productivity growth above positive wage growth"”as in Germany in the past 15 years"”is politically more feasible"”as it is associated with growth rather than recession"”than a recessionary adjustment where wages need to fall in nominal terms as productivity growth remains stagnant while output stagnates for a number of years. Given the nominal downward rigidity of wages and prices, outright deflation is extremely hard to achieve in the absence of a severe and persistent depression.
Third, deflation/internal devaluation is not politically-socially feasible if it leads"”as is likely"”to persistent recession. Deflation"”a 5% fall in prices and wages for five years leading to a cumulative compound reduction of prices and wages of 30% that undoes the loss of competitiveness of the periphery"”would be most likely associated with a continued recession for five more years, likely turning into a depression.
The international experience of "internal devaluations" is mostly one of failure. Argentina tried the deflation route to a real depreciation and, after three years of an ever-deepening recession/depression, it defaulted and exited its currency board peg. The case of Latvia's "successful" internal devaluation is not a model for the EZ periphery: Output fell by 20% and unemployment surged to 20%; the public debt was"”unlike in the EZ periphery"”negligible as a percentage of GDP and thus a small amount of official finance"”a few billion euros"”was enough to backstop the country without the massive balance-sheet effects of deflation; and the willingness of the policy makers to sweat blood and tears to avoid falling into the arms of the "Russian bear" was, for a while, unlimited (as opposed to the EZ periphery's unwillingness to give up altogether its fiscal independence to Germany); and even after devaluation and default was avoided, the current backlash against such draconian adjustment is now very serious and risks undermining such efforts (while, equivalently, the social and political backlash against recessionary austerity is coming to a boil in the EZ periphery).
The other cases of successful reductions of large external and fiscal deficits and debts in the European member states in the 1990s"”Belgium, Sweden, Finland, Denmark, etc."”are just as irrelevant as Latvia's example as they occurred against a background of growth (not the current EZ recession), falling interest rates as expectations of EMU led to convergence trades (not the current blowing up of sovereign spreads and loss of market access) and, in some cases, via nominal and real depreciations within the flexible terms of the European Monetary System (not the rigid constraints of a monetary union where there is no national currency and the value of the euro remains excessively strong).
Some EZ periphery members"”notably Ireland"”are undergoing a degree of internal devaluation, but it is too slow and small to rapidly restore competitiveness: A fall in public wages may, in due course, push down private wages in traded sectors and eventually reduce unit labor costs.
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