Europe - Is Anybody Watching?

Europe doesn't seem to be getting its act together. The new head of the ECB does look more willing to take action, but the pressure for austerity in the peripheral countries is strong. This seems likely to drag those countries further into debt and economic distress.

I believe this is economic foolishness on a grand scale. These are contractionary policies and European countries aren't going to be able to reduce their debt burden without expanding their economies. The big question is whether they have already entered a death spiral. The Euro zone is looking more and more shaky.

Last month I mentioned that the discussion blaming Greek and Italian debt entirely on improvident actions by Greece and Italy reminded me of discussions in the sixties and seventies about balance of payments issues.

British economist Gavyn Davies makes the connection explicit and clear in a recent blog post "The Eurozone Decouples From the World."

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"It is normal to discuss the sovereign debt problem," Davies explains,  "by focusing on the sustainability of public debt in the peripheral economies. But it can be more informative to view it as a balance of payments problem." I think that analysis is exactly right. He goes on to provide statistics: "Taken together, the four most troubled nations (Italy, Spain, Portugal and Greece) have a combined current account deficit of $183 billion. Most of this deficit is accounted for by the public sector deficits of these countries, since their private sectors are now roughly in financial balance. Offsetting these deficits, Germany has a current account surplus of $182 billion, or about 5 per cent of its GDP."

So what should be done?  If it is a balance of payments problem, Davies explains, "it is clear that there needs to be a capital account transfer each year amounting to about 5 per cent of German GDP from the core to the periphery. Without that, the euro will break up. Until 2008, this transfer happened voluntarily, by private sector flows, mainly in the form of bank purchases of higher yielding sovereign bonds in the peripheries, and to a lesser extent via asset purchases (notably housing in Spain). Since 2008, these private flows have dried up, and in fact reversed, so the public sector has had to step in. It has done so in the form of direct sovereign loans, and more importantly by international transfers which have been heavily disguised within the balance sheet of the ECB. Although disguised, these transfers are very real." What Davies fails to explain as clearly as he might, is that the reason the current account balance is a problem is that: a) the periphery countries don't have their own currency, but are forced to borrow in a currency over which they lack control; b) they are precluded from achieving balance by devaluation (that is, they have a very fixed exchange rate); and c) they still have all of the burdens of sovereignty with respect to things like funding armies, police forces, social programs, etc.

Davies goes on: "The eurozone’s proposed solution to this problem – budget contraction plus economic reform in the debtor nations, with no change in policy in the creditor nations – is very familiar to students of balance of payments crises in fixed exchange rate systems such as the Gold Standard or the Bretton Woods system in the past. It is not impossible for these solutions to work, but they are very contractionary for economic activity, and very frequently they fail. When they fail, they lead to devaluations by the debtor economies, normally because the required degree of contraction proves politically impossible to undertake. That is where Greece probably finds itself today. Others may be in the same position before too long."

Now Davies reaches the crux of the matter. The EU has decreed a punishing regime for Greece and soon will for Italy. It isn't clear how long Greek and Italian voters will stand for the solution. Leaving the Euro zone will not be painless, but it may turn out to be the best solution.

"The reason why the eurozone strategy is so difficult to implement is that both of its required actions are likely to make the European recession worse in the immediate future. This has already become clearly apparent in the negative feedback loops which have developed as budgetary policy has been tightened. None of the austere budgetary plans which have been announced during 2011 will achieve their fiscal targets in 2012 in the context of the recessions which will probably be encountered by many countries, and that includes France. There is no such thing as “expansionary austerity”, certainly not in countries which cannot devalue or reduce their long term interest rates. These countries are now chasing their own tails."

"Less widely appreciated," Gavyn explains,  "is the fact that structural economic reform will also make the recession worse in the next couple of years. This reform is absolutely essential in countries like Italy, which are otherwise facing a future of indefinite stagnation, but IMF research shows that in previous similar examples, labour market reform has initially led to higher unemployment and lower GDP as workers are shaken out of unproductive employment. The IMF warns that these reform programmes work best when economies are beginning to recover from recessions, and when there is scope in government budgets to compensate the losers through tax cuts or other measures of support. Neither of these conditions apply today."

"Is there," Gavyn asks,  "any way of improving the chances of success for the eurozone’s chosen strategy? Theoretically, yes. Germany, as the main creditor nation could choose to grow faster, and accept higher domestic inflation for a while, in order to ease the process of adjustment. In practice, Germany shows no sign of accepting this, but it is the best solution available, not only for the debtor economies, but also for Germany itself."

So the logical conclusion is, if the Euro zone collapses, it should not be Greece or Italy which shoulders the blame, but Germany.