Several major issues need to be addressed in order to restore market confidence in an unwieldy and wobbly-looking eurozone, says Guy Monson
Several major issues need to be addressed in order to restore market confidence in an unwieldy and wobbly-looking eurozone, says Guy Monson
AS CONTINENTS VIE for the world’s largest bailouts, Europe’s faltering and indecisive offering looks positively unimpressive when set alongside the US post-Lehman bank rescue plans and the Chinese emergency fiscal package last year.
Perhaps the Europeans were always bound to disappoint in the competition for effective and timely use of financial firepower, but the Greek rescue package has demonstrated all the inherent weaknesses of European decision-making, and the lack of executive authority in a multi-country system. Sixteen governments were needed to approve the bailout, narrow domestic voter issues interfered, policy was skewed by inconvenient regional electoral timetables (notably in North Rhine-Westphalia), and treaty restrictions on cross-border subsidies forced the use of opaque special purpose vehicles.
However, despite Germany ’s unilateral decision to introduce a selling ban on European sovereign debt securities (as well as on ten large German financial institutions), the political will to make painful reductions is generally impressive, as demonstrated by the recent government-approved wage reductions in Spain, the announcement of a €24 billion austerity package over two years in Italy, and ferocious public-sector cuts in Ireland, Portugal and Greece.
Related
This may seem a mildly chaotic start to the fiscal consolidation needed globally, but that it is not perfect is probably helpful; a terrible ‘Shift to Thrift’ could derail the nascent recovery. We believe that financial markets will slowly but surely come to realise this, but market fears concerning the viability of the eurozone will only subside if credible frameworks to address certain key issues are developed.
Firstly, how should a country that becomes insolvent go about restructuring its debt? The IMF-led package enables Greece to be able to borrow at non-market rates for roughly three years (a window during which it will have to restore the primary balance to surplus), but the bigger issue of Greek solvency — ie how Greece will manage to service a debt-to-GDP level of 150 per cent in 2013 — is left to be dealt with at a later date. Massive liquidity injections today do not alter the fundamental risk of sovereign insolvency, and this is what markets are unhappy with; liquidity today by no means ensures solvency tomorrow.
Secondly, how should the eurozone promote sound fiscal policies at national level when it does not have a strong fiscal centre? This is essential for long-term credibility as long as it seeks to function without a strong federal budget. The Stability and Growth Pact will need to develop sharp teeth and exact punitive costs for transgressions, and good times will need to be banked for a rainy day, not squandered as they have been in the recent past.
HOWEVER, SO MANY column inches are now being devoted to the desire for budget balance and the need for aggressive fiscal retrenchment that markets are beginning to fear that this in itself will damage economic growth. Keynes’s ‘Paradox of Thrift’ identifies the fallacy of composition: what is prudent for one may not be prudent for all. In other words, simultaneous belt-tightening by different members of the eurozone can reduce total demand and savings, potentially triggering an economic contraction that could leave the economy in a more vulnerable state than where it began.
But while the ‘Paradox of Thrift’ correctly identifies the possibilities of a negative multiplier effect, it does gloss over the fact that there are many instances where fiscal contractions can improve private-sector confidence and bring about a sustainable expansion. Even more paradoxically, this is popularly known as the ‘expansionary fiscal contraction’. The most recent Economic Outlook from the OECD analysed the extent to which the private-sector response can offset the public retrenchment.
Content from our partners
Typically, private-sector ‘dis-savings’ offset 40 per cent of the public sector ‘savings’, increasing with the size of government debt and credibility of the fiscal consolidation. In other words, the euro crisis could be a remarkable opportunity to improve the efficiency of the public sector, setting up a ‘right-sized’ government that uses scarce tax revenues more effectively. This is not new — in the Eighties, Denmark, Finland and Ireland all successfully used this template to bring about an economic recovery at the same time as fiscal consolidation.
Another reason to downplay the ‘Paradox of Thrift’ is the fact that it is not the aggregate amount of debt (consumer, corporates and government) that is the real problem for the eurozone; this stands at only 220 per cent of GDP for Europe, compared with 280 per cent for the US, 300 per cent for the UK and 363 per cent for Japan. The savings ratio in core Europe is six times that of the US; the problem is rather the distribution of the government debt.
Hence, from an economic point of view, core Europe can (in theory) continue to finance transfer payments to the periphery for a long time.
Perhaps the trend to thrift in the periphery, matched by extended private-sector consumption in the core, is the ultimate goal.
