Financial market quiescence has removed pressure for immediate policy action on the Eurozone crisis. This column argues that while important repairs were made in 2012, the most difficult ones still lie ahead. Much remains to be done by unwilling politicians. Things will have to get worse before they get better. The best hope is that this happens in 2013 rather than in 2014.
The situation of the Eurozone is now becoming clearer. This article lists ten observations and draws five consequences. The bottom line is that, even though some important steps were taken in 2012, the most difficult ones still lie ahead. Much remains to be done by unwilling politicians. So, regrettably, things will have to get worse before they get better. Maybe 2013 will the year of bottoming up.
It was predictable. Policy responses were initially easy. What was not as predictable was how policymakers would make a mess of it. Economists too bear a fair share of responsibility as they indulged in total disharmony, with many of us floating irresponsible propositions backed by deeply confused analyses. As time is passing by, the Darwinian process of separating out bad from good analyses is taking hold and things become clearer. Hopefully the following ten observations are less controversial in 2013 than in previous years.
- As long known by elementary textbook readers, austerity policies have contractionary effects.
More sophisticated economists know of non-Keynesian effects, but they also know the exacting conditions under which these effects occur. They are certainly not expected in the midst of a sharp downturn partly provoked by bank deleveraging.
- Debt reduction is a very long process; we're talking about decades, not about the next Troika review.
Whether it starts in 2011 or in 2016 makes no material difference for that process, but it matters a great deal for the macroeconomy.
- The debt-to-GDP ratio is best reduced through sustained nominal GDP growth.
Inflation may seem to be the easiest solution, but it is not. Japan has shown how a lame central bank can be unable to extract the country from a deflation trap. A more active central bank can 'do things' but public bonds are no longer what they used to be: in a globalised world, promise two decades of moderate inflation and you get another sovereign debt crisis on your hands. Besides, having been there, no one really wants to unleash inflation anymore. That leaves us with real GDP growth as a necessary condition for bringing the debt-to-GDP down painlessly.
- In a better world, we would have a fiscal union whereby the famed benevolent dictator would both coordinate national fiscal policies to achieve a good Eurozone policy mix and organise transfers from the countries that achieve their lowest unemployment rates in a decade to those where social suffering is acute.
But in today’s world voters are angry at everything that is called Europe and will not back a fiscal union. And, by the way, we do not have benevolent dictators either.
- The crisis has delivered a surprising degree of wage flexibility and labour mobility.
This means that the need for dissolving the euro back into national currencies at almost any cost has evaporated.
- The long-hoped-for awakening of the ECB has produced several miracles, especially a major relaxation of market anguish.
The predictable result, unfortunately, is that politicians too have relaxed. They now are ever less willing to face reality.
- In most Eurozone countries, structural reforms are as needed now as they were before the crisis.
There are hopes that the crisis is somehow – i.e. through external pressure – making it less impossible to carry them out. But progress has been limited and, crucially, the results take a very long time to materialise.
- Banks are at the heart of a diabolic loop: bank holdings of their national public debts (Brunnermeier et al., 2011).
As these debts lose market value, banks suffer losses. If the banks fail, governments must borrow to rescue them. But national banks are the only remaining private buyers of public debts. Over 2012, national public debts have been alarmingly concentrating in their respective banks.
- Massive forbearance has allowed many banks to not fully account for the losses that they incurred in 2007-8.
For that reason, they deleverage, which leads to a credit crunch, which slows growth down. As the recession spreads and deepens, bank loan quality is quickly deteriorating. This second diabolic loop links banks and the real economy.
- The ECB is the lender of last resort both to banks and to governments.
This involves massive moral hazard. Moral hazard can be sharply reduced with appropriate institutional measures (Wyplosz, 2006).
If these observations are agreeable, what are the policy implications? We all draw different lessons from the same observations, unfortunately. Here are mine.
- Sustained real growth should be the number one priority.
In the longer run, structural reforms will produce their magic effects, but we must also worry of the short run, and we have run out of instruments. Like the other central banks, the ECB has reached the limit of macroeconomic effectiveness. A few basis points off the policy interest rate are not commensurable with the depth of the recession.
- Austerity policies must stop, now.
However, this does not mean that expansionary fiscal policies are possible. Countries that have lost market access cannot borrow their way out unless official lenders are willing to help out. As more countries lose market access, official lending can only be provided by a dwindling number of countries, many of which are already highly indebted. Germany is a case in point. So we cannot expect fiscal policies to turn expansionary, especially in countries where the recession is deepest.
- Growth will not return unless bank lending is adequately available.
For that to happen, the banks must be extracted from the two diabolic loops described above: (1) they must stop lending to their own governments, and (2) they must be shut down if they are unable to raise the capital needed for them to lend to the private sector. But their governments may not have the resources to carry out resolution.
- The ECB may act as lender in last resort to banks and governments, but who will bear the residual costs?
The ESM is much too small for the task ahead and there is little chance that the better-off countries will agree ex ante to bear huge and unpredictable costs.
This all means that we have hit a wall of contradicting needs – barring an export miracle, something will have to give.
- The only remaining option is public debt restructuring, a purging of the legacy.
This will lead to bank failures. This means that debt reductions must be deep enough to make it possible for governments to then borrow, to shift to expansionary fiscal policies and to bail out the banks that they destroyed in the first place, in effect undoing the diabolic loop.
Who will lend? Even the best-crafted bank restructuring will not allow an immediate recovery of market access. The ECB is the only institution in the world that can help out. That means massive losses on its balance sheet and therefore negative capital, which is not an economic problem but a potentially severe political one.
There is no easy option for the Eurozone after three years of deep mismanagement. Governments will not accept drastic action unless forced to. This means that we need another round of crisis worsening. Since every day that passes by is a day of misery and since the eventual costs are rising as public debts keep growing, the best that we can hope for is that it happens in 2013 rather than in 2014.
Brunnermeier, Markus, Luis Garicano, Philip Lane, Stijn Van Nieuwerburgh, Marco Pagano, Ricardo Reis, Tano Santos and Dimitri Vayanos (2001) "European Safe Bonds: An executive summary”, The Euro-nomics Group, www.euro-nomics.com.
Wyplosz, Charles (2012) “Fiscal discipline in the monetary union”, VoxEU, 26 November.
© VoxEU.org Used with permission.
The British government's attempt to rebalance the UK economy has failed. In 2012, the deficit on the country's current account (the broadest measure of foreign trade) was larger than in any year since 1990. Britain's problem is not its trade performance with non-European markets: exports to these are rising strongly and the country runs a small surplus with them. The UK's problem is the weakness of its exports to the EU, and the huge trade deficit it runs with its EU partners. As the eurozone’s biggest trade partner, the UK is bearing the brunt of the eurozone’s neglect of domestic demand.
The UK's current account deficit narrowed from 2.3 per cent of GDP in 2007 to 1.3 per cent in 2011, before jumping to an estimated 3.5 per cent of GDP in 2012. There is no doubting the scale of the challenge posed by this deterioration. After all, a key element of the government’s growth strategy is to rebalance the economy away from an excessive dependence on private and public consumption in favour of business investment and exports. It was relying on a positive contribution to economic growth from net trade (exports minus imports) to help offset the impact of fiscal austerity, and to narrow the country’s external deficit.
The UK's persistently weak trade position is often attributed to British firms' failure to tap fast growing markets outside Europe. This narrative does not bear scrutiny. The truth is that British exports, and with it chances of rebalancing the economy, are being held back by the country's trade with the rest of Europe rather than with the supposedly hyper-competitive economies in Asia or the Americas. The value of exports to non-EU markets is growing quickly: between 2006 and 2012 they increased by half (a 65 per cent rise in goods exports and a 35 per cent rise in exports of services). The value of exports to the EU, meanwhile, rose by just 5 per cent over this period (a 5 per cent fall in goods exports and a 23 per cent rise in services). As a result of these trends, the UK earned almost 60 per cent of its foreign currency earnings from non-EU markets in 2012, up from under a half in 2006.
With imports from the EU easily outpacing exports, the trade position with the EU has deteriorated steadily. Despite exports to the EU accounting for little over 14 per cent of GDP in 2012, the UK is estimated to have run a current account deficit with its EU partners equivalent to 4.5 per cent of GDP, double the deficit of five years ago. The value of goods exports to the EU are estimated to have fallen by 5 per cent in 2012, led by declines of 18 per cent to Italy and 12 per cent to Spain. Exports of services to EU markets also fell, as did the returns on British investments in the eurozone, pushing the balance of income with the EU deeper into deficit. By contrast, exports of goods and services to the rest of world rose 5 per cent in 2012, and trade with these markets remained in surplus.
The UK runs a surplus with the non-European world, which accounts for almost three-fifths of its foreign current earnings, but is massively in deficit with the EU, which accounts for just over two-fifths. This is not because the UK is 'competitive' with the rest of the world and uncompetitive in Europe, but because of the collapse in demand across the EU. UK exports are rising to the rest of the world because demand is rising in the rest of the world, and are falling to EU markets because demand for imports is falling across the eurozone. The reason why the UK's current account deficit rose sharply in 2012 and those of Italy and Spain fell is not because the latter have improved their 'competitiveness' more than the UK. Spain's and Italy's current account deficits have shrunk because demand in their economies has declined dramatically, leading to a steep fall in imports.
The eurozone’s decision to eschew symmetric adjustment of trade imbalances within the currency union in favour of asymmetric rebalancing (where domestic demand contracts in the deficit countries but there is no offsetting rise in demand in the surplus countries) has serious implications for the UK. Britain was criticised for allowing its currency to fall in value following the onset of the financial crisis in 2007, on the grounds that it constituted a competitive devaluation. But it is the eurozone, not the UK, which is pursuing a mercantilist strategy.
What can the UK do about its increasingly unbalanced trade with the EU? It would make no sense for the UK to leave the EU. As the data show, membership of the EU has not undermined Britain’s exports to non-European markets. And leaving the union would have little impact on the trade imbalance with European economies; the UK outside the EU would not be able to erect significant trade barriers against imports from EU countries. Not only is EU membership no obstacle to increased trade with the rest of the world, it is probably facilitating such growth: with the growth of bilateral trade deals in place of multilateral ones, it pays to be part of a heavy-weight negotiating bloc.
The British government could emulate the Italians and the Spanish and tighten fiscal policy by so much that import demand implodes. This would lead to a sharp narrowing of the UK's trade deficit with the EU and a rising trade surplus with the rest of the world (as the British imported less from non-EU markets). Such a strategy would be politically impossible in the UK. The coalition government would suffer a huge defeat at the next general election and for good reason: this approach would depress investment and push up unemployment, eroding the country's growth potential.
David Cameron and George Osborne could mount a campaign for more expansionary economic policies across the eurozone. However, even if the British government were not increasingly isolated and resented within the EU, such pleas would fall on deaf ears: the rest of the eurozone could also justifiably argue that they are only doing what the British government has routinely argued that every country must do: cut public spending and 'live within its means'.
The British government should give up on any hope that stronger EU demand for British exports will help rebalance the UK economy. In all likelihood, demand across the eurozone will remain chronically weak for a very long time. Instead, Cameron and Osborne should concentrate all their efforts on boosting domestic economic activity. They should slow the pace of austerity and kick-start a large-scale housing and infrastructure programme. Combined with aggressively expansionary monetary policy – the incoming governor of the Bank of England, Mark Carney, has indicated that monetary policy is set to remain very loose – this should be enough to drive an economic recovery.
If the UK government were to opt for this approach, the British economy would no doubt suck in imports from the rest of the EU, leading to a further widening of the bilateral trade deficit. However, the worsening of the country's trade position, together with the Bank of England's more inflationary strategy than the ECB, would almost certainly prompt a fall in the value of sterling. A significant devaluation would probably suffice to halt the rise in Britain's deficit with the rest of the EU, although the shortfall is unlikely to narrow much while demand remains so weak across the eurozone. Eurozone governments would no doubt accuse the UK of engaging in a competitive devaluation. Given the recent trend in the EU-UK trade balance, such accusations would ring hollow.
© 2013 Centre for European reform, used with permission.
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