Archive for the ‘Contagion’ Category
If you’ve wondered why I haven’t proffered a “solution” to the eurozone crisis, this post should suffice. Here we have experts far more knowledgeable than I who reach diametrically opposed conclusions regarding the fate of the eurozone and, by implication, the futures of economies and financial markets. The optimistic argument is that the euro will be saved because everyone realizes that the consequences of it not being saved are so dire. The pessimistic argument is that, while the euro’s collapse would have serious negative consequences, these consequences are preferrable to the political and financial costs of preventing the collapse.
The optimistic argument smacks of idealism (a.k.a.wishful thinking); the pessimistic of realism (a.k.a., defeatism). At the bottom of it all lies this question, which always arises at times of crisis: are there forces at work that are beyond the keen of even the most well-intentionned, hard-working, knowledgeable people?
The economic and financial problems in the euro area are clearly serious and plentiful. An increasing number of commentators and economists have begun to question whether the euro can survive. There are only two alternatives. Europe can jettison the monetary union or it can adopt a complementary economic union. Every policymaker in Europe knows that the collapse of the euro would be a political and economic disaster for all and thus totally unacceptable. Europe’s overriding political imperative to preserve the integration project will surely drive its leaders to ultimately secure the euro and restore the economic health of the continent.
The key is to observe what Europe does rather than what it says. At each critical stage of the crisis, both Germany and the European Central Bank have demonstrated they will pay whatever is necessary to preserve the euro area and avoid defaults (except possibly Greece). But neither can say they will provide unlimited bailouts because this would alleviate the pressure on the debtor countries to reform and weaken the bargaining position of each creditor group (northern European governments, ECB, private lenders, IMF) vis-à-vis the others as they allocate the costs of the bailouts. Europe’s key political actors in Berlin, Frankfurt, Paris, Rome, Athens, and elsewhere will thus quite rationally exhaust all alternative options in searching for the best possible deal before at the last minute coming to an agreement. For all this turmoil, however, Europe is well on its way to completing a true economic and monetary union, and will emerge from the crisis much stronger as a result.
The eurozone has fallen into a spiral of downgrades, falling economic output, rising debt and further downgrades. A recession has just started. Greece is now likely to default on most of its debts and may even have to leave the eurozone. When that happens, the spotlight will fall immediately on Portugal, and the next contagious round of downgrades will begin.
Europe’s insufficient rescue fund, the European Financial Stability Facility, now also faces a downgrade because it had borrowed its ratings from its members. The way the EFSF is constructed means that its effective lending capacity will thus be reduced . . .
By downgrading France and Austria but not Germany and the Netherlands, Standard & Poor’s also managed to shape expectations of the economic geography of an eventual break-up. A downgrading of all triple A rated members would have been much easier to deal with politically. Germany is now the only large country left with a triple A rating. The decision will make it harder for Germany to accept eurozone bonds. The ratings wedge between France and Germany will make the relationship even more unbalanced.
[...] The conclusion of the fiscal treaty, which is the top priority of EU politics right now, is at best an irrelevant distraction. Most likely, it will enhance the trend towards pro-cyclical austerity of the kind we have seen in Greece . . .
[...] With each turn of the spiral, the financial and political costs of an effective resolution increase. We have moved past the point where electorates and their representatives are willing to pay the ever-rising costs of repairing the system. Last week a couple of senior parliamentarians from the ruling CDU party, whom I had previously considered voices of moderation, argued that a Greek exit from the eurozone would not be such a big deal. Expectations are changing quickly, and so is the acceptance of a violent ending.
And no, the European Central Bank’s huge liquidity boost is not going to fix the problem either. I do not want to underestimate the importance of that decision. The ECB prevented a credit crunch and deserves credit for that. The return of unlimited long-term money might even have a marginal impact on banks’ willingness to take part in government debt auctions. If we are lucky it might get us through the intense debt rollover period this spring. But a liquidity shower cannot address the underlying problem of a lack of macroeconomic adjustment.
Even economic reforms, necessary as they may be for other reasons, cannot solve this problem. This is another European illusion. We are now at a point where effective crisis resolution would require a strong central fiscal authority, with the power to tax and allocate resources across the eurozone. Of course, it will not happen.
This is the ultimate implication of last week’s ratings downgrades. We have moved beyond the point where a technical fix would work. The toolkit is exhausted.
Earlier this month, the European Central Bank announced an emergency loan program known as “longer-term refinancing operations,” or LTROs. The program will become operational tomorrow (Wednesday). The Financial Times says that the ECB expects strong demand for the loans, which will be available in “unlimited” quantities.
The purpose of the program, which enables banks to avail themselves of three-year loans at extremely favorable interest rates, is to ease the severe strains in the eurozone’s financial system. If demand for the loans is strong, it should reduce the likelihood that banks will substantially shrink their balance sheets (by selling assets and reducing new loans to their customers) to meet their funding needs (which are especially large in early 2012). The hope, then, is that the LTRO will improve the economic performance of countries in the eurozone. It’s important to note, however, that this provision of additional liquidity doesn’t attack the eurozone’s fundamental problem: severe and persistent balance-of-payment imbalances among its members.
The funding problem that the LTRO is aimed to ease is having a contagion effect. Asset sales by European banks have put pressure on securitized mortgage prices in the U.S. Instead of selling distressed assets in their home markets, the banks are selling assets elsewhere (as encouraged by their governments).
- The ABX, an index of prices for securities backed by 2006 vintage subprime mortgages, has fallen 29 per cent since the start of the year, to trade at levels not seen since late 2009.
- European banks alone hold about $100 billion in US mortgage-backed securities that are not backed by Fannie Mae and Freddie Mac, according to data from Deutsche Bank.
In combination with the sharp drop in Spanish short-term interest rates that took place today, the imminent start of the LTRO program may be responsible for the sharp rally in the U.S. equity markets. If demand is as strong as the ECB expects, contagion fears could ease, allowing for a short-term bounce in the stocks of financial institutions holding mortgage-backed securities.
Excerpts from an FT editorial:
Europe’s economic prospects are deteriorating frighteningly fast, and the world outlook is darkening in step with the Old World’s woes. Unless the world’s leaders manage to pull together soon, we should brace ourselves for a second phase of the credit crisis that will be even worse than the first.[...] A credit crunch is gaining force, and Europe’s economy grinding to a halt because of it. This is making the twin crises – bank and sovereign – harder to resolve and is hitting emerging economies whose credit is drying up and whose export markets are withering. If the ECB cannot stimulate growth, governments must do so, and fast.
Today the whole world badly needs Europe to grow. Long-term growth and rebalancing are sine qua non for overcoming the debt crisis, but short-term recovery is a greater priority. Austerity by those who must should now be compensated by stimulus from those who can.
My sentiments, exactly.
“Those who do not remember the past are condemned to repeat it.”
– George Santayana
Few quotes are more frequently mentioned than this one. Keep it in mind while taking a few minutes to read (and ponder) this article from the Economist’s December 10th issue.
In 2008 the world dodged a second Depression by avoiding the mistakes that led to the first. But there are further lessons to be learned for both Europe and America
“YOU’RE right, we did it,” Ben Bernanke told Milton Friedman in a speech celebrating the Nobel laureate’s 90th birthday in 2002. He was referring to Mr Friedman’s conclusion that central bankers were responsible for much of the suffering in the Depression. “But thanks to you,” the future chairman of the Federal Reserve continued, “we won’t do it again.” Nine years later Mr Bernanke’s peers are congratulating themselves for delivering on that promise. “We prevented a Great Depression,” the Bank of England’s governor, Mervyn King, told the Daily Telegraph in March this year.
The shock that hit the world economy in 2008 was on a par with that which launched the Depression. In the 12 months following the economic peak in 2008, industrial production fell by as much as it did in the first year of the Depression. Equity prices and global trade fell more. Yet this time no depression followed. Although world industrial output dropped by 13% from peak to trough in what was definitely a deep recession, it fell by nearly 40% in the 1930s. American and European unemployment rates rose to barely more than 10% in the recent crisis; they are estimated to have topped 25% in the 1930s. This remarkable difference in outcomes owes a lot to lessons learned from the Depression.
Debate continues as to what made the Depression so long and deep. Some economists emphasise structural factors such as labour costs. Amity Shlaes, an economic historian, argues that “government intervention helped make the Depression Great.” She notes that President Franklin Roosevelt criminalised farmers who sold chickens too cheaply and “generated more paper than the entire legislative output of the federal government since 1789”. Her book, “The Forgotten Man”, is hugely influential among America’s Republicans. Newt Gingrich loves it.
A more common view among economists, however, is that the simultaneous tightening of fiscal and monetary policy turned a tough situation into an awful one. Governments made no such mistake this time round. Where leaders slashed budgets and central banks raised rates in the 1930s, policy was almost uniformly expansionary after the crash of 2008. Where international co-operation fell apart during the Depression, leading to currency wars and protectionism, leaders hung together in 2008 and 2009. Sir Mervyn has a point.
Look closer, however, and the picture is less comforting. For in two important—and related—areas, the rich world could still make mistakes that were also made in the 1930s. It risks repeating the fiscal tightening that produced America’s “recession within a depression” of 1937-38. And the crisis in Europe looks eerily similar to the financial turmoil of the late 1920s and early 1930s, in which economies fell like dominoes under pressure from austerity, tight money and the lack of a lender of last resort. There are, in short, further lessons to be learned.
Riding for a fall
It was far easier to stimulate the economy in the 2000s than in the 1930s. Social safety nets—introduced in the aftermath of the Depression—mean that today’s unemployed have money to spend, providing a cushion against recession without any active intervention. States are more relaxed about running deficits, and control much larger shares of national economies. The package of public works, spending and tax cuts that President Herbert Hoover introduced after the crash of 1929 amounted to less than 0.5% of GDP. President Barack Obama’s stimulus plan, by contrast, was equivalent to 2-3% of GDP in both 2009 and 2010. Hoover’s entire budget covered only about 2.5% of GDP; Mr Obama’s takes 25% of GDP and runs a deficit of 10%.
Roosevelt raised spending to 10.7% of output in 1934, by which point the American economy was growing strongly. By 1936 inflation-adjusted GDP was back to 1929 levels. Just how much the New Deal spending helped the recovery is still debated. Some economists, such as John Cochrane of the University of Chicago and Robert Barro of Harvard, say not at all. Fiscal measures never work, they say.
Those who think that fiscal measures do work nonetheless tend to believe that, in the 1930s, spending was less important than monetary policy, which they see as the prime cause of suffering. In a paper in 1989 Mr Bernanke and Martin Parkinson, now the top civil servant in Australia’s finance ministry, wrote that rather than providing recovery itself “the New Deal is better characterised as having ‘cleared the way’ for a natural recovery.” Others, such as Paul Krugman, would ascribe a more positive role to stimulus spending.
Whatever relative importance is assigned to monetary and fiscal policy, though, there is little doubt that their simultaneous tightening five years into the Depression led to a vicious relapse. Spurred by his treasury secretary, Henry Morgenthau—who worried in 1935 that “we cannot help but be riding for a fall unless we continue to decrease our deficit each year and the budget is balanced”—Roosevelt urged fiscal restraint on Congress in 1937.
By that point the national debt had reached an unheard of 40% of GDP (huge by the standards of the day, but half what Germany’s debt is now). Congress cut spending, increased taxes and wiped out a deficit of 5.5% of GDP between 1936 and 1938. That was a larger consolidation than Greece now faces over two years (see chart 1), but is much smaller than what is planned for it in the longer term. At the same time the Federal Reserve doubled reserve requirements between mid-1936 and mid-1937, encouraging banks to pull money out of the economy. The Treasury began to restrict the money supply in step with the level of gold imports. In 1937 and 1938, the recession within a depression brought a drop in real GDP of 11% and an additional four percentage points of unemployment, which peaked at 13% or 19%, depending on how you count it.
The Snowdens of yesteryear
Today’s monetary policy hasn’t turned contractionary, as America’s did in the 1930s. As The Economist went to press, the European Central Bank (ECB) was expected to announce a further reduction in interest rates. But in many places fiscal policy is moving rapidly in that direction. Mr Obama’s stimulus is winding down; state- and local-government cuts continue. Republican candidates for the presidency echo the arguments of Mr Morgenthau, claiming that deficit-financed stimulus spending has done little but add to the obligations of future taxpayers. Mr Obama, like Roosevelt, has started to stress the need for budget-cutting. If the current payroll-tax cut and emergency unemployment benefits were to lapse, growth over the next year would be reduced by around one percentage point of GDP.
America is not alone. Under David Cameron, Britain’s hugely indebted government introduced a harsh programme of fiscal consolidation in 2010 to avert a loss of confidence in its creditworthiness. The rationale was similar to that for chancellor Philip Snowden’s emergency austerity budget of 1931, with its tax rises and spending cuts. On that occasion confidence was not restored, and Britain was forced to devalue the pound and abandon the gold standard. On this occasion the measures have indeed boosted investor confidence, and thus bond yields; that the country still faces a second recession is in large part due to the euro zone’s woes. That said, the possibility of such shocks should always be a counsel for caution when a government embarks on fiscal tightening.
Some say tightening need not hurt. In 2009 Alberto Alesina and Silvia Ardagna of Harvard published a paper claiming that austerity could be expansionary, particularly if focused on spending cuts, not tax increases. Budget cuts that reduce interest rates stimulate private borrowing and investment, and by changing expectations about future tax burdens governments can also boost growth. Others doubt it. An International Monetary Fund (IMF) study in July this year found that Mr Alesina and Ms Ardagna misidentified episodes of austerity and thus overstated the benefits of budget cuts, which typically bring contraction not expansion.
Roberto Perotti of Bocconi University has studied examples of expansion at times of austerity and showed that it is almost always attributable to rising exports associated with currency depreciation. In the 1930s the contractionary impact of America’s fiscal cuts was mitigated to some extent by an improvement in net exports; America’s trade balance swung from a deficit of 0.2% of GDP to a surplus of 1.1% of GDP between 1936 and 1938. Now, most of the world is cutting budgets and not every economy can reduce the pain by boosting exports.
The importance of monetary policy in the 1930s might suggest that central banks could offset the effects of fiscal cuts. In 2010 the IMF wrote that Britain’s expansionary monetary policy should mitigate the contractionary impact of big budget cuts and “establish the basis for sustainable recovery”. Yet Britain is now close to recession and unemployment is rising, suggesting limits to what a central bank can do.
The move to austerity is most dramatic within the euro zone—which can least afford it. Operating without floating currencies or a lender of last resort, its present predicament carries painful echoes of the gold-standard world of the early 1930s.
In the mid-1920s, after an initially untenable schedule of war reparations payments was revised, French and American creditors struck by the possibility of rapid growth in the battered German economy began to pile in. The massive flow of capital helped fund Germany’s sovereign obligations and led to soaring wages. Germany underwent a credit-driven boom like those seen on the European periphery in the mid-2000s.
In 1928 and 1929 the party ended and the flow of capital reversed. First, investors sent their money to America to bet on its soaring market. Then they yanked it out of Germany in response to financial panic. To defend its gold reserves, Germany’s Reichsbank was forced to raise interest rates. Suddenly deprived of foreign money, and unable to rely on exports for growth as the earlier boom generated an unsustainable rise in wages, Germany turned to austerity to meet its obligations, as Ireland, Portugal, Greece and Spain have done. A country with a floating currency could expect a silver lining to capital outflows: the exchange rate would fall, boosting exports. But Germany’s exchange rate was fixed by the gold standard. Competitiveness could only be restored through a slow decline in wages, which occurred even as unemployment rose.
As the screws tightened, banks came under pressure. The Austrian economy faced troubles like those in Germany, and in 1931 the failure of Austria’s largest bank, Credit Anstalt, triggered a loss of confidence in the banks that quickly spread. As pressure built in Germany, the leaders of the largest economies repeatedly met to discuss the possibility of assistance for the flailing economy. But the French, in particular, would brook no reduction in Germany’s debt and reparations payments.
Recognising that the absence of a lender of last resort was fuelling panic, the governor of the Bank of England, Montagu Norman, proposed the creation of an international lender. He recommended a fund be set up and capitalised with $250m, to be leveraged up by an additional $750m and empowered to lend to governments and banks in need of capital. The plan, probably too modest, went nowhere because France and America, owners of the gold needed for the leveraging, didn’t like it.
So the dominoes fell. Just two months after the Credit Anstalt bankruptcy a big German bank, Danatbank, failed. The government was forced to introduce capital controls and suspend gold payments, in effect unpegging its currency. Germany’s economy collapsed, and the horrors of the 1930s began.
It is all dreadfully familiar (though no European country is about to elect another Hitler). Membership in the euro zone, like adherence to the gold standard, means that uncompetitive countries can’t devalue their currencies to reduce trade deficits. Austerity brings with it a vicious circle of decline, squeezing domestic demand and raising unemployment, thereby hurting revenues, sustaining big deficits and draining away confidence in banks and sovereign debt. As residents of the periphery move their money to safer banks in the core, the money supply declines, just as it did in the 1930s (see chart 2). High-level meetings with creditor nations bring no surcease. There is no lender of last resort. Though the European Financial Stability Facility (EFSF) has got further off the ground than Norman’s scheme, which it chillingly resembles, euro-zone leaders have yet to find a way to leverage its €440 billion up to €2 trillion.
Even if they succeed, that may be too little to end the panic. Investors driven by turmoil in Italian markets are pre-emptively reducing their exposure to banks and sovereign bonds elsewhere in the euro zone. Even countries with relatively robust economies such as France and the Netherlands have not been spared. No matter how secure an economy’s fiscal position, a short-term liquidity crunch driven by panic can drive it into insolvency.
History need not repeat itself. Norman’s Bank of England was created in the 17th century to lend to the government when necessary; central banks have always been obliged to lend to governments when others will not. The ECB could take on this role. It is prohibited by its charter from buying debt directly from governments, but it can purchase debt securities on the secondary market. It has been doing so piecemeal and could declare its intention to do so systematically. Its power to create an unlimited amount of money would allow it credibly to announce its willingness to buy any bonds markets want to sell, thus removing the main cause of panic and contagion.
This week France and Germany proposed the adoption of legally binding budgetary “golden rules” by euro-zone members, ahead of a summit of European leaders in Brussels on December 8th-9th. Mario Draghi, the ECB’s new president, has hinted that were a fiscal pact to be agreed, the ECB might buy bonds on a larger scale. What scale he has in mind, though, is unclear. Jens Weidmann, president of Germany’s Bundesbank and an influential member of the ECB’s governing council, has clearly stated that the ECB “must not be” the euro zone’s lender of last resort.
Where this path leads
On the present course, conditions in developed economies look like getting worse before they get better. Growth in America and Britain will probably be less than 2% in 2012 on current policy, and in both recession is quite possible. A euro-zone recession is likely. The ECB could improve the euro zone’s economic outlook by loosening its monetary policy, but widespread austerity and uncertainty will be difficult to overcome. As in 1931 and 2008, a grave financial crisis may cause a large drop in output. That, in turn, would place more pressure on euro-zone economies struggling to avoid default.
As panic built in 1931, country after country faced capital flight. The effort to defend against bank and currency runs prompted rounds of austerity and plummeting money supplies in pressured economies, helping generate the collapse in output and employment that turned a nasty downturn into a Depression. It took the end of the gold standard, which freed central banks to expand the money supply and reflate their economies, to spark recovery. Today the ECB has the tools needed to salvage the situation without breaking up the euro. But the fact that the ECB and euro-zone governments have options does not mean that they will take them.
The collapse of the gold standard led to recovery, but caused terrible economic damage as countries erected trade barriers to stem the flood of imports from those that had devalued their currencies. Governments elected to fight unemployment experimented with wage and price controls, cartelisation of industry and other interventions that often impeded the recovery enabled by expansionary monetary and fiscal policies. In the worst-hit countries long-suffering citizens turned to fascism in the false hope of relief.
The world today is better placed to cope with disaster than it was in the 1930s. Then, most large economies were on the gold standard. Today, the euro zone represents less than 15% of world output. In developed countries unemployment, scourge though it is, does not lead to utter destitution as it did in the 1930s. Then, the world lacked a global leader; today, America is probably still up to the job of co-ordinating disaster response in troubled times. International institutions are much stronger, and democracy is more firmly entrenched.
Even so, prolonged economic weakness is contributing to a broad rethinking of the value of liberal capitalism. Countries scrapping for scarce demand are now intervening in currency markets—the Swiss are fed up with their franc appreciating against the euro. America’s Senate has sought to punish China for currency manipulation with tariffs. Within Europe the turmoil of the euro crisis is encouraging ugly nationalists, some of them racist. Their extremism is mild when compared with the continent-wrecking horrors of Nazism, but that hardly makes it welcome.
The situation is not yet beyond repair. But the task of repairing it grows harder the longer it is delayed. The lessons of the 1930s spared the world a lot of economic pain after the shock of the 2008 financial crisis. It is not too late to recall other critical lessons of the Depression. Ignore them, and history may well repeat itself.
Marc Schulman, “A Golden Future?,” (August 2011)
The eurozone standard is the modern day equivalent of the gold standard. Countries that are in economic trouble are forced to implement austerity measures that have ramifications outside their borders. In the 1930s, a crisis in little Austria spread like wildfire to Germany, Great Britain and, finally, to the United States. In our time, a crisis that began in little Greece has spread like wildfire to Portugal, Spain, Italy, and, perhaps France.
Deutsche Bank, “Is the Euro today the Gold Standard of the 1930s for European Economies?,” (December 2011):
The 1930s in Europe was a slow moving game of falling dominoes with countries one by one leaving the narrow confines of the Gold Standard after chronic growth problems that a fixed currency system intensified. There was a definite trend in the 1930s that saw those countries that left the Gold Standard seeing a much quicker recovery from the Depression than those that stayed on for a number of years into the latter half of the decade. Figure 12 shows a case study of six countries currencies relative to Gold in the 1930s. We’ve rebased them to 100 at the start of the series. In order of leaving the Gold Standard, we had the UK (left September 1931), Sweden (also left September 1931), US (April 1933), Belgium (March 1935), France (September 1936) and Italy (October 1936).
Interestingly, by the middle of 1937 all had devalued by at least 40% to Gold except Belgium who had devalued by around 30% in 1935. France, which held on until September 1936, then saw its currency collapse by nearly 70% in the three years up to WWII. Figure 13 then shows the same six countries nominal (left) and real (right) GDP performance over the same period.
The UK and Sweden, which left the Gold Standard earliest (September 1931) in this sample, saw a ‘relatively’ mild negative growth shock compared to the other four. In contrast, France which stuck to Gold until late 1936 saw growth notably under-perform until they left the standard. Interestingly as discussed above, France later saw a dramatic 3 year 70% devaluation to Gold which helped restore nominal GDP close to that of the UK and Sweden by the end of the 1930s. However, in real terms they were still the laggard at this point. The worst slump of all was that seen in the US between 1929 and 1932 where they lost nearly half the value of their economy in nominal terms and nearly 30% in real terms. However, the bottom pretty much corresponded to the end of the Dollar’s gold convertibility and subsequent devaluation. From this point on, the recovery was fairly dramatic until the 1937 recession we’ll discuss below. Overall, Figure 13 does indicate some fairly strong evidence that growth did seem to respond to currency debasement and that countries which left this later ended up with weaker economies for longer and also, in France’s case, a more dramatic end devaluation.
Round 2 of Reactions to the EU Summit (and some other stuff)
The title of the FT’s editorial — “Europe fails to reach summit” — says it all:
It should have been the climax to Europe’s thriller, a summit that would kill off the sovereign debt crisis with a salvo of confidence-restoring measures. But, apart from Britain’sdramatic exit, last week’s European summit was entirely predictable in its inconclusiveness.
To be fair, it is good news that even modest steps were taken towards closer fiscal integration. But the real, comprehensive fiscal union needed to restore faith in the euro, as opposed to a few new rules, remains elusive.
More urgently, the deal that was struck does nothing to resolve the immediate crisis. Moves to bolster the International Monetary Fund and hints of more support next year for Europe’s two bail-out vehicles are neither big enough nor fast enough to deal with the titanic task of funding peripheral countries’ debt until confidence returns.
Hopes in the existence of a big bazooka proved misplaced. Mario Draghi, European Central Bank president, on Thursday quashed hopes that he would launch an unlimited bond-buying programme to help indebted sovereigns, as European rules do not allow this.
Now there is the suggestion that the ECB has a cunning plan to give the bazooka to Europe’s banks, which will be lent bags of cheap money, with which to buy their own countries’ debt.
The argument is tempting. Friday’s summit declared that there will be no more haircuts on sovereign debt. So if banks can get three-year ECB money at 1 per cent and buy Italian bonds at 6 per cent, this could help cut debt costs while bringing seemingly risk-free returns. This is not contrary to European rules and it could be in both parties’ interests. If the sovereigns go, Europe’s banks are front line victims.
However, there are many reasons to be wary of such a solution, not least because it fools no one. The ECB would in effect be funding sovereign debt through Europe’s banks. This is hardly in the spirit of the European treaty. Second, shareholders might rightly question why banks, which have been shedding periphery bonds despite having had the arbitrage opportunity for some time now, were suddenly scooping them up. Most importantly, if the current crisis was sparked by the link between sovereign and bank risk, does it make sense to intensify that link? Right now there may be no alternative to save the euro. But it amounts to little more than sleight of hand in a crisis where clarity and resolve would do much more to restore confidence.
Unsurprisingly, the FT’s Wolfgang Munchau agrees:
. . . the decision to set up a fiscal union outside the European treaties will do nothing whatsoever to resolve the eurozone crisis . . . this is not something you would wish to do outside European treaties. The existing treaties form the legal basis for all policy co-ordination of monetary union. It gets very messy when you try to circumvent them.[...] A fiscal union set up outside the European treaty would face severe legal and practical limitations. Unless a trick is found, it cannot make recourse to the resources and institutions of the EU. Nor can it issue eurozone bonds. The only conceivable counterparty for a eurozone bond is the EU itself.
More important even, a fiscal union created through a legal trapdoor would not help solve the crisis. The eurozone is facing a generalised loss of confidence. Investors no longer trust its crisis management, the solidarity of its citizens, even the ability to conduct sensible economic policies. The EU is not going to restore confidence through legal gimmickry that will face numerous court challenges.
Leaders should have admitted on Friday that the summit had simply failed, or perhaps have given it a few more days. Negotiations might have produced a compromise. With the fake pretence of another treaty, that is no longer possible.
Remember what everybody said a week ago? To solve the crisis, the eurozone requires, in the long run, a fiscal union with a prospect of a eurozone bond and, in the short run, unlimited sovereign bond market support by the European Central Bank. What we now have is no treaty change, no eurozone bond and no increase either in the rescue fund or in ECB support.
Policy changes the ECB announced last week will help banks directly and governments indirectly. But the EU fell short on every element of a comprehensive deal. On Friday, investors reacted positively to what was sold to them as a “fiscal compact”. But once the implications of a separate treaty are understood, I fear disillusionment will set in.
The rating agencies are equally unimpressed.
In its Weekly Credit Outlook, Moody’s says that “Pressure Remains on Euro Area Sovereigns in Absence of Decisive Initiatives” and “European Bank Recapitalization Plan Is Credit Positive, but Encourages Deleveraging”:
Pressure Remains . . .
. . . the [EU summit] communiqué reflects the continuing tension between euro area leaders’ recognition of the need to increase support for fiscally weaker countries and the significant opposition within stronger countries to doing so. Amid the increasing pressure on euro area authorities to act quickly to restore credit market confidence, the constraints they face are also rising. The longer that remains the case, the greater the risk of adverse economic conditions that would add to the already sizeable challenges facing the authorities’ coordination and debt reduction efforts.
As a result, the communiqué does not change our view that the crisis is in a critical, and volatile, stage, with sovereign and bank debt markets prone to acute dislocation which policymakers will find increasingly hard to contain. While our central scenario remains that the euro area will be preserved without further widespread defaults, shocks likely to materialise even under this ‘positive’ scenario carry negative credit and rating implications in the coming months. And the longer the incremental approach to policy persists, the greater the likelihood of more severe scenarios, including those involving multiple defaults by euro area countries and those additionally involving exits from the euro area.The credit implications of these and further measures likely to be announced in coming weeks require careful consideration against the backdrop of decelerating regional economic activity, fragile banking systems, partly dysfunctional credit markets, and the varying degree of success of country-specific measures aimed at structural change and fiscal consolidation. But in the absence of credit market conditions stabilising, the system remains prone to further shocks which would likely lead to selective rating changes. More broadly, in the absence of any decisive policy initiatives that stabilise credit market conditions effectively, our intention as announced in November is to revisit the level and dispersion of ratings during the first quarter of 2012.
European Bank Recapitalization . . .
Additional capital is credit positive as it enables banks to cope with increased stress. However, there is a risk that tighter capital requirements will encourage further deleveraging, thereby increasing the risk of a credit crunch and additional impairments.
The establishment of a sovereign exposure buffer follows criticism that the EBA’s stress test earlier this year inadequately reflected the true value of, and impairments in, banks’ sovereign exposures. Disclosures in banks’ interim statements also point to inadequate evaluation and provisioning and, in some cases, a failure to comply with international accounting standards.
[...] Supervisors are not simply seeking to achieve higher capital ratios, but also higher capital. Nevertheless, the incentive for banks to deleverage remains high and will only be exacerbated by higher capital requirements. More fundamentally, higher capital buffers cannot address the underlying cause of the disruption to the funding markets which is the sovereign debt crisis.
Fitch says that the “Summit Does Little To Ease Pressure on Eurozone Sovereign Debt”:
After the latest EU crisis meeting it is clear that politicians are responding to the eurozone sovereign debt crisis through incremental improvements. It seems that a “comprehensive solution” to the current crisis is not on offer.
This Summit demonstrated strong political support for the euro, and that its members are putting in place the institutional and policy framework for a more viable eurozone and ultimately greater fiscal union. But taking the gradualist approach imposes additional economic and financial costs compared with an immediate comprehensive solution. It means the crisis will continue at varying levels of intensity throughout 2012 and probably beyond, until the region is able to sustain broad economic recovery.
In the short term we predict a significant economic downturn across the region. The eurozone faces intense market pressure, which is triggering loss of business and consumer confidence, and weak industrial activity and retail sales. Our forecast of 0.4% eurozone GDP growth next year and 1.2% in 2013 would be significantly higher if there was a comprehensive solution to the crisis. The lack of a comprehensive solution has increased short-term pressure on eurozone sovereign credit profiles and ratings.
The latest EU Summit, like others before it, has resulted in some positive developments. There is an extra EUR200bn of funding for the IMF, the ESM has been brought forward, and there has been policy change on private-sector involvement in any future sovereign crisis. As with all Summits there is execution risk.
The extra resources for the IMF are welcome but it is not clear how and under what circumstances they would be deployed. The move away from requiring private-sector involvement (PSI) as a condition for ESM programmes is clearly positive for bondholders. The European Commission said it will “strictly adhere to the well established IMF principles and practices.” PSI has been a feature of past IMF programmes, but the Fund sets out to attract private capital to sovereigns and can be expected to use PSI as a last rather than a first resort.
Separately, the ECB also announced changes to its repo schemes that will aid bank liquidity, such as three-year liquidity lines and looser collateral requirements for structured finance. This could be positive for eurozone sovereigns if it eases pressure on them to introduce or re-activate bank debt guarantee schemes.
The Summit’s conclusions show a longer-term desire to move towards some form of fiscal integration in return for enforced fiscal prudence. We believe that most of the vulnerable eurozone countries are already implementing aggressive austerity programmes, and some are already changing their national constitutions. It is too early to judge how effective the fiscal compact will be due to the uncertainty regarding how it will be implemented.
We still believe the ECB, either directly through its sovereign bond purchase programme or indirectly by allowing the EFSF/ESM to access its balance sheet, is the only truly credible “firewall” against liquidity and even solvency crises in Europe.
Hopes that the ECB would step up its actions in support of its sovereign shareholders as a quid pro quo for institutional and legal changes that gave the ECB greater confidence in the long-run commitment of eurozone governments to fiscal discipline appear to have been misplaced.
Lurking in the background, according to the Wall Street Journal, is an old nemesis: credit default swaps, which have been used in copious quantities by European banks:
Dozens of banks across Europe have sold large quantities of insurance to other banks and investors that protects against the risk of ailing countries defaulting on their debts, the latest illustration of the extensive financial entanglements among the continent’s banks and governments.
New data released last week by European banking regulators suggest the risks of banks suffering losses tied to European government bonds could be higher and more widespread than previously realized.
The numbers show European banks have sold a total of €178 billion ($238 billion) worth of insurance policies, in the form of financial derivatives known as credit-default swaps, on bonds issued by the financially struggling Greek, Irish, Italian, Portuguese and Spanish governments. If those bonds default, as some investors fear they might, banks could be on the hook for making large payments to the holders of the swaps.
The banks have at least partly insulated themselves from such potential losses by buying large quantities—roughly €169 billion worth—of credit-default swaps tied to the same bonds, apparently in large part from other European banks, according to European Banking Authority data.
Some analysts and investors say they had assumed that sovereign credit-default swaps, known as CDS, were primarily sold by giant global investment banks in the U.K., France and Germany, as well as in the U.S. Those banks sell the swaps to big corporate clients and other banks and institutions.
But the new EBA data show a surprising breadth of large and small European banks—at least 38 of them—have sold instruments that protect against potential losses on Greek, Irish, Italian, Portuguese and Spanish government bonds.
Of the total protection that European banks have written on government bonds in Europe’s five most-stressed countries, nearly one-third originated from German banks.
The diverse array of banks in the sovereign CDS market means that risks can spread more quickly through the financial system. It also means it is harder to predict how losses would ricochet among institutions and countries, analysts say.
The banks and some analysts argue that the industry’s actual exposure is far less than the €178 billion of swaps they have sold because the banks have purchased €169 billion in similar protection from other sources, which can offset the exposure. Many of Deutsche Bank’s purchases and sales of CDSs, for example, are with the same counterparties, with whom the German bank has legally enforceable netting agreements in place.
But some experts say it is risky to assume that all banks’ CDS transactions neatly cancel each other out.
“Netting is all very well provided that you trust your counterparty,” said Jon Peace, a Nomura Securities banking analyst. But in a crisis situation, “what you thought was net could tend toward your gross exposures” because certain sellers of the default insurance could themselves go bust.
For example, two of Italy’s biggest banks, UniCredit SpA and Banca Monte dei Paschi di Siena SpA, have sold a total of about €5.3 billion of protection against the risk of an Italian sovereign default, according to the new EBA data. The problem is that, in a default scenario, both banks likely would be in trouble themselves due to their huge holdings of Italian government bonds and the fact that their businesses are largely concentrated in Italy.
While the Organisation for Economic Co-operation and Development (OECD) hasn’t issued a statement setting forth its view of the results of the EU summit, the Financial Times reports that it “will warn in its latest borrowing outlook, due to be published this month, that financial stresses are likely to continue with the “animal spirits” of the markets – their unpredictable nature – a threat to the stability of many governments that need to refinance debt.”
For the foreseeable future it will be a “great challenge” for a wide range of OECD countries to raise large volumes in the private markets, with so-called rollover risk a big problem for the stability of many governments and economies.
Rollover risk is the threat of a country not being able to refinance or rollover its debt, forcing it either to turn to the European Central Bank in the case of eurozone countries or to seek emergency bail-outs, which happened to Greece, Ireland and Portugal. The OECD says the gross borrowing needs of OECD governments is expected to reach $10.4tr in 2011 and will increase to $10.5tr next year – a $1tr increase on 2007 and almost twice as much as in 2005. This highlights the risks for even the most advanced economies that in many cases, such as Italy and Spain, are close to being shut out of the private markets.
While borrowing was higher in 2009 and 2010, the risks are greater than ever because of rising borrowing costs in turbulent, unpredictable markets.
The OECD says that the share of short-term debt issuance in the OECD area remains at 44 per cent, much higher than before the global financial crisis in 2007. This, according to some investors, is a problem as it means governments have to refinance, sometimes as often as every month, rather than being able to lock in more debt for the longer term that helps stabilise public finances.
The OECD also warns that a big problem is the loss of the so-called risk-free status of many sovereigns, such as Italy and Spain, and possibly even France and Austria. The latter two have triple A credit ratings but investors no longer consider them risk-free.
Contagion from the eurozone crisis appears to be spreading to emerging markets: Indian industrial production dropped by 5.1 percent in October. From the Financial Times:
“The data are way worse than we were expecting,” said A Prasanna, economist at ICICI securities in Mumbai. “Usually output is lower during the months of October and November as there are fewer working days due to the festival season but a 5.1 per cent drop is significantly more than we predicted,” he added.
Manufacturing output, which represents about 76 per cent of industrial production, dropped 6 per cent in October, compared with a year ago and capital goods production, which is considered to be a key barometer of investment sentiment in the country, fell 25.5 per cent. Meanwhile, mining production was down 7.2 per cent, as a series of scandals in the sector and continued uncertainty over the outcome of a long-awaited mining bill hurt the industry.
Reactions to the Results of the EU Summit Meeting
This is an extremely long post with complete articles from the Financial Times, the Economist, the Guardian, Spiegel Online, and the Centre for European Reform (a British think tank). So as to avoid inserting my own slant on the outcome of the summit meeting, I decided not to post shortened, edited versions.
The articles are below the fold.
“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. “
– John Maynard Keynes, The General Theory of Employment, Interest and Money
Diligent readers of this blog (hopefully, there are some) may have noted that I have, on several occasions, taken exception to Reinhart’s and Rogoff’s (R&R) contention that a government’s debt-to-GDP ratio is the metric of choice for assessing its exposure to a sovereign debt crisis. Their seminal work published in 2009, This Time Is Different: Eight Centuries of Financial Folly, has been highly influential, as has their January, 2010, paper, “Growth in a Time of Debt.” It is not an exaggeration to say that the book and paper have become the standard references for policymakers and opinion leaders (the “practical men” to which Keynes refers) who argue that the primary ingredient in the recipe for restoring the health of the American and European economies is public sector fiscal consolidation. In the book and paper, these individuals find the intellectual justification for austerity programs intended to reduce public sector debt-to-GDP ratios.
By the time the paper was published, the financial abyss had been avoided. Naturally, attention then turned to how a repeat of the near-disaster could be avoided and prospects for long-term economic growth could be enhanced. It was in this context that, in the abstract of the paper, R&R summarized their findings as follows:
We study economic growth and inflation at different levels of government and external debt. Our analysis is based on new data on forty-four countries spanning about two hundred years. The dataset incorporates over 3,700 annual observations covering a wide range of political systems, institutions, exchange rate arrangements, and historic circumstances. Our main findings are: First, the relationship between government debt and real GDP growth is weak for debt/GDP ratios below a threshold of 90 percent of GDP. Above 90 percent, median growth rates fall by one percent, and average growth falls considerably more. We find that the threshold for public debt is similar in advanced and emerging economies. Second, emerging markets face lower thresholds for external debt (public and private)—which is usually denominated in a foreign currency. When external debt reaches 60 percent of GDP, annual growth declines by about two percent; for higher levels, growth rates are roughly cut in half. Third, there is no apparent contemporaneous link between inflation and public debt levels for the advanced countries as a group (some countries, such as the United States, have experienced higher inflation when debt/GDP is high.) The story is entirely different for emerging markets, where inflation rises sharply as debt increases. [Emphasis added]
The paper provided what the book did not: a metric. Since early 2010, 90 percent has become a magic number; when a country’s debt-to-GDP ratio is greater than 90 percent, its economic future is endangered. While R&R do not state explicitly that this is a cause-and-effect relationship, they come very close to doing so. While they say that the relationship is “weak” below the 90 percent “threshold,” no proviso is attached to the relationship when the ratio is greater than 90 percent. Their words make it sound like causality is at work. Of course, because the threshold value was established on the basis of a statistical analysis, the result of R&R’s research is to establish a correlation. Thus, by its very nature, it cannot establish cause and effect. One suspects that this critical distinction is easily, if not purposely, overlooked — specifically, by organizations, governments and columnists having ideological agendas predisposing them to view austerity in a favorable light.
The most glaring defect in the policy prescription implicit in R&R’s conclusions is that it hasn’t worked. Despite the ever widening adoption of ever more draconian austerity programs in mature economies, debt-to GDP ratios have risen and investor confidence has fallen. As highly trained economists, R&R are surely aware of the “paradox of thrift.” Perhaps they failed to consider the possibility that numerous countries would more-or-less simultaneously enact fiscal consolidation programs.
“For although the amount of his own saving is unlikely to have any significant influence on his own income, the reactions of the amount of his consumption on the incomes of others makes it impossible for all individuals simultaneously to save any given sums. Every such attempt to save more by reducing consumption will so affect incomes that the attempt necessarily defeats itself.”
– John Maynard Keynes, The General Theory of Employment, Interest and Money
If only a small number of countries accounting for a modest percentage of mature economies’ GDP were tightening their fiscal policies, austerity could work, as the other countries could easily absorb the spillover effects. But that’s not what happening. Every country — including those with historically low interest rates — has tightened. The result is a feedback loop that is more than vaguely reminiscent of the feedback loop created by competitive currency devaluations and tariff increases in the 1930s. Widespread fiscal austerity at a time of private sector deleveraging is a recipe for a downward spiral.
Nothing could be worse than having the results of a widely-adopted policy be the opposite of what was intended, but this comes close: the fixation on austerity as the cure-all for economic and financial distress has prevented eurozone governments and international financial organizations — in particular, the Bank for International Settlements (the central bankers’ bank) and the International Monetary Fund — from correctly identifying the root cause of the currency union’s sovereign debt crisis.
In his totally convincing column in the Financial Times, Martin Wolf unambiguously places the blame on current account imbalances within the eurozone and, especially, on Germany “for not recognizing the nature of the crisis.” He reaches this conclusion after using readily available macroeconomic data to rule out the alternatives: fiscal deficits and public (sovereign) debt, both of which were useless as leading indicators of the sovereign debt crisis:
Take a look at the average fiscal deficits of 12 significant (or at least revealing) eurozone members from 1999 to 2007, inclusive. Every country, except Greece, fell below the famous 3 per cent of gross domestic product limit. Focusing on this criterion would have missed all today’s crisis-hit members, except Greece. Moreover, the four worst exemplars, after Greece, were Italy and then France, Germany and Austria. Meanwhile, Ireland, Estonia, Spain and Belgium had good performances over these years.
Now consider public debt. Relying on that criterion would have picked up Greece, Italy, Belgium and Portugal. But Estonia, Ireland and Spain had vastly better public debt positions than Germany. Indeed, on the basis of its deficit and debt performance, pre-crisis Germany even looked vulnerable.
In contrast, the predictive power of current account deficits was perfect:
Now consider average current account deficits over 1999-2007. On this measure, the most vulnerable countries were Estonia, Portugal, Greece, Spain, Ireland and Italy. So we have a useful indicator, at last. This, then, is a balance of payments crisis. In 2008, private financing of external imbalances suffered “sudden stops”: private credit was cut off. Ever since, official sources have been engaged as financiers. [My emphasis]
When truth — a readily available and easily comprehended truth, at that — is staring you in the face, it’s difficult to understand why it’s been ignored by policymakers. In a case like this, all I can do is follow the money. One country’s current account deficit is another’s current account surplus, and within the eurozone, Germany’s surplus is by far the largest. Countries with surpluses want to maintain them (think China), and Germany is no exception. What this means, of course, is that Germany would have the most to lose if policies aimed at reducing the eurozone’s “structural imbalances” were implemented. The German Government would rather have its weaker siblings in the eurozone implement austerity policies than have its current account surplus reduced. And, given Germany’s economic and financial dominance within the eurozone, it’s in a position to get what it wants.
I’ve yet to read a commentary suggesting that Germany’s policy position isn’t self-defeating. In time — and probably soon — forcing austerity down the throats of the eurozone’s have-nots (of which there’s a growing number) will weaken German exports. Surely, Germany must understand this. If so, its policy preference is politically, not economically and financially motivated. Public opinion polls indicate that a voluntary reduction of the structural imbalance would be seen by a substantial majority of the thrifty, hard-working Germans as bailing-out the spendthrift, lazy “Club Med” countries. What will not happen voluntarily will take place involuntarily which, in the twisted logic that seems to be in play, is the more politically palatable of the two alternatives.
Robert Shiller of Irrational Exuberance fame proffers a different kind of criticism of the 90 percent magic number:
One might be misled into thinking that, because 90% sounds awfully close to 100%, awful things start happening to countries that get into such a mess. But if one reads their paper carefully, it is clear that Reinhart and Rogoff picked the 90% figure almost arbitrarily. They chose, without explanation, to divide debt-to-GDP ratios into the following categories: under 30%, 30-60%, 60-90%, and over 90%. And it turns out that growth rates decline in all of these categories as the debt-to-GDP ratio increases, only somewhat more in the last category. [My emphasis]
There is also the issue of reverse causality. Debt-to-GDP ratios tend to increase for countries that are in economic trouble. If this is part of the reason that higher debt-to-GDP ratios correspond to lower economic growth, there is less reason to think that countries should avoid a higher ratio, as Keynesian theory implies that fiscal austerity would undermine, rather than boost, economic performance.
The fundamental problem that much of the world faces today is that investors are overreacting to debt-to-GDP ratios, fearful of some magic threshold, and demanding fiscal-austerity programs too soon. They are asking governments to cut expenditure while their economies are still vulnerable. Households are running scared, so they cut expenditures as well, and businesses are being dissuaded from borrowing to finance capital expenditures.
The lesson is simple: We should worry less about debt ratios and thresholds, and more about our inability to see these indicators for the artificial – and often irrelevant – constructs that they are.
I couldn’t agree more and I seem to remember learning a long time ago that, appropriately juggled, statistics can be used to prove just about anything. Caveat emptor.
The most resounding and thorough criticism of R&R’s methodology is hidden away about a third of the way through Credit Suisse’s 174-page 2012 Global Outlook. The Credit Suisse analysts are so sure of themselves that they are willing to directly confront R&R by proclaiming that “this time is different.” In the section of the report titled “Questioning Reinhart & Rogoff on Long-Term Growth,” they lay it on the line. Because the density of information is so great and the content isn’t easily condensed, I’ve chosen to include this section in its entirety. All emphases are mine.
Many of our clients think that developed market growth will be weak for years as a result of high debt levels. The theme was famously explored in the book This Time is Different by Carmen Reinhart and Kenneth Rogoff. We find, however, that there is almost no evidence of a relationship between trend growth rates and government debt levels or between debt and an economy’s ability to get back to full employment after a shock.
The history of sovereign debt is intertwined with wars and deflationary shocks. Often, debt appears to affect growth when war itself is driving the path of activity. In times of deflation, debt levels can grow sharply, but the solution is aggressive monetary policy, which need not worsen the debt burden and can usually help it.
There are simple reasons why government debt should not affect underlying trends in real growth. Government debt doesn’t destroy a nation’s factories; it won’t make a population less intelligent and industrious; it can’t halt the technological progress that has driven efficiency for centuries. However, many market observers, citing Reinhart and Rogoff’s research, insist that fiscal tightening is essential to encourage future economic growth.
Of course, a ballooning interest burden creates the need for a government to run a primary surplus in order to maintain stable debt dynamics. A sudden shift toward primary surplus might negatively affect short-run growth, but longer term, there is no relationship between primary balance and trend growth, except for the tendency for primary balances to increase with high growth as tax revenue floods in.
Output gaps, in contrast to debt levels, do consistently forecast above-trend future growth. Economies running well below potential output tend to grow above trend as they return to full employment. Clearly, low resource utilization creates deflation risks, but competent central banks often can manage those. In the second part of this note, we examine the current drags on US growth and argue that today’s missing output is mostly housing related and likely to return over time. This real adjustment should make higher primary surpluses easier to establish and maintain, but admittedly, the US has a long way to go in both output adjustment and in budget adjustment.
Debt adjustments can occur as an economy simultaneously returns to full employment while establishing higher primary surpluses. For forecasting purposes, this is a radically different proposition from starting by observing debt levels and claiming that growth must be weak as a result. We believe that much of the anxiety about debt levels in the developed world represents a misreading of history. Although it is ironic, given the title of Reinhart’s and Rogoff’s seminal work, the biggest reason not to worry about high debt levels is that this time really is different from the historical episodes that drive Reinhart’s and Rogoff’s conclusions.
Consider what is perhaps Reinhart’s and Rogoff’s strongest evidence. They provide a table that presents mean annual growth rates for developed nations. It clearly demonstrates that nations typically experience lower annual growth when their debt levels exceed the 90% threshold. The evidence is mixed across the whole sample, but the numbers for the US in particular stand out. Although this is strong prima facie evidence for believing that high debt can affect growth, there are key problems with this method of analysis.
The first problem is simply that the variable of interest, annual growth rates, doesn’t properly capture the “long-run growth” of a nation. Annual growth rates are volatile and mean reverting, suggesting that a low annual growth rate doesn’t provide much evidence of persistent economic malaise. Switching to a ten-year future growth rate, we can see a much clearer picture of how an economy evolves in response to high levels of sovereign debt.
. . . changing the focus to longer-term growth removes a great deal of the effect identified by Reinhart and Rogoff. In addition to this methodological adjustment, however, there is a much deeper problem with the application of Reinhart’s and Rogoff’s result to the present situation of developed economies. Their results areprimarily driven by extreme historical circumstances (war, in particular), which are not easily applicable to contemporary debates on debt.
To show this, it makes sense to go more in depth into historical experiences of high sovereign debt. Perhaps the most eye-popping statistic in Reinhart’s and Rogoff’s table is the fact that US growth averaged -1.8% when debt/GDP exceeded 90%. More than any other nation, the US has experienced a falloff in growth (to the point of outright contraction) when its debt has risen above this threshold.
However, what the table fails to display is the historical circumstances surrounding the US experience with high levels of debt. First, it is worth noting that in the 220 years of data available on US debt/GDP, in only 6 of those years (1944-1949) did debt levels exceed the 90% threshold. Indeed, the reason for the high debt levels was the massive mobilization of resources for World War II. And unsurprisingly, the run-up in debt was associated with impressive levels of economic growth. As debt levels rose from 44% of GDP in 1939 to 91% of GDP in 1944, the economy grew 14% per annum.
Coincidently, however, the United States reached the 90% debt/GDP threshold at the beginning of the post-war demilitarization. In 1945 alone, the economy contracted by 11%. However, it would be absurd to believe that this contraction was caused by a high debt-to-GDP ratio. Even if there were no debt, the fact would remain that nearly half (48%) of US GDP in 1944 that was dedicated to fighting the Axis powers ceased to be useful in 1945. This can be seen clearly by looking at GDP growth ex-government spending. Indeed, the entire six years of high debt saw US private GDP grow at a 23% average annual rate.
It is absurd to believe that this historical episode offers any insight for current debates about national debt. Yet Reinhart and Rogoff’s table is full of similar cases. Unsurprisingly, the frequency of high-debt episodes peak around World War II. In these cases, growth outcomes were not caused by high debt levels. Clearly, the actual cause of debt and growth levels is total war, which commands a huge amount of resources and leads to vast destruction of human and physical capital. It is unreasonable to imagine that
these historical experiences provide any insight to the potential consequences of current debt-to-GDP levels in the developed world.
The other obvious clusters occur in periods of Gold-Standard deflation: the late 19th century and 1920s-1930s. In this case, it is easy to see both high debt and low growth simultaneously caused by monetary contraction. As in World War II, high levels of debt appear to be a side effect of a more plausible cause for low growth – deflation. Although these historical examples might be relevant to the present European debt crisis, there is little similarity to economies with independent monetary policy.
However, economic history does offer some evidence that applies to current debates about sovereign debt. In particular, one of the best examples for thinking about the United States’ present situation comes from public finance in the United Kingdom. In the 179 years of data used by Reinhart and Rogoff, the UK had a debt-to-GDP ratio in excess of 90% for 81 years. National debt peaked following the Napoleonic Wars and again in the two World Wars. But unlike most other nations, the UK paid down these debts slowly and consistently – carrying large levels of debt for long periods of time. This allows us to see the effects of high debt during relatively ordinary times, rather than exclusively during extreme historical episodes. In the entire UK sample, debt appears to have had no impact on growth whatsoever. Although annual growth was slightly lower, as reported in Reinhart and Rogoff, long-term future growth was actually slightly higher for high levels of debt.
The statistics produced by Reinhart and Rogoff are an invaluable contribution to economic history, but it is important to think deeply about when they might apply to a contemporary situation. Their simple table relies on the crucial assumption that all high-debt episodes are comparable. Yet the United States is not in the midst of a World War. It is not on the gold standard. It has not lost the Franco-Prussian war, unified the Italian Peninsula, or struggled to maintain territories in Latin America. Economic history has a great deal to teach us – as long as we always remember that this time is very different.
While Reinhart and Rogoff are living, not “defunct” economists, Keynes was right when he said that “practical men” distill their “frenzy” from academics. In the present instance, the distillation is from academic works which, when applied to the problems the world currently faces, are methodologically flawed and persuade practical men to conceive and implement counterproductive policies. Austerity is a bridge to worse than nowhere.
For those with short memories or not enough years under their belts, the title of this post is a variant of the “it’s the economy, stupid” theme that won the presidency for Bill Clinton in 1992.
From the FT’s Martin Wolf:
The summit on Friday is a huge moment. What we have heard from Mr Sarkozy and Ms Merkel does not create confidence. The problem is that Germany – the eurozone’s hegemon – has a plan, but that plan is also something of a blunder. The good news is that eurozone opposition will prevent its full application. The bad news is that nothing better seems to be on offer.
The German faith is that fiscal malfeasance is the origin of the crisis. It has good reason to believe this. If it accepted the truth, it would have to admit that it played a large part in the unhappy outcome.
It’s not fiscal deficits:
Take a look at the average fiscal deficits of 12 significant (or at least revealing) eurozone members from 1999 to 2007, inclusive. Every country, except Greece, fell below the famous 3 per cent of gross domestic product limit. Focusing on this criterion would have missed all today’s crisis-hit members, except Greece. Moreover, the four worst exemplars, after Greece, were Italy and then France, Germany and Austria. Meanwhile, Ireland, Estonia, Spain and Belgium had good performances over these years. After the crisis, the picture changed, with huge (and unexpected) deteriorations in the fiscal positions of Ireland, Portugal and Spain (though not Italy). In all, however, fiscal deficits were useless as indicators of looming crises.
It’s not public debt, Reinhart and Rogoff not withstanding:
Now consider public debt. Relying on that criterion would have picked up Greece, Italy, Belgium and Portugal. But Estonia, Ireland and Spain had vastly better public debt positions than Germany. Indeed, on the basis of its deficit and debt performance, pre-crisis Germany even looked vulnerable. Again, after the crisis, the picture transformed swiftly. Ireland’s story is amazing: in just five years it will suffer a 93 percentage point jump in the ratio of its net public debt to GDP.
It’s a balance of payments crisis:
Now consider average current account deficits over 1999-2007. On this measure, the most vulnerable countries were Estonia, Portugal, Greece, Spain, Ireland and Italy. So we have a useful indicator, at last. This, then, is a balance of payments crisis. In 2008, private financing of external imbalances suffered “sudden stops”: private credit was cut off. Ever since, official sources have been engaged as financiers. The European System of Central Banks has played a huge role as lender of last resort to the banks, as Hans-Werner Sinn of Munich’s Ifo Institute argues.
There’s no solution unless Germany recognizes the nature of the crisis:
If the most powerful country in the eurozone refuses to recognise the nature of the crisis, the eurozone has no chance of either remedying it or preventing a recurrence. Yes, the ECB might paper over the cracks. In the short run, such intervention is even indispensable, since time is needed for external adjustments. Ultimately, however, external adjustment is crucial. That is far more important than fiscal austerity.
If Germany doesn’t, fiscal austerity (as I’ve been arguing for months) will make matters worse:
In the absence of external adjustment, the fiscal cuts imposed on fragile members will just cause prolonged and deep recessions. Once the role of external adjustment is recognised, the core issue becomes not fiscal austerity but needed shifts in competitiveness. If one rules out exits, this requires a buoyant eurozone economy, higher inflation and vigorous credit expansion in surplus countries. All of this now seems inconceivable. That is why markets are right to be so cautious.
The failure to recognise that a currency union is vulnerable to balance of payments crises, in the absence of fiscal and financial integration, makes a recurrence almost certain. Worse, focusing on fiscal austerity guarantees that the response to crises will be fiercely pro-cyclical, as we see so clearly.
Maybe, the porridge agreed in Paris will allow the ECB to act. Maybe, that will also bring a period of peace, though I doubt it. Yet the eurozone is still looking for effective longer-term remedies. I am not sorry that Germany failed to obtain yet more automatic and harsher fiscal disciplines, since that demand is built on a failure to recognise what actually went wrong. This is, at its bottom, a balance of payments crisis. Resolving payments crises inside a large, closed economy requires huge adjustments, on both sides. That is truth. All else is commentary.
A few words of my own:
- Wake up, Germany. Get over your moralizing and your Weimar hyperflation complex before you destroy the European Project and, with it, the world economy.
- Will market participants be smart enough to realize that a Summit agreement that doesn’t address the balance of payments crisis isn’t a solution to the eurozone’s malaise? We’ll see in a few days.
From the Financial Times:
- EU talks on doubling financial firewall
- The fall of the Berlin Wall to a US of Europe
- Why this crisis could run and run
- Debate: Euro end-game (video)
- Sarkozy rides through the storm
- Fast-track ‘fiscal compact’ drawn up
- S&P feels Europe’s ire over ratings threat
- Sovereign downgrade could hit eurozone banks
- Don’t fear a downgrade (video)