Thoughts on Europe, November 2010 and December 2011

Back in November of last year, when Jeff Frieden and I were putting the finishing touches on Lost Decades, we wrote:

Many countries with foreign debts in their own currency reduce their real debt burden by allowing their currency to drop in value, so that foreigners get repaid in less-valuable currency. But Greece and the other PIIGS cannot pursue this option on their own, for they share the euro with other countries, including some of the countries to which they owe money. Given this dynamic, investors and others worried that the European Central Bank would be forced to allow euro-zone inflation to rise — and perhaps even to allow the euro to depreciate — in order to alleviate some of the pain and suffering caused by its members’ debts.

An alternative was for the rest of the euro zone to bail out the debtors. The rationale here was like that of bailing out a bank: a collapse of Greek or Portuguese finances could harm the rest of the euro-zone financial systems. If Bank of America was too big to fail, then so was Greece. And since a deepening of the financial crisis that drew in the entire euro zone would affect the entire global financial system, the International Monetary Fund was also drawn into the rescue. So, just as American taxpayers got stuck with the bill for bailing out banks whose failure would have had dire effects on the economy as a whole, European and international taxpayers got stuck with a €110 billion bill for bailing out Greece. And because the Greek emergency triggered a crisis of confidence in other euro-zone countries whose failure could harm the region as a whole, the European Union was driven into a massive trillion-dollar package for other troubled European debtors.

These figures — and the corresponding problem — seem almost trivial in comparison to the challenges that face the eurozone now. The debt problem of Italy dwarfs that of Greece, and Italy is truly “too big to fail” and sustain the survival of the Economic and Monetary Union (EMU). It is clear to everyone that the policy of muddling through, the operating procedure for the past two years, is not viable. However, that realization has not yet led to a commensurate removal of the political road blocks to a feasible solution.

Here is a graphical depiction of the extent of the debt problem.

Figure 1: European banks have different exposures to sovereign debt. Source: Torsten Slok, Outlook for the US, Europe, China, and Financial Markets, Deutsche Bank, December 2011. Not online.

Most sovereign debt is held domestically in Spain and Italy, but there are substantial cross border holdings for some; note German and French holdings in particular.

The discussion of tightening the bonds of a fiscal union, mainly by enforcing more rigorously the restrictions on budget deficits and government debt. Even if this were to prove successful as a long term means of sustaining the monetary union, the essential question is how to build a bridge to that long term solution. And as Wolfgang Münchau has observed, the short term has a certain immediacy.

As Jim observed yesterday, the Fed’s extension of swap lines to European central banks only solves the liquidity problem; if you think this was going to happen eventually anyway, you would be befuddled (see Krugman) by the extent of the equity market boom (for more on the effect of these currency swap arrangements, see Goldberg et al.).

What will do the trick? Tim Duy has a summary of what is, and is not, on the table. Here’s his list of what you don’t see:

  1. A path to true fiscal integration, which would imply direct transfers from relatively rich to relatively poor member states.
  2. Similarly, a new path toward internal rebalancing. A commitment to stronger fiscal oversight implies continued pursuit of rebalancing via deflation in troubled economies. Moreover, as Paul Krugman notes, this will be attempted in the context of low inflation, which only exacerbates and extends the pain of adjustment. This path only ensures deeper recession.
  3. A coordinated, continent-wide banking sector recapitalization. Note that Moody’s just placed European bank debt under review. Downgrades are almost inevitable at this point.
  4. An open door for stimulative policies to offset the demand contraction currently underway.

I think item 2 is worthy of more investigation. In the various discussions and presentations I’ve seen over the past few weeks in Europe, there seems to be a surprisingly widespread view that nominal price adjustment can occur even in large countries. I think this is misguided. The proposition that Greece, or Italy for that matter, can achieve more sustainable configurations for wages and prices with average inflation rates around 2 percent or less seems untenable. That is, Italy is not Latvia. (Also, reducing debt loads is more difficult with negative or near zero inflation.)

Item 4 also merits further discussion. When one cuts government spending and increases taxes, both in terms of demand determined models and empirics income falls, so that the decrease in budget deficits is not dollar for dollar for reduction in spending/increases in (e.g.) lump sum taxes. (I.e., in general ,there are not many instances of expansionary fiscal contractions, and the UK is proving that ever more the truth day by day). But when the economies are closely interlinked by large trade flows, a whole set of countries engaging in fiscal consolidation will make the challenge of successful consolidation even more difficult.

To see this, consider the two country demand-determined model discussed here (all the math you could want, here). In a small open economy, the government spending multiplier is given by:

ΔY/ΔG = 1/(1-c(1-t)+m)

Where m is the marginal propensity to import. For a large country (consider a two-country model), the multiplier is given by:

ΔY/ΔG = 1/(1-c(1-t)+[(m*m)/(1-c*(1-t*))])

Where m*, c*, t* are the corresponding foreign country parameters. Fiscal contraction in both countries will reinforce the contractionary effects so that deficit cutting will be self-defeating to a greater extent than in the one-country case. Or as, Deutsche Bank has noted:

Ratcheting up of fiscal austerity, deteriorating bank credit supply, and rapidly deteriorating market confidence is not a backdrop against which to forecast a countercyclical improvement in household and business confidence. Indeed, the latest survey indicators continue to show declining confidence.

Here is Deutsche Bank’s forecast for Euro area q/q growth (not annualized).

Figure 5: from Mark Wall, Gilles Moec, 2011, “2012: A deeper recession,” Focus Europe (London: Deutsche Bank, 25 November). Not online.

I will also observe that it seems implausible that political constituencies will be willing to endure years of austerity measures in order to maintain the euro. As my coauthor, Jeff Frieden wrote in “Europe’s Lehman Moment”:

In Europe as in America, the real question is how the costs of this devastating debt crisis will be distributed. Who will pay — creditors or debtors? Taxpayers or government employees? Germans or Greeks? More realistically, what combination of sacrifices will be politically tenable, both across countries and within countries. The aftermath of every debt crisis sinks into conflict over who will bear the burden of adjustment to the new reality. The sooner Europeans recognize the true nature of the debates they’re having, and the inevitability of working out some mutually acceptable conclusion, the better off they will be.

This post originally appeared at Econbrowser and is posted with permission.