It might seem almost churlish to wonder what would happen if Spain were to leave the euro. The official European position is that the battle of the euro has been pretty much won, and anyone who argues otherwise will be accused of being a euro hater, an Anglo-Saxon or, even worse, a writer for theFinancial Times.
But there is more than one “battle” around the euro. While the battle of liquidity seems to have been won, the solvency and the unemployment battles (the latter of which is really a battle of unbalanced demand) have not even been addressed. Every sovereign debt crisis in modern history has been preceded by assurances that it was only a liquidity crisis, but as I see it there were three separate problems that erupted in the 2008-09 euro crisis:
- A liquidity crisis. After the US subprime crisis set off a more general financial crisis in the US, investors were spooked. As they looked around to see who else was vulnerable, they began to wonder about peripheral Europe and, even worse, they wondered if everyone else was wondering. Once that process begins, it is just a question of time before credit dries up for at-risk borrowers. Suddenly heavily-indebted European sovereign borrowers found themselves unable to roll over their debt.
- A solvency crisis. Wondering about the sustainability of peripheral European debt was not irrational. In fact debt levels for many countries had soared, even before it was obvious that these countries were on the hook for an explosion in contingent liabilities generated by bad debts in the banking system. It is not at all clear that even at current levels these countries can repay their debts without imposing tremendous pain on an electorate that might (rightly in my opinion) refuse to accept it.
- A demand imbalance. Policies in Germany around 2000 aimed at improving Germany’s international competiveness did so by forcing down wage growth and, with it, household consumption growth. For reasons about which I am not sure it seems that investment growth also slowed dramatically, compounding the problem of weak household consumption growth. As German domestic demand fell relative to its total production of goods and services, instead of seeing unemployment rise as German producers cut back on capacity, Germany was able to resolve its domestic demand deficiency in the form of a rising trade surplus, as excess German savings poured into peripheral Europe. These ignited an asset boom that, by making peripheral Europeans feel richer than ever,ignited a consumption boom. Germany’s domestic demand deficiency, in other words, was matched by excessive demand in peripheral Europe, but this could go on only as long as the asset boom continued on the back of rising debt. Once it ended it could only be resolved by a rise in unemployment.
Have Europe’s problems been resolved? The ECB’s resolve to do “whatever it takes” has resolved the first of these three problems, at least temporarily. The ECB has promised to supply unlimited liquidity to roll over European sovereign debts, and as long as this promise is credible, private investors are happy to step in and roll the debt over themselves. Plentiful global savings have encouraged an urgent search for yield, and the ECB’s very credible commitment did the rest. But has Europe resolved the other two crises?
Clearly the second problem, the solvency crisis, hasn’t been resolved. Debt has grown much faster than GDP in all of the heavily indebted countries of Europe, making the debt burden worse than ever, and the visible debt is almost certainly understated by contingent liabilities that might arise within the banking systems of the afflicted countries.
For now low interest rates make the debt burden seem manageable, but if debt continues to grow faster than GDP (and even if Europe is able to achieve the optimistic GDP growth targets promised by the various governments, debt will still grow faster than GDP for many more years), at some point debt levels will seem so high that further unlimited promises by the ECB will simply not seem credible. At that point investors will flee the government bonds issued by peripheral European governments.
But we probably won’t need to wait even that long. If the ECB were ever to hint at an end to low interest rates, or an end to the promise of indefinite rollovers, the debt level would quickly become unmanageable as the cost of rolling over the debt soared. Like in Japan today, high debt levels are made manageable because of low interest rates, and the hope is that at some point a resurgent economy will allow the countries like Spain to grow their way out of their debt burdens.
But here is the dilemma. Interest rates are low mainly because growth is non-existent. Should Europe start to grow, interest rates would be forced up and, depending on the maturity structure of the debt when this occurs, higher interest rates could cause financial distress costs to rise quickly enough to stifle growth. We are likely, in other words, to relearn the lesson of nearly every previous debt crisis in history –the debt burden itself prevents the kind of economic resurgence that allows highly indebted countries to grow their way out of debt. It is only when the debt has been written down to some manageable levels that afflicted countries ever begin again to grow.
The third problem, the demand imbalance, hasn’t been resolved either. In Germany there is talk of raising wages to rebalance demand. There continues to be, however, reluctance to do so because of the fear that higher wages will undermine Germany’s international competitiveness and force its economy to rely on productivity growth, of which there has been precious little in the past twenty years.
If German consumption doesn’t rise, then in principle the domestic imbalance can be resolved by a rise in German investment, but it isn’t clear how this could happen. The German private sector – not surprisingly given excess global capacity and weak global demand – seems reluctant to embark upon a domestic investment boom.
The German government also seems reluctant to invest because this would require a rise in government debt, and were perceptions of German credit to weaken, it would undermine the credibility of implicit German support for the weaker European sovereign borrowers. What makes the whole process maddeningly complex is that Germany’s creditworthiness is itself vulnerable to any perceived deterioration in the creditworthiness of peripheral European governments because German banks, who were among the main conduits for the export of German savings to peripheral Europe, are too heavily exposed to peripheral Europe.
Until we see higher German consumption or higher German investment, however, German businesses must continue to rely indirectly on demand from the rest of Europe, which must consequently continue to absorb weak German demand in the form of higher domestic unemployment.
A quick digression on bilateral trade balances
Many analysts have trouble understanding how Germany’s demand deficiency has been absorbed by peripheral Europe when much of Germany’s exports go elsewhere, to China for example. Quite a few analysts besides me – Martin Wolf, for example, or Heiner Flassbeck – have pointed out that distortions that forced up German savings relative to investment after around 2000 (and so caused Germany to swing from large trade deficits in the 1990s to among the largest trade surpluses in the world in the 2000s and through to today) were directly responsible for the collapse in savings relative to investment in peripheral Europe.
Germany’s trade surplus, in other words, required – and probably caused – the trade deficits of the rest of peripheral Europe (many of whom ran large surpluses in the 1990s). Some analysts find this hard to understand because, they point out, Germany does not run bilateral surpluses with peripheral Europe, or not anywhere near the extent of aggregate German surpluses and aggregate peripheral European deficits. This proves, they argue, that the deficits of a country like Spain, for example, have nothing to do with German surpluses, and were caused by domestic failures within those countries.
It proves no such thing. The reason has to do with the nature of global trade. Imbalances have to settle on an aggregate basis and do not need to settle bilaterally. In fact they rarely do. The key is to focus on capital flows. Remember that if Germany is a net capital exporter, it must run a trade surplus. If its capital exports cause other countries in Europe to become net importers of capital, they must run the trade deficits that correspond to Germany’s trade surplus (I am glossing over the differences between the trade and current accounts, but this does not affect the argument).
It isn’t necessary, in other words, that German run a trade surplus bilaterally with other European countries in order that German demand deficiency be resolved by the rest of Europe. The trade surpluses and deficits can occur bilaterally, but it is actually unlikely that they will. Perhaps it is easier to think in terms of the currency. Without a common currency Germany’s currency should have risen, and the currencies of other European countries dropped, given their respective trade account balances. The common currency prevented this, however, so that Germany benefitted from a weak euro while other European countries suffered from a strong euro.
In my book, The Great Rebalancing, I create a very simply four-country model (I call them the US, China, Mexico, and Brazil) in which China exports capital to the US, with Brazil and Mexico in balance, and show that China must consequently run a trade surplus, the US must run a trade deficit, but not necessarily bilaterally. There doesn’t even have to be direct trade between the two. Even if they can each trade only with Brazil and Mexico, China will still have a surplus and the US a deficit.
This confuses a lot of people who think the causes and consequences of trade imbalances must show up in bilateral trade balances, but even simple trade theory recognizes that bilateral balances almost never matter. It is the direction of capital flows that will direct the trade imbalances. This is why Germany’s net capital exports, mainly in the form of bank loans, to peripheral Europe had to result in German trade surpluses and peripheral European trade deficits, whether or not these countries even traded with each other, let alone ran trade balances that matched the capital balances.
Back to the problem of debt
How much longer is the rest of Europe willing to maintain high unemployment in order to support the German economy? On May 26 we will discover, I suspect, that at least some parts of the rest of Europe have little interest in continuing to maintain the euro if that simply means that they must suffer unemployment in order to protect Germany from its unwillingness to pay workers more.
For now the policy-making elite in peripheral Europe continues to insist that there will be absolutely no flexibility on the matter of the euro. But in the 1920s the British policy-making elite, who insisted then that there would be absolutely no flexibility on the matter of free trade, was forced to abandon its principles as high unemployment and voter revolt forced it into devaluing sterling and setting up tariffs. There is huge controversy on the sequence and causality (not surprisingly), but there is little doubt that after these occurred the British economy improved significantly and unemployment dropped. Meanwhile it was trade-surplus America that suffered mightily from the rise of global protection, not trade-deficit England.
What does this mean for the survival of the euro? Perhaps that when the policy-making elite is determined to act “responsibly” and maintain its highest principles (protect the bankers), but mainly at the expense of the working and middle classes, policymakers are eventually forced into retreat by an angry electorate. And perhaps it also means that the electorate isn’t quite as stupid about economic policymaking as the elite might think.
There are at least two things I would suggest we should consider in thinking about the future of the euro:
- Peripheral Europe has so far been remarkably tolerant of high unemployment, but of course the longer this goes on the lower the tolerance. If at some point opposition to the euro, or opposition to servicing the debt, becomes an obvious way to gain political support, we may see the debate about the euro move from the radical and occasionally lunatic fringe to a more respectable part of the political spectrum, in which case financial distress costs will intensify and the process of unraveling the euro will intensify.
- My model argues that the German imbalances are forced onto the peripheral countries in the aggregate, who together have to absorb the shortfall in German demand by increasing their unemployment. This suggests that if any country were to leave the euro, the total imbalances would rise (every time a weak country leaves the euro, the euro will strengthen) and would furthermore be concentrated among a smaller group of countries, which would then face additional pressure and weaker credibility. No matter how determined any individual country is to stay in the euro, in other words, its ability to stay may well be determined by the weakest “link”.
The May 26 votes might end up reminding us that the euro crisis isn’t over. The longer unemployment and hopelessness drag on, the greater the erosion of support for the establishment and the stronger the support for the radicals who want to abandon the euro.
By refusing to allow the introduction of any flexibility into the discussion of the long-term outlook for the euro, Brussels is forcing Europeans to choose among two absolutes: stay in the euro as it is, or break the currency union permanently. This is risky, because over time the second option becomes increasingly viable, and any movement toward to second option is self-reinforcing – which means that as long as opposition to the euro is low, the growth of opposition to the euro will be slow, but when we reach the point at which opposition to the euro is large enough to be taken seriously, the growth in opposition will accelerate.
Policymakers who think, in other words, that we do not need to discuss alternatives to the hard euro position until much later, when there is a real threat to the hard euro, are taking a huge gamble. Once we have reached that point, the risk is that we get the intellectual and institutional equivalent of a “bank run”, and policymakers will be shocked by the speed with which things fall apart. It will then be too late to introduce a more flexible position on the euro.
By the way those who advocate more flexibility on the euro are usually painted as enemies of Europe and the euro, but this is nonsense of course. In my opinion the world is better off with a united Europe (more united than now) and with a common currency, but it might very well be that the only way to achieve both is to introduce flexibility into the current system, which means, among other things, the possibility of a temporary withdrawal. Otherwise any break will be permanent.
What does withdrawal look like?
Along those lines I have been thinking about what would happen if Spain were to leave the euro. I confess I know very little about the legal and political implications about a euro exit, and although I have heard often enough that it is impossible to leave the euro, I don’t think anything such thing can be true about a sovereign nation. It may be difficult, it may be messy, and it certainly will be unpleasant, but it can happen.
But aside from legal issues, there are a number of economic and financial considerations that I base on my fifteen years of trading the sovereign debt of defaulted and restructured countries and my addiction to financial history. Here are the things I considered as being relevant to any breakup.
- First and most obviously if Spain leaves the euro its debt burden will soar. If Spain left the euro and returned to the peseta, the peseta will immediately fall, and as it does the peseta value of the euro-denominated debt will rise commensurately. Let us assume that when this happens Spanish external debt is 110% of GDP. In that case a 20% decline in the value of the peseta will immediately raise the debt to 137.5% of GDP and a 50% devaluation of the peseta will raise the debt to 220% of GDP.
- By how much will the peseta devalue? You might think this is a question about how “overvalued” the Spanish euro is (15%? 20%?), but in fact the debt burden itself determines the amount of the depreciation because of the way it forces certain types of investor behavior. In the end the amount of depreciation will have nothing to do with economists’ estimate of the amount of peseta overvaluation.
Why? Because a devaluation will the lock the country into a self-reinforcing cycle in which a devaluing currency forces up debt, which forces Spanish businesses and households to hedge by buying euros and selling pesetas, which forces down the peseta further, which causes even more hedging, and so on, so that the peseta will drop down unrestrainedly until investors believe Spanish assets are cheap enough that they begin to counteract peseta hedging by buying pesetas to acquire Spanish assets. The structure of the balance sheet, in other words, is what determines the amount of the devaluation, and countries with a great deal of external debt are likely to see their currencies fall far below any “rational” level.
If Spain were a developing country, I would argue that given its debt level the peseta would fall at least 50-70% (and so its debt burden would triple), but because it has a credible legal structure (I am assuming no radical party wins the election before a euro exit), a decline of 30-40% might be enough to set off foreign buying. My guess, in other words, is that if Spain left the euro with a center-right or center-left administration, the peseta would likely drop no more than 30-40%. This still will cause an already unbearable debt burden to become impossible, especially because interest rates will immediately rise.
- This, by the way highlights the importance of the political process and the speed with which Spain decides on its strategy. The longer it takes for Spain to arrive at a decision to abandon the euro, and the more bitter the fight to get there, the greater the likelihood of a radical right or left party taking power, in which case the euro might not stabilize at a 30-40% discount.
- There might be a way to limit the drop further. Over the longer term I think a more tightly organized Europe, with a single currency and a real fiscal center, is good for Europe and the world, and a euro exit might even be just the way to achieve this. If Spain were credibly (this means with full German support) to commit to returning to the euro within, say, five years, at a predetermined level – for example one implying a 20% depreciation over five years – Spain might be able to get most of the competitive benefits of a depreciation without giving up the benefits of monetary and economic integration. It would be a “stable” departure from and reentry to the euro.
- However much the devaluation, whether it is catastrophic or orderly, debt would surge. There is a foolish belief that as long as we can find a way to roll over the debt the debt burden itself does not matter, but of course it does for two reasons. First, resources must be appropriated from some part of the economy to service the debt, and second, debt creates financial distress costs that can far exceed the actual cost of the debt.
Spain must restructure its debt burden to a “reasonable” level, which means a level at which the mechanisms that create financial distress are minimal. High levels of debt, remember, force creditors, businesses, household savers, household consumers, and policymakers all to act in ways that increase balance sheet fragility and reduce growth, not because they are evil but because they are rational. For this reason countries that are perceived as having too much debt never grow until the debt burden has been resolved. It is in everyone’s interest that Spain immediately receive a significant debt haircut or else it will not return to growth and the devaluation will have been wasted. I would argue that Spanish external debt should be reduced to 60% of GDP and payments stretched out between 10-30 years.
- Significant debt forgiveness doesn’t mean equally significant losses for creditors. Financial distress costs are triggered by the perception of a high probability of default. Spain’s creditors, of course, will hate to see their claims on Spain sharply reduced, but this is almost certainly going to happen anyway (I don’t think Spain has much chance of “growing” its way out of its debt burden without debt forgiveness), and if done in an orderly way, it is possible to compensate creditors for at least part of the debt reduction without incurring financial distress costs.
Spain can replace debt claims with a different set of claims whose payment schedule is positively correlated with economic performance. Instruments that pay according to GDP growth, the performance of the stock market, or land prices, for example, are the right way to line up the interests of the Spanish economy with those of the creditors. These are not unprecedented – Argentina provided GDP warrants on its defaulted 2001 debt – but they are used far too little. If a devaluation plus a sharp cut in Spanish debt causes Spain’s economy to come roaring back, as it most certainly will, creditors will be paid on the basis of how well the economy does, and can eventually recover a substantial part of the value of their original claims.
This is a very important point that few understand. High fixed claims will continue to drag down the economy because they increase the probability of default, and an increase in the probability of default sets off the self-reinforcing process of financial distress, in which agents behave in ways that worsen the debt burden, and worse debt burdens create pressure for agents to exacerbate their adverse behavior. But this doesn’t happen with high variable claims that are correlated with how well the economy does (like equity in a company, which cannot create financial distress costs). These claims are high when Spain can pay and low when Spain cannot, so they do not increase default probabilities at all. For this reason they will create absolutely no financial distress costs.
- If Spain were to eliminate financial distress costs and lower its domestic costs by 20% with a devaluation, the economy, at least part of whose poor legal structure has been reformed under Rajoy, would almost certainly soar, clocking in growth rates of 5% or more for several years. Spain has not completely wasted the crisis. It has implemented very serious reforms, especially labor reforms, but these reforms were aimed at old distortions in the Spanish economy and had nothing to do with the current crisis, which is caused by excess debt and an uncompetitive exchange rate.
I go to Spain often to see my family (I will go there this Thursday, for example). It is incredibly frustrating to see how terribly Spaniards are suffering, especially in the south, where my family lives. To add insult to injury, Spanish suffering is being blamed on old stereotypes – their fiscal irresponsibility and their laziness – when in fact Spain was among the most fiscally responsible countries in Europe before the crisis and Spanish workers worked more hours every year than did the Germans.
Spain clearly has a lot of serious policy problems, and way too much corruption, but these problems pre-date the crisis and pre-date Spain’s joining the euro. They have nothing to do with the current crisis, which was primarily the result of a demand imbalance in Germany. As I argue in my last blog entry, both the explosion in Spanish consumption before 2008 and the surge in Spanish unemployment after are automatic consequence of a savings glut for which Spain bears no responsibility.
Spain, in other words, cannot resolve its crisis on its own. It requires concerted action by Europe, and especially by Germany, in order to bring down unemployment. Germany cannot play its role because this must involve debt forgiveness, and Germany will not be prepared to acknowledge the need for debt forgiveness until German banks are sufficiently capitalized to recognize the obvious. There are no winners here, Europe’s demand deficiency means that there will be high unemployment somewhere, but Spain can decide how to distribute the cost of adjustment by deciding whether or not to remain inflexibly within the euro.
This piece is cross-posted from Michael Pettis’ China Financial Markets with permission.