The Wilder View

Europe: Why the One-Size-Fits-All Solution Won’t Work

I’d like to remind the Troika – the ECB/EU/IMF – that their one-size-fits-all (OSFA) solution won’t work for every economy in the euro area. OSFA: forced fiscal consolidation for each euro area country that falls into the throes of a liquidity crisis, thereby finding themselves in need of funding at “reasonable” rates.

First it was Greece – then it was Ireland – then it was Portugal – and then it was Italy and Spain. But don’t forget France – they recently instituted new fiscal cutbacks to accommodate a lower growth trajectory.

The rationale for the OSFA approach is pretty simple. Ireland, Portugal, Greece, Spain, Italy, and France (among the headline candidates) are  forced (either explicitly by the Troika – Ireland, Portugal, Greece, the ECB – Italy and Spain, or the bond markets – France along with the others) to drive down domestic demand via fiscal consolidation to the point where prices (wages) fall, thereby shifting relative prices to drive increased competitiveness and net export income. Basically, it’s push the buck onto the global economy.

Often times they cite the need to improve prospects for potential growth through ‘structural reform – that takes time, and a lot of it. But it’s counterintuitive to force fiscal consolidation when it’s the private sector that will consolidate – the one large drawback of the OSFA approach.

The Table below lists the leverage by sector: Private sector ( household + non-financial corporation) and Public sector (General government) as the total debt outstanding and normalized by the country’s level of GDP (see ECB data here). Update: the government net-debt data is from the IMF World Economic Outlook, April 2011.  I’ve eyeballed the levels and circled the areas that could be considered ‘high leverage’ (generally 90% or above, except for the Spanish household sector which I circled at 84.9% due to its stark contrast with the core countries).

The thing to notice here is, that broadly speaking the 2010 leverage build was not in the government  sector (fiscal consolidation) but generally in the private sector. Ireland is in a real quandary – what was previously leverage heavily weighted in the private-sector is now passing through to the public sector via meager growth and harsh fiscal reform (see Edward Hugh’s post on the latest in Ireland).

The only way for some of these countries to drive down fiscal deficits amid such high private-sector leverage (presumably increased desire to save) is to run massive current account surpluses. Just look at Rob Parenteau’s 3 Sector Financial Balances Map. With the US growing at stall-speed and China still in tightening mode, there’s not much hope for the OSFA approach in Europe.

The policy directive needs to change.

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