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4 options to address the eurozone's stock and flow imbalances the rising risk of a disorderly break-up - november 1 2011 (1)
Nov 10, 2011
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4 options to address the eurozone's stock and flow imbalances the rising risk of a disorderly break-up - november 1 2011 (1)
1. ECONOMIC RESEARCH 1 November 1, 2011 Four Options to Address the Stock and Page | 1 Flow Imbalances: The Rising Risk of a Disorderly Break-‐Up By Nouriel Roubini The latest eurozone (EZ) rescue package starts to deal with some but not all of the stock imbalances (large and potentially unsustainable debt levels in the public and private sectors) between the core and periphery of the bloc, but does not address the serious flow imbalances (lack of growth and competitiveness and large current account and fiscal deficits in the periphery) and, as such, will not . The package fails to recognize that the restoration of growth and competitiveness are the key to success as they make stocks of liabilities more sustainable and reduce flow imbalances (such as current account and fiscal deficits); in fact, the proposals heighten the risk of a deeper and longer recession. Thus, financial engineering alone is bound to fail, as markets started to recognize soon after the new plan was announced. Stock and flow problems can be addressed with a variety of policy tools. Stock imbalances can be addressed via growth, higher savings, inflation/depreciation or debt reduction/conversion into equity. Flow imbalances require policies that lead to the reduction of fiscal and current account deficits and the restoration of competitiveness and growth. The reduction of large current account deficits requires both expenditure reduction (relative to income) and expenditure switching via real depreciation. Such real depreciation can be achieved via: Nominal depreciation of the euro; structural policies that increase productivity growth above wage growth and thus reduce unit labor costs; deflation via a reduction of nominal wages and prices; or exit from the monetary union and a return to national currencies. The restoration of growth is conditional on the restoration of competitiveness and other macro policies (monetary easing; a weaker currency; and fiscal easing in the core) to restore growth in the short run as fiscal austerity and reforms have a negative short-‐run effect on output. We identify four possible sets of policy options for the EZ to address its stock and flow problems: o 1) Growth and competiveness are restored (through aggressive monetary easing, a much weaker euro and fiscal easing in the core, while the periphery undergoes painful fiscal austerity and structural reforms) and the monetary union survives for most members, with debt reductions being the exception rather than the rule; o 2) A deflationary/depressionary adjustment in tandem with painful structural reforms that becomes, for some member states, socially unsustainable as growth is depressed for many years and growth and competitiveness are restored too late; o 3) The core permanently subsidizes the periphery via both debt reduction and unilateral transfers that take the form of a transfer union to avoid break-‐up if the periphery is stuck in an outcome of permanent stagnation and loss of competitiveness; www.roubini.com NEW YORK -‐ 95 Morton Street, 6th Floor, New York, NY 10014 | TEL: 212 645 0010 | FAX: 212 645 0023 | firstname.lastname@example.org LONDON -‐ 174-‐177 High Holborn, 7th Floor, London WC1V 7AA | TEL: 44 207 420 2800 | FAX: 44 207 836 5362 | email@example.com | firstname.lastname@example.org © Roubini Global Economics 2011 All Rights Reserved. No duplication or redistribution of this document is permitted without written consent.
ECONOMIC RESEARCH 2 o 4) The EZ sees widespread debt restructurings/reductions to reduce unsustainable stocks of debt and eventually breaks up to restore competitiveness and flow balances via a return to Page | 2 national currencies. These four policy options recent three main scenarios for the EZ: o Scenario 1 (everything goes according to plan, so Italy and Spain grow again and are once more able to borrow at affordable spreads without official support; to which we assign a 40% probability) is, in our view, likely to succeed only if Option 1 (macro policy reflation of the EZ) is implemented soon; but Germany, the EZ core and the ECB want to achieve Scenario 1 by implementing Option 2 (deflation, austerity and reforms), which will only lead to entrenched recession for many years and a backlash against this draconian adjustment. o Scenario 2 (kick the can, but hit a wall in 12 months as Spain, Italy and other fragile affordable sovereign spreads; 50% probability) is reached if the recessionary and deflationary Option 2 is pursued; however, pursuit of Option 2 could also lead to Scenario 3. o Scenario 3 (kick the can and it explodes as Greece collapses in a disorderly fashion before Italy and Spain are given the time to resolve their illiquidity, solvency and growth problems; 10% probability) is analogous to Option 4 (widespread debt restructurings/reductions and break-‐up of the EZ). Option 4 (debt reductions and EZ break-‐up) is also the outcome of this policy if the pursuit of Option 2 (favored by Germany, the core and the ECB) fails and Option 1 (macro reflation) is then not attempted, while Option 3 (permanent subsidy by the core of a depressed uncompetitive periphery) turns out to be politically unfeasible. Then, debt reductions and exit from the EZ across the periphery become the most likely outcome, i.e. a break-‐up of the EZ. So, in terms of this non-‐linear set of scenarios, the periphery will push for Options 1 or 3 as a way to avoid Option 4; but if Germany/the core/the ECB stick with Option 2, Scenarios 2 or 3 rather than 1 will materialize and the EZ will eventually end up with Option 4, i.e. debt reductions, exit from the monetary union and the break-‐up of the monetary union. We are of the view that, unless Option 2 is abandoned and Option 1 is soon adopted, a vicious and ever-‐deepening recession will envelope both the periphery and the core of the EZ and a disorderly break-‐up will gradually occur as first private and public debts are coercively reduced and next a growing number of EZ countries exit the union. Among the six EZ countries in trouble so far (Greece, Portugal, Ireland, Cyprus, Spain and Italy), a subset of them will experience restructurings and reductions of their public and private debts as a way to resolve their stock imbalances. And a different subset of these six countries may also eventually decide to exit the EZ to resolve their flow imbalances. If enough of them coercively reduce their debts and exit the monetary union, the EZ will effectively break-‐up over time, in a slow motion train wreck. www.roubini.com NEW YORK -‐ 95 Morton Street, 6th Floor, New York, NY 10014 | TEL: 212 645 0010 | FAX: 212 645 0023 | email@example.com LONDON -‐ 174-‐177 High Holborn, 7th Floor, London WC1V 7AA | TEL: 44 207 420 2800 | FAX: 44 207 836 5362 | firstname.lastname@example.org | email@example.com © Roubini Global Economics 2011 All Rights Reserved. No duplication or redistribution of this document is permitted without written consent.
ECONOMIC RESEARCH 3 The announcement of the most recent EZ rescue package (acceptance of a bigger haircut for Greek private creditors, the recapitalization of EZ banks and the use of guarantees and financial leverage in the hope of Page | 3 preventing Italy and Spain losing market access) led to markets rallying for a day as the tail risk of a disorderly situation in the EZ, temporarily, diminished. By the next day, Italian yields and spreads were still close to their high, serving as a reminder as we argued in The Last Shot on Goal: Will Eurozone Leaders Succeed in Ending the Crisis?, co-‐authored with Megan Greene that the fundamental problems will not be resolved by this trio of policy actions. To put the latest package in context, we need to first assess the fundamental problems facing the EZ and the potential scenarios for the monetary union. EZ Flow Problems The EZ suffers from both stock and flow problems, which are related to each other. The flow problems were and/or are: Large fiscal and current account deficits in most members of the EZ periphery (Greece, Ireland, Portugal, Cyprus, Spain and Italy); Economic weakness, manifesting itself in renewed near recession or outright recession and weak actual and potential growth; The long-‐term loss of competitiveness, driven by three factors: Loss of export market share to emerging markets (EMs) in traditional labor-‐intensive low-‐valued-‐added sectors; real appreciation, driven by wages growing more than productivity since the inception of the EZ; and the relative strength of the value of the euro in the past decade. EZ Stock Problems The stock problems are the large and possibly unsustainable stock of liabilities of: The government (in most of the periphery with the exception of Spain); the private non-‐financial sector (mostly in Spain, Ireland and Portugal); the banking and financial system (in most of the periphery); and the country (external debt), especially in Greece, Spain, Portugal, Cyprus and Ireland. Stock vulnerabilities are the result of flow imbalances: A big fiscal deficit results in a growing and large stock of public debt (Greece, Italy, Ireland, Cyprus, Portugal) and in a large stock of foreign debt when private sector savings-‐investment imbalances are also large; a wide current account deficit whether driven by private sector imbalances (like in Spain and Ireland) or public sector ones (Greece, Cyprus, Portugal) leads to a build-‐up of foreign debt. In some cases, the excesses started in the private sector (housing boom and then bust in Ireland and Spain); so, initially it was a buildup of private debts and of foreign debts driven by large current account deficits. In other cases, the excesses started in the public sector (Greece, Italy, Portugal, Cyprus), leading to a large stock of public debt and of foreign debt via current account deficits in the subset of countries with fragile savings-‐ investment imbalances in their private sectors (Greece, Portugal, Cyprus). Until recently, Italy had a public debt problem but not current account and foreign debt problems as the high savings of the household sector prevented the fiscal deficit from turning into a current account deficit. But now, the sharp fall in private savings has led to the emergence of a current account deficit even there. In Spain and Ireland, the flow and stock imbalances started in the private sector leading to large current account deficits and foreign debts, but once the Spanish and Irish housing sectors went bust and resulted in sharp fiscal deficits in www.roubini.com NEW YORK -‐ 95 Morton Street, 6th Floor, New York, NY 10014 | TEL: 212 645 0010 | FAX: 212 645 0023 | firstname.lastname@example.org LONDON -‐ 174-‐177 High Holborn, 7th Floor, London WC1V 7AA | TEL: 44 207 420 2800 | FAX: 44 207 836 5362 | email@example.com | firstname.lastname@example.org © Roubini Global Economics 2011 All Rights Reserved. No duplication or redistribution of this document is permitted without written consent.
ECONOMIC RESEARCH 4 part, due to the socialization of private losses the ensuing rise in public debt created a sovereign debt sustainability problem. Page | 4 Recent Policy Actions Start to Deal With Some Stock Vulnerabilities The recent EZ package starts to deal with some but by no means all of the stock imbalances in the EZ periphery. First, public debt in some (Greece) but not all of the countries where it is unsustainable (Portugal, Ireland, Cyprus, Italy) will be reduced (50% haircut on private creditors, though the July plan will have to be completely scrapped, and the new details are lacking at this point). Second, the excessive amount of debt relative to the equity/capital of EZ banks will be partly addressed to prevent insolvency by recapitalizing EZ banks (both in the periphery and the core). These banks suffer from low capital ratios and potential erosion of their capital through losses, given exposures to sovereigns, busted real estate and rising non-‐performing loans as a result of the growing recession. But the capital needs of EZ banks, given these tail-‐risk losses, are much larger than the 100 billion of recapitalization needs that the EZ has identified. Third, illiquidity of banks and sovereigns risks turning illiquidity into insolvency as self-‐fulfilling bad equilibria of runs on short-‐term liabilities of banks and governments are possible. Thus, the full allotment policy would prevent such a run on bank liabilities in principle only for banks that are illiquid but solvent, but in practice even possibly for insolvent banks. For sovereigns that have lost market credibility and whose spreads could blow to an unsustainable level . Bail-‐ big bazooka of the fin is necessary to provide time and financing for the flow adjustment fiscal and structural to restore market confidence and reduce spreads to sustainable levels. In each case, assumptions need to be made about whether a country is a) illiquid but solvent given financing to prevent loss of market access, time and enough adjustment/austerity (possibly Italy and Spain); b) illiquid and insolvent (Greece, clearly); or c) illiquid and near insolvent and already needing conditional financing given that market access has already been lost (Portugal, Ireland and Cyprus). But even if Italy and Spain were illiquid and solvent given time, financing and adjustment, the big bazooka that the EZ needs to backstop banks and sovereigns in the periphery is at least 2 trillion and possibly 3 trillion rather than the fuzzy 1 trillion that the EZ vaguely committed to at the recent summit. So, on all three counts, the recent EZ plan falls short of addressing the stock problems of highly indebted sovereigns, the capital needs of EZ banks and the liquidity needs of EZ banks and sovereigns; it also does little or nothing to restore competitiveness and growth in the short run. Critical Role of Flow Factors in Resolving Stock Sustainability Issues To make stocks sustainable, it is crucially important to address flow imbalances, for several reasons. First of all, without economic growth, you have a dual problem: a) The socio-‐political backlash against fiscal austerity and reforms becomes overwhelming as no society can accept year after year of economic contraction to deal with its imbalances; b) more importantly, to attain sustainability, flow deficits (fiscal and current account) and excessive debt stocks (private and public, domestic and foreign) need to be stabilized and reduced, but if output keeps on falling, such deficit and debt ratios keep on rising to unsustainable levels. Second, restoring growth is also important because, without growth, absolute fiscal deficits become larger rather than smaller (given automatic stabilizers). Third, restoring external competitiveness is key as that loss of competitiveness led in the first place to current account deficits and the accumulation of foreign debt and to www.roubini.com NEW YORK -‐ 95 Morton Street, 6th Floor, New York, NY 10014 | TEL: 212 645 0010 | FAX: 212 645 0023 | email@example.com LONDON -‐ 174-‐177 High Holborn, 7th Floor, London WC1V 7AA | TEL: 44 207 420 2800 | FAX: 44 207 836 5362 | firstname.lastname@example.org | email@example.com © Roubini Global Economics 2011 All Rights Reserved. No duplication or redistribution of this document is permitted without written consent.
ECONOMIC RESEARCH 5 lower economic growth as the trade balance detracts from GDP growth when it is in a large and growing deficit. So, unless growth and external competitiveness are restored, flow imbalances (fiscal and current account deficits) Page | 5 persist and stabilizing domestic and external deficits becomes mission impossible. Finally, note that, unless growth and competitiveness are restored, even dealing with stock problems via debt reduction will not work as flow deficits (fiscal and current account) will continue and, eventually, even reduced debt ratios will rise again if the denominator of the debt ratio (debt to GDP), i.e. GDP, keeps on falling. Growth also matters as credit risk measured by real interest rates on public, private and external debt, which measures the default risk will be higher the lower the economic growth rate. So, for any given debt level, a lower GDP growth rate that leads to a higher credit spread makes those debt dynamics more unsustainable (as sustainability depends on the differential between real interest rates and growth rates times the initial debt ratio). The Current Account Flow Deficit Problem in the EZ Periphery While the issue of fiscal deficits and public debt has been overemphasized in the recent policy debate about the problems of the EZ, one should not underestimate the role of external current account imbalances. These periphery has suffered implies that such deficits are now not financeable in the absence of official finance. These deficits are the result of savings-‐investment imbalances in both the private (Spain, Ireland, Portugal) and public sectors (Greece, Portugal, Cyprus, Italy); they are also the result of the real appreciation of these countries following a decade of declining export market share, the growth of wages in excess of productivity growth and the strength of the euro. Some of these deficits are now cyclically lower given that the collapse of output/demand has led to a fall in imports. But, on a structural basis, unless the real appreciation is reversed, the restoration of growth to its potential level would result in the resumption of large and now not financeable external deficits. So, the modest reduction in current account deficits in the periphery that has been seen since 2009 is deceptive: It for the most part reflect an improvement in competitiveness; it is only the result of a severe and persistent recession. Real depreciation is required to restore such competiveness while ensuring sustained economic growth. An inability to restore competitiveness and thus growth would eventually undermine the monetary union as private creditors are now after a sudden stop unwilling to finance such deficits. So, eliminating the external current account deficit is as critical to restoring debt sustainability as reducing flow fiscal deficits. And fiscal deficits are not the only explanation of the external deficits as real appreciation and loss of competitiveness are as important, if not more important, than fiscal imbalances, in explaining such external imbalances. The Recent EZ Package Does Little or Nothing to Restore, in the Short Term, Growth and Competitiveness, Which Are the Key to Sustainability The latest economic data such as the EZ PMIs strongly suggest that the EZ not just the periphery, but also the core are falling back into a recession. This is very clear in the periphery where some countries never got out of their first 2008 recession, while the others are plunging back into recession after a very moderate recovery. But even in the core of the EZ, the latest data suggest that a recession is looming. The recent EZ package (a bigger Greek haircut, bank recaps and a levered European Financial Stability Facility (EFSF), together with more fiscal austerity and a push toward structural reforms) does nothing to restore competitiveness and growth in the short run. In fact, it actually exacerbates the risk of a deeper and longer recession. Fiscal austerity is necessary to prevent a fiscal train wreck, but, in the short run (as recent IMF studies www.roubini.com NEW YORK -‐ 95 Morton Street, 6th Floor, New York, NY 10014 | TEL: 212 645 0010 | FAX: 212 645 0023 | firstname.lastname@example.org LONDON -‐ 174-‐177 High Holborn, 7th Floor, London WC1V 7AA | TEL: 44 207 420 2800 | FAX: 44 207 836 5362 | email@example.com | firstname.lastname@example.org © Roubini Global Economics 2011 All Rights Reserved. No duplication or redistribution of this document is permitted without written consent.
ECONOMIC RESEARCH 6 suggest), raising taxes, reducing transfer payments and cutting government spending (even inefficient/unproductive expenditure) has a negative effect on economic growth, as it reduces aggregate demand Page | 6 and disposable income. Moreover, even structural reforms that will eventually boost growth via higher productivity growth have a short-‐run negative effect: You need to fire unproductive public employees; you need to fire workers in weak firms and sectors; you need to shut down unprofitable firms in declining sectors; you need to move labor and capital from declining sectors to new sectors in which the country may have a comparative advantage. This all takes time and, in the absence of a rapid real depreciation, what are the sectors in which a periphery country has a new comparative advantage? Even necessary structural reforms like fiscal austerity reduce output and GDP in the short run before they have beneficial medium-‐term effects on growth. To restore growth and competitiveness: The ECB would have to rapidly reverse its policy hikes, sharply reduce policy rates toward zero and do more quantitative and credit easing; the value of the euro would have to sharply fall toward parity with the U.S. dollar; and the core of the EZ would have to implement significant fiscal stimulus if the periphery is forced into necessary but contractionary fiscal austerity (which will have a short-‐term drag on growth). Options for Dealing with Stock and Flow Problems Stock imbalances large and potentially unsustainable liabilities can be addressed in multiple ways: a) high economic growth can heal most wounds, especially debt wounds given that fast growth in the denominator of the debt ratio (i.e. GDP) can lead over time to a lowering of debt ratios; b) low spending and higher savings in the private and public sectors can lead to lower fiscal deficits and lower current account deficits (lower flow imbalances) that, over time, reduce the stocks of public and external debt relative to GDP; c) inflation and/or forms of financial repression can reduce the real value of debts; the same can occur with unexpected depreciation of the currency if the liabilities are in a domestic currency; d) debts can be reduced via debt restructurings and reductions, including the conversion of debt into equity. The last option is key: If growth remains anemic in the EZ; if savings lead to the paradox of thrift (a more severe short-‐term recession) and if monetization, inflation or devaluations are not pursued by the ECB, the only way to deal with excessive private and public debts becomes some orderly or disorderly reduction of such debts and/or their conversion into equity. Flow imbalances are more difficult to resolve as they imply a reduction of fiscal and current account deficits that are consistent with sustainable growth and with the restoration of competitiveness, which requires real depreciation. To reduce external current account deficits the key to restoring competitiveness and growth you need both decreases in expenditure (private and public) and expenditure-‐switching through a real depreciation. Such real depreciation can occur in four ways: a) a nominal depreciation of the euro large enough to lead to a sharp real depreciation in the periphery; b) structural reforms that increase productivity growth while keeping a lid on wage growth below productivity growth and thus reduce unit labor costs over time; c) real depreciation via deflation a cumulative persistent fall in prices and wages that achieves a sharp real depreciation; and d) exit from the monetary union and return to a national currency that leads to a nominal and real depreciation. The key issue here is as we will discuss in detail below that achieving the real depreciation via route a) is unlikely, as there are many reasons why the euro will not weaken enough; getting it via b) may take way too long a decade or more when the sudden stop requires a rapid turnaround of the external deficit; achieving it via c) may also take too long and would be associated with a persistent recession, while leading to massive balance-‐sheet effects; thus the d) option exit from EZ becomes the only available one if the other three are not feasible/desirable. www.roubini.com NEW YORK -‐ 95 Morton Street, 6th Floor, New York, NY 10014 | TEL: 212 645 0010 | FAX: 212 645 0023 | email@example.com LONDON -‐ 174-‐177 High Holborn, 7th Floor, London WC1V 7AA | TEL: 44 207 420 2800 | FAX: 44 207 836 5362 | firstname.lastname@example.org | email@example.com © Roubini Global Economics 2011 All Rights Reserved. No duplication or redistribution of this document is permitted without written consent.
ECONOMIC RESEARCH 7 Additionally, if growth and competitiveness are restored in short order, this is the best way on top of decreased expenditure via fiscal austerity to reduce both the fiscal and current account imbalances as well as the relative Page | 7 ones (i.e. as a share of GDP). In other terms, fiscal austerity and structural reforms eventually restore growth and productivity, but they are, in the short run, recessionary. Thus, other macro policies are needed to restore growth, which is critical to make the adjustment politically and financially feasible. Therefore, macro policies consistent with a rapid return to economic growth are the key to resolving flow problems. Four Options to Address the Stock and Flow Problems of the EZ Given the above analysis of the structural and fundamental problems faced by the EZ, there are four possible options to deal with the stock and flow problems; each option implies a different future for the monetary union. Each reduces unsustainable debts and restores growth and competitiveness and reduces flow imbalances via a different combination of the policies discussed above 1. Growth and Competiveness Are Restored. In this first option, policies are undertaken to rapidly restore growth and competitiveness (monetary easing, a weaker euro, core fiscal easing and the reduction of unsustainable public and private debts in clear insolvency cases), to reduce flow deficits and to restore private, public and external debt sustainability, all while the periphery undertakes continued painful austerity and structural reforms. In this scenario, the EZ survives in the sense that most members maybe with the exceptions of Greece and possibly Portugal remain in the EZ and most members again, with the exceptions of Greece and possibly Portugal avoid a coercive restructuring of their public and private debts. This solution requires a nominal and real depreciation of the euro and, for a period of time, higher (lower) inflation in the core (periphery) of the EZ than the current ECB target to restore, via real depreciation, the competitiveness of the periphery and rapidly eliminate its unsustainable current account deficit. 2. The Deflationary/Depressionary Route to the Restoration of Competitiveness. Growth and competitiveness are not restored in the short run as the core/Germany imposes an adjustment based on deflationary and depressionary draconian fiscal austerity and structural reforms that, in the absence of appropriate expansionary macro policies, makes the recession of the periphery severe and persistent and does This depression/deflationary path becomes politically and socially unsustainable for most but possibly not all of the EZ periphery as it implies five-‐ten years of ever-‐falling output to restore competitiveness via deflation and eventual structural reforms. And with output falling in the short run and a fall in prices/wages, stock problems worsen for a while (as both nominal and real GDP are falling) until the restoration of growth eventually takes care of the stock imbalances. Since, for most EZ members, Option 2 becomes politically and socially unfeasible, in the absence of a path that leads to Option 1, Option 2 evolves into Options 3 or 4. 3. The Core Permanently Subsidizes the Periphery. If Option 1 does not materialize while Option 2 becomes politically-‐socially unsustainable, the only other way to avoid Option 4 (EZ break-‐up) is not just via a reduction of the unsustainable stocks of liabilities in the periphery (a capital levy on the core of creditors), but also via a permanent subsidization of the uncompetitive periphery by the core. Since the lack of a restoration of growth/competiveness implies a permanent external deficit (trade deficit) in the periphery with a trade surplus in the core that implies an unsustainable current account deficit in the periphery, the only way in which the core can prevent the periphery from exiting the EZ www.roubini.com NEW YORK -‐ 95 Morton Street, 6th Floor, New York, NY 10014 | TEL: 212 645 0010 | FAX: 212 645 0023 | firstname.lastname@example.org LONDON -‐ 174-‐177 High Holborn, 7th Floor, London WC1V 7AA | TEL: 44 207 420 2800 | FAX: 44 207 836 5362 | email@example.com | firstname.lastname@example.org © Roubini Global Economics 2011 All Rights Reserved. No duplication or redistribution of this document is permitted without written consent.
ECONOMIC RESEARCH 8 flow deficit problem) is to make a unilateral permanent yearly transfer payment (of the order of several percentage points of core Page | 8 GDP, possibly as high as 5% of GDP) to the periphery to prevent the trade deficit from turning into an unsustainable current account deficit that in turn leads to the accumulation of even more unsustainable external debt. Such a unilateral transfer sustains the GNP of the periphery while its GDP remains permanently depressed as competitiveness is not restored. So, stock problems are addressed via repeated restructurings, extensions and haircuts of privately held debt (bonds) and bilateral/multilateral loans as well as via recapitalizations of banks that include some conversion of debt into equity. Meanwhile, flow problems are addressed via a permanent yearly subsidy to the periphery from the core. 4. The EZ Experiences Widespread Debt Restructurings. Members of the periphery react to the Option 2 (depression/deflation) that is currently imposed on them by Germany and the ECB by, first, losing market access (or not regaining it) and are thus forced, once official finance runs out (because of political and/or financial constraints in the core), to coercively restructure their public and also their private debts (say, of banks and financial institutions). Even such a debt reduction is insufficient to restore growth and competitiveness as it partially deals with stock problems, but does not deal with flow problems. If, then, the flow problem is not resolved via a permanent subsidization of the income of the periphery by the core (Option 3), then the only other way to restore growth and competitiveness is via exit from the monetary union and a return to the national currency. The EZ can survive the exit of its smaller members (Greece, Portugal, Cyprus), but if debt restructurings and the exit of Italy and/or Spain become necessary/inevitable, the EZ effectively breaks up, with only a small core Germany and a few core members remaining in a smaller and much damaged monetary union. An Assessment of the Likelihood of the Four Options Option 1: Most Desirable But Quite Unlikely as Contrary to the Goals and Constraints of Germany/the ECB Which one of these four options is most likely? Option 1 appears the most desirable as it leads to the survival and success of the EZ. However, it is not necessarily the most likely option as it would imply radical, rapid and presumably unacceptable changes in macro-‐policy. First, the ECB would have to reverse its policy tightening and aggressively cut rates; even that would not be sufficient as aggressive quantitative easing (QE) would be necessary to restore growth and provide unlimited lending of last resort (LOLR) to sovereigns such as Spain and Italy that are possibly illiquid but solvent if given enough time and liquidity to resolve their problems. Even traditional QE would not be sufficient as unconventional credit easing may be necessary to restore credit growth to smaller firms and households subject to a credit crunch. This is obviously not acceptable to the ECB and Germany as it would require a radical change (maybe via a treaty change) to the formal mandate (the bank is currently supposed to only pursue the goal of price stability). The ECB and eventually Germany as a recap of the ECB would fall to Germany/core would also take a significant risk in becoming (for a while) the LOLR for Italy and Spain, which may turn out even with massive liquidity to be not just illiquid but also insolvent (there are many future paths via which the latter could happen). Second, the value of the euro would have to fall sharply compared with current levels, possibly toward parity with the U.S. dollar to reverse the loss of competitiveness of the periphery. This would imply that inflation would rise in the core starting in Germany for a number of years above 2% to allow the real depreciation of the periphery to www.roubini.com NEW YORK -‐ 95 Morton Street, 6th Floor, New York, NY 10014 | TEL: 212 645 0010 | FAX: 212 645 0023 | email@example.com LONDON -‐ 174-‐177 High Holborn, 7th Floor, London WC1V 7AA | TEL: 44 207 420 2800 | FAX: 44 207 836 5362 | firstname.lastname@example.org | email@example.com © Roubini Global Economics 2011 All Rights Reserved. No duplication or redistribution of this document is permitted without written consent.
ECONOMIC RESEARCH 9 occur. being politically acceptable to Germany and the ECB. Also, with Germany being uber-‐ competitive and with a large external surplus, while the U.S. dollar needs to a weaken given the large U.S. current Page | 9 account deficit, it is not obvious that the euro would fall as sharply as the periphery needs, unless the ECB aggressively pursues QE and credit easing and jawbones the euro down with verbal and actual intervention: All very unlikely outcomes given the current mandate and the German/ECB goal of restoring the periphery Third, the core would have to accept and implement a fiscal stimulus to compensate for the recessionary effects of the fiscal austerity of the periphery. But Germany and the core are vehemently against back-‐loaded fiscal austerity let alone fiscal easing of the type that even the IMF is now suggesting to them. Germany/the core is of the view that the problems of the periphery were self-‐inflicted even when private imbalances (like in Spain and Ireland) rather than public ones were at the core of financial difficulties. So, austerity and reform are viewed by the core as a must for both the periphery and also for the core. Option 2: Socially-‐Politically Unacceptable as Implies a Persistent Recession-‐Depression in Most of the Periphery Option 2 is the type of adjustment that the ECB and Germany would like to impose on the periphery, but it would be socially and politically unacceptable for most. It is thus not a stable equilibrium but rather an unstable disequilibrium that would eventually lead to Options 3 or 4. Since fiscal deficits are excessive, they need to be rapidly reduced via front-‐loaded austerity to make public debts sustainable. Current account deficits will be partly reduced via the reduction of public dis-‐savings. The rest of the external imbalance will be corrected via deflation (internal devaluation) and via accelerated structural reforms that increase productivity growth, while keeping a lid on wage growth below such higher productivity growth will progressively reduce unit labor costs and restore external competitiveness. The problems with the German/ECB solution to the growth/competitiveness issue are multiple. First, fiscal austerity is necessary, but if implemented by the entire EZ it makes the periphery recession worse, deeper and longer and thus undermines the restoration of growth that is necessary to make the debts sustainable. Also, such recession damages attempts to reduce fiscal deficits; and it improves external balances only temporarily via a compression of imports, not via a true restoration of competitiveness; structural external deficits mostly remain. Second, reducing unit labor costs via accelerated reforms that increase productivity growth while keeping a lid on wage growth below such rising productivity growth is easier said than done. It took 10 to 15 years for Germany to achieve its reduction of unit labor costs via that route. And since German unit labor costs have fallen by 20% since the inception of the EZ, while they have risen by 30% in the EZ periphery, the unit labor cost gap between Germany and periphery is now about 50%. So, if the EZ periphery were to accelerate reforms that actually depress output in the short run, the benefits will start to show up after five years or so; and no country can accept five years of recession or depression before it returns to growth. Also, a reduction in unit labor costs via a rise in productivity growth above positive wage growth as in Germany in the past 15 years is politically more feasible as it is associated with growth rather than recession than a recessionary adjustment where wages need to fall in nominal terms as productivity growth remains stagnant while output stagnates for a number of years. Given the nominal downward rigidity of wages and prices, outright deflation is extremely hard to achieve in the absence of a severe and persistent depression. Third, deflation/internal devaluation is not politically-‐socially feasible if it leads as is likely to persistent recession. Deflation a 5% fall in prices and wages for five years leading to a cumulative compound reduction of www.roubini.com NEW YORK -‐ 95 Morton Street, 6th Floor, New York, NY 10014 | TEL: 212 645 0010 | FAX: 212 645 0023 | firstname.lastname@example.org LONDON -‐ 174-‐177 High Holborn, 7th Floor, London WC1V 7AA | TEL: 44 207 420 2800 | FAX: 44 207 836 5362 | email@example.com | firstname.lastname@example.org © Roubini Global Economics 2011 All Rights Reserved. No duplication or redistribution of this document is permitted without written consent.
ECONOMIC RESEARCH 10 prices and wages of 30% that undoes the loss of competitiveness of the periphery would be most likely associated with a continued recession for five more years, likely turning into a depression. Page | 10 The international experience of to a real depreciation and, after three years of an ever-‐deepening recession/depression, it defaulted and exited its currency board peg. The case of EZ periphery: Output fell by 20% and unemployment surged to 20%; the public debt was unlike in the EZ periphery negligible as a percentage of GDP and thus a small amount of official finance a few billion euros was enough to backstop the country without the massive balance-‐sheet effects of deflation; and the willingness of the policy makers to sweat blood and tears to avoid falling into , for a while, unlimited (as opposed to the EZ periphery unwillingness to give up altogether its fiscal independence to Germany); and even after devaluation and default was avoided, the current backlash against such draconian adjustment is now very serious and risks undermining such efforts (while, equivalently, the social and political backlash against recessionary austerity is coming to a boil in the EZ periphery). The other cases of successful reductions of large external and fiscal deficits and debts in the European member states in the 1990s Belgium, Sweden, Finland, Denmark, etc. are just example as they occurred against a background of growth (not the current EZ recession), falling interest rates as expectations of EMU led to convergence trades (not the current blowing up of sovereign spreads and loss of market access) and, in some cases, via nominal and real depreciations within the flexible terms of the European Monetary System (not the rigid constraints of a monetary union where there is no national currency and the value of the euro remains excessively strong). Some EZ periphery members notably Ireland are undergoing a degree of internal devaluation, but it is too slow and small to rapidly restore competitiveness: A fall in public wages may, in due course, push down private wages in traded sectors and eventually reduce unit labor costs. Finally, the deflation route to real depreciation even if it were politically feasible makes the private and debt unsustainability problem more severe: After prices and wages have fallen 30% after a painful deflation, the real value of private and public debts would be 30% higher, making the case for a sharp reduction in unsustainable debts even more compelling. Some EZ countries notably Ireland may have a better chance of restoring their competitiveness via internal devaluation than others Portugal, Greece, Cyprus. Ireland has a large and productive manufacturing base as two-‐thirds of its manufacturing industry is owned by multinational firms many in tech or high-‐value-‐added sectors that made a lot of FDI in Ireland in the past two decades to create an industrial base in a low corporate tax economy for their European and international production activities. So, Ireland, with some difficulty, could regain its competitiveness in due time if the fiscal adjustment more rapidly leads to a change in the relative prices of traded to nontraded goods. But, in the case of Greece, Portugal and Spain, the problems of competitiveness are much more chronic and un-‐ resolvable without a nominal currency depreciation: They have permanently lost export market shares in labor intensive and low-‐value-‐added sectors textile, apparel, leather products, light labor intensive manufacturing to EMs -‐value-‐added tech industries of Ireland, for example. Also, in these periphery countries (unlike in Ireland), productivity growth www.roubini.com NEW YORK -‐ 95 Morton Street, 6th Floor, New York, NY 10014 | TEL: 212 645 0010 | FAX: 212 645 0023 | email@example.com LONDON -‐ 174-‐177 High Holborn, 7th Floor, London WC1V 7AA | TEL: 44 207 420 2800 | FAX: 44 207 836 5362 | firstname.lastname@example.org | email@example.com © Roubini Global Economics 2011 All Rights Reserved. No duplication or redistribution of this document is permitted without written consent.
ECONOMIC RESEARCH 11 was mediocre even in the years of positive economic growth and restoring comparative advantage without a sharp and rapid real depreciation looks less likely to be achievable. Page | 11 Spain and Italy are in between Ireland on one side and Greece/Portugal/Cyprus: They experienced as much of an increase in unit labor costs as the rest of the periphery (especially Spain) and they have permanently lost export market share in traditionally labor-‐intensive sectors. Italy has implemented more structural corporate restructuring than Spain which restored some competitiveness in higher-‐value-‐added sectors because Spain, growing rapidly during its unsustainable real estate bubble, had little incentive to improve the competitiveness of its traded sector. Also, until recently, Italy did not have the unsustainable current account deficit of Spain as its private saving compensated for the dis-‐savings of the public sectors. Spain, instead, faces a massive stock of private sector foreign liabilities held by households, corporate firms, banks and financial firms that are not easily re-‐financeable as an external sudden stop has now occurred. But, in the past year, deficit has now significantly increased, despite depressed economic activity: A worrisome signal of a loss of competitiveness. Option 3: Not Acceptable to the EZ Core as it Implies Permanent Subsidies to a Large Part of the Periphery, I.e. a Transfer Union Rather Than a Fiscal Union Option 1 implies a policy adjustment that is biased against Germany/the core/the ECB as it implies that these agents/countries take on significant credit risk and accept higher inflation to adjust inter-‐EZ real exchange rates; thus, it is unacceptable to them. Option 2 implies that all the burden of adjustment is born by the periphery in terms of many years of fiscal belt-‐tightening and, worse, a deflationary recession that could turn into a depression. Thus, it eventually becomes unacceptable to the EZ periphery. Then, the periphery would be tempted to unilaterally reduce its debt burdens via coercive debt restructuring first and via exit from the EZ next, as exit, on top of debt reduction, becomes necessary to restore competitiveness and growth. Then, if the EZ would want to prevent a disorderly break-‐up of the EZ, it would not only have to accept a reduction of the unsustainable debts that imposes a capital levy on the core creditors (something that becomes unavoidable to resolve the stock problems), but, more importantly, it would also have to permanently subsidize the chronic trade deficits to prevent such deficits from causing unsustainable current account deficits that are no longer financeable. Thus, a unilateral permanent fiscal transfer by the core to the periphery would be necessary to boost the periphery GNP given its depressed GDP and maintain a current account balance in both the core and periphery, despite the persistent trade imbalances between the two regions. If Germany/the EZ core were to run a permanent trade surplus of say 4-‐5% of GDP relative to that of the EZ periphery, then a permanent yearly transfer of up to 4-‐5% of GDP from the core to periphery would be necessary to bribe the periphery to stay in the EZ rather than exit the monetary union. Such unilateral transfers from rich to poor regions are not very common, the context of nation states where there is a political union. In Italy, the north has transferred income to the south Similarly, West Germany has paid for unification with East Germany with massive transfer payments and government spending on reconstruction that have lasted for over 20 years now and that are not over yet (like the still-‐existing income tax surtaxes to pay for massive reunification costs). In Australia, the fiscal system permanently transfers income to Tasmania, which is the Australian equivalent in terms of poverty/low incomes of the Italian Mezzogiorno or East Germany. But even in the context of unified nation states with a common national identity, such permanent transfers become politically and socially unacceptable as the rich regions resent such transfers and eventually revolt against them: In Italy, for www.roubini.com NEW YORK -‐ 95 Morton Street, 6th Floor, New York, NY 10014 | TEL: 212 645 0010 | FAX: 212 645 0023 | firstname.lastname@example.org LONDON -‐ 174-‐177 High Holborn, 7th Floor, London WC1V 7AA | TEL: 44 207 420 2800 | FAX: 44 207 836 5362 | email@example.com | firstname.lastname@example.org © Roubini Global Economics 2011 All Rights Reserved. No duplication or redistribution of this document is permitted without written consent.
ECONOMIC RESEARCH 12 example, political movements representing the rich north (notably, the Lega Nord) have become influential and are now imposing a form of fiscal federalism that will, over time, significantly reduce transfers from the north to Page | 12 the south. And concerns are now being expressed that such fiscal reform will lead to a sharp political backlash in the south; even, in the extreme, threats of secession or national breakdown. So, permanent unilateral transfers of income from rich to poor regions become politically problematic even in a unified political union with a homogenous national identity. This suggests that the idea that Germany or the core of the EZ would accept a permanent several percentage points of its GDP transfer of its income to the periphery as a condition for the periphery not exiting the EZ runs against political trends and is extremely unlikely to occur. The EU has a system of structural payments from rich to poor states (southern and new eastern European members), but these transfers are relatively modest (less than 0.5% of the GDP). Ramping them up by a factor of 10 to bribe the periphery into staying in the EZ would be totally unacceptable politically and otherwise to Germany and the rest of the core. Also, it would not make economic sense: Until now, the excess of income (spending) over spending (income) in the core (periphery) that has taken the form of a current account surplus (deficit) in the core (periphery) has been financed with debt that, in principle, is an asset of the core and should be paid back with interest by the periphery over time. Now, instead, the core would have first to accept a capital levy on its accumulated assets over the periphery (its foreign assets accumulated through decades of current account surpluses) to allow the reductions of the unsustainable foreign private and public debts. The EZ core is now grudgingly accepting some of this capital levy (losses on EZ creditors coming from the debt reduction in Greece), but similar capital levies are unavoidable for the debts of Portugal, Ireland and Cyprus, and may become unavoidable even for Italy and Spain. But even this much larger capital levy would not be enough as the persistent chronic trade deficit of the periphery would next have to be financed not via debt-‐creating flows, but rather unilateral transfers within a currency union. Providing a system of vendor financing from the core to periphery may have made sense for the core for a while to sustain its export and GDP growth even if it eventually leads to a capital levy when the debtor is unable to pay. But a system of unilateral transfers from the core to periphery where the excess of spending over income of the periphery is financed by permanent grants not loans core: It is a permanent reduction of income and welfare and consumption for no sensible reason apart from the vague goal of keeping the EZ together. The discussion above suggests that the usual recent argument i.e. that the EZ needs to become a fiscal union to survive its crisis is partially wrong and confusing. There is a substantial and critical difference between a fiscal union and a transfer union. In a fiscal union, there is true risk-‐sharing and no permanent transfer of income from one state/region to another. Where revenues and spending are partially shared at the federal level, there is risk-‐ sharing: When an idiosyncratic shock occurs in one region (such as a recession in one state of the union, but not in other states), risk-‐sharing implies that revenues and transfers/spending are adjusted to reduce the effect of that temporary state-‐specific shock to the output (GDP) of that state on its income (GNP). If such state-‐specific shocks are random sometimes hitting one region/state, sometimes hitting another region/state of the union the worse-‐off region subject to the negative output shock gets partially and temporarily subsidized by the region/state that is temporarily better off. And over time like in any actuarially fair insurance scheme mutual insurance smoothes shocks to income that are driven by shocks to output. No region/state permanently subsidizes another one. This is a fiscal union where risk is pooled and shared. www.roubini.com NEW YORK -‐ 95 Morton Street, 6th Floor, New York, NY 10014 | TEL: 212 645 0010 | FAX: 212 645 0023 | email@example.com LONDON -‐ 174-‐177 High Holborn, 7th Floor, London WC1V 7AA | TEL: 44 207 420 2800 | FAX: 44 207 836 5362 | firstname.lastname@example.org | email@example.com © Roubini Global Economics 2011 All Rights Reserved. No duplication or redistribution of this document is permitted without written consent.
ECONOMIC RESEARCH 13 A transfer union is a very different animal: it is not a fiscal union aimed at sharing, insuring and smoothing temporary regional output shocks. It is instead a mechanism that uses fiscal resources taxes, transfer payments Page | 13 and public spending to permanently transfer income from richer region/states to poorer regions/states. Transfer unions are politically problematic even in unified nations that are political unions and are nationally homogenous. They are much more problematic when a political union does not exist and where the arguments for a permanent transfer union are not acceptable. For a German to accept a permanent transfer of her income to the Greeks as a because they breed moral hazard. Even if one could make the argument that initial differences in per-‐capita income between different regions/states of an economic union were explained by exogenous factors different from endogenous policy/economic efforts, the existence of a permanent transfer union would obviously breed over time moral hazard. The weak/poor region might not want to make much economic/policy/fiscal effort to improve its economic/fiscal conditions as it is permanently subsidized by the richer region. Moral hazard is thus the reason why fiscal unions come with binding rules that limit the risk attached to the transferee being fiscally undisciplined, to prevent a fiscal union becoming a transfer union. This is also the reason why the current efforts of Germany/the core EZ to help the periphery are subject to strict fiscal and structural conditionality: Only if the periphery does significant and painful fiscal austerity and structural reforms, will the core help the periphery to overcome its temporary fiscal and financial problems. This is also the reason why any inter-‐ EZ debate on future quasi or full fiscal union comes with the express request by Germany/the core for binding fiscal rules (balanced budgets over time, balanced budget amendments, sanctions against deviant states) to prevent such a fiscal union from turning into a transfer union. In conclusion, Option 3 is highly unlikely and undesirable for the core EZ as it would imply the creation of a transfer union, rather than a fiscal union. But if Option 2 deflationary depression is unacceptable to the periphery, only a transfer union prevents the periphery from being tempted to avoid a persistent recession, from considering exiting the monetary union and restoring its growth and competitiveness via a return to its national currency. Option 4: Widespread Debt Reductions and Eventual EZ Break-‐Up Becomes the More Likely Outcome as the Other Three Options Are Not Likely or They Are Not Desirable or Sustainable The core of the EZ is unlikely accept a symmetric adjustment Option 1 that restores competitiveness and growth in the periphery via monetary and fiscal easing and a weaker euro that implies higher inflation for a period of time in the core, a persistent LOLR role for the ECB and significant credit risk for the core if some periphery members end up being both illiquid and insolvent. It is instead pushing for Option 2, recessionary deflation in the periphery, which is not politically acceptable in most of the periphery. Then, the only way to keep the periphery in the EZ becomes both a capital levy on the core creditors to make the debts of the periphery sustainable and, on top of that, unilateral transfers in the form of a transfer union that permanently subsidizes the depressed income of the EZ periphery (caused by the permanent loss of competitiveness that remaining in the EZ implies). But such a transfer union is not politically or economically acceptable to the core. Then, the only other option is first a capital levy imposed by the periphery on the core in the form of a reduction of unsustainable foreign private and public liabilities to reduce such unsustainable debt. But even that debt reduction is not sufficient to restore competitiveness and growth. And if competitiveness cannot be restored via Option 1 (a much weaker euro), or Option 2 (depressive deflation or too-‐slow structural reform) or Option 3 (where the incipient permanent loss of www.roubini.com NEW YORK -‐ 95 Morton Street, 6th Floor, New York, NY 10014 | TEL: 212 645 0010 | FAX: 212 645 0023 | firstname.lastname@example.org LONDON -‐ 174-‐177 High Holborn, 7th Floor, London WC1V 7AA | TEL: 44 207 420 2800 | FAX: 44 207 836 5362 | email@example.com | firstname.lastname@example.org © Roubini Global Economics 2011 All Rights Reserved. No duplication or redistribution of this document is permitted without written consent.
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