|International Economic Outlook logo 130|
No. 2, September 2010
The outbreak of a sovereign-debt crisis in the eurozone's peripheral economies has been among the more important developments in the global economy in 2010. Sadly, this crisis will likely intensify in the months ahead as markets increasingly focus on the intractable solvency and competitiveness issues confronting countries like Greece, Portugal, Spain, and Ireland. Such intensification will affect Europe's already-troubled banking system, seriously threatening both the European and the global economic recovery.
Key points in this Outlook:
- Budget deficits in Greece, Ireland, and Spain have ballooned to double-digit levels as a percentage of GDP.
- Within the eurozone, countries cannot resort to currency devaluation to restore competitiveness or boost exports.
- The International Monetary Fund has prescribed painful budget adjustments that will increase rather than reduce these countries' public-debt-to-GDP ratios.
- A series of defaults in the eurozone's periphery would have devastating consequences for the European banking system and the global economy.
In January 1999, when the euro was launched, Milton Friedman famously warned that the euro would not survive Europe's first major economic recession. He based his misgivings on his assessment that Europe was not an optimal currency area like the United States. In particular, he noted that Europe lacked the degree of wage flexibility and labor-market mobility necessary for a well-functioning monetary union. He also noted that Europe lacked a system of federal fiscal transfers, like that enjoyed in the United States, whereby federal funds are routinely transferred from stronger states to weaker ones.
Aware of the intrinsic structural issues to which Friedman alluded, European leaders realized that strict budget and public-debt limits were fundamental to the euro's success. They also recognized the dangers of different inflation rates among member countries. As a result, eurozone members agreed upon a Stability and Growth Pact to discipline member countries' public finances. This pact requires member countries to keep their budget deficits below 3 percent of GDP and limit their public debt to less than 60 percent of GDP.
In his darkest moments, Friedman could not have foreseen the imbalances that have since built up in countries like Greece, Portugal, Spain, and Ireland--a consequence of markets readily providing the necessary financing and the eurozone lacking the instruments to enforce the limits of the Stability and Growth Pact. As figures 1 and 2 show, budget deficits for nearly all these peripheral countries have ballooned to double-digit levels as a percentage of GDP, placing public-debt levels on course to exceed 100 percent of GDP. At the same time, these countries have generally lost in excess of 20 percent in international competitiveness--a principal reason for double-digit current-account deficits. Further complicating matters have been inappropriately low European Central Bank (ECB) interest rates for Europe's periphery, which together with unduly easy credit conditions spawned outsized housing-market bubbles in Ireland and Spain.
Stuck within the eurozone, these peripheral countries cannot resort to currency devaluation to restore international competitiveness. Nor can they devalue their currency to boost exports to offset the highly negative economic impact of the major fiscal retrenchment that the International Monetary Fund (IMF) and the European Union (EU) are requiring as a condition for financial support. Under such conditions, these countries can expect many years of painful deflationary and recessionary conditions that will only compound their debt problems.
|IEO No. 2, September 2010, Figure 1|
|IEO No. 2, September 2010, Figure 2|
Greece's Unpleasant Budget Arithmetic
Greece, where economic imbalances are the greatest, illustrates most vividly the futility of trying to hew to the IMF's prescription of painful budget adjustment without resorting either to currency devaluation or to debt restructuring. Greece's two basic problems are its extraordinarily bad public finances and its large loss in international competitiveness within the straightjacket of eurozone membership. Despite the strictures of the Stability and Growth Pact, Greece's budget deficit ballooned to 14 percent of GDP in 2009, while its public-debt-to-GDP ratio increased to 115 percent. At the same time, Greece lost over 20 percent in wage and price competitiveness over the past decade--widening its external current-account deficit to over 12 percent of GDP.
Not wishing to countenance either debt restructuring or euro exit as part of its support package, for fear of the effects this would have on the rest of the eurozone, the IMF is prescribing draconian fiscal retrenchment as a cure-all to Greece's economic ills. Indeed, it is requiring Greece to cut its budget deficit by no less than 11 percent of GDP over the next three years, with half of that adjustment to occur in the first year. Recognizing that fiscal retrenchment will cause a significant recession, eroding Greece's tax base, the IMF is insisting that Greece implement tax hikes and public-spending cuts that total as much as 10 percent of GDP in 2010.
Clearly, the IMF has not learned that undertaking a herculean budget adjustment, without the benefit of a currency depreciation to boost exports, will plunge the Greek economy into a major recession--particularly when Greece's borrowing costs have soared, its banks are losing deposits, and labor disturbances have become the order of the day. Look, for example, at the recent experience of Latvia and Ireland, where output has collapsed by over 20 and 10 percent, respectively, over the past two years. It has done so precisely as a result of IMF-style budget-deficit reduction within a fixed exchange-rate system, on a much lesser scale than what is now being proposed for Greece.
Greece's economy could very well contract by 15 percent over the next two years rather than by the IMF's projected 6 percent. If such a contraction occurred, Greece could have difficulty continuing to service its debt and remain in the eurozone. This raises the question of whether Greece would not be better served by restructuring its debt and exiting the euro now rather than being forced to do so in the aftermath of a costly IMF austerity program.
In addition to proposing radical budget adjustment, the IMF is urging Greece to reverse its 20 percent loss in international competitiveness over the past decade through an "internal devaluation." Given the limitations on Greece's ability to increase labor productivity through structural reform, this will necessarily involve major wage and price deflation over the next few years.
If successfully implemented, the IMF-sponsored program will have the unwanted effect of substantially increasing rather than reducing Greece's public-debt-to-GDP ratio. If Greece's nominal GDP declined by 20 percent over the next few years, as a result of a deep recession and price deflation, Greece's public-debt-to-GDP ratio would rise from its present level of around 120 percent to 175 percent. Calculations of this sort have recently led Standard and Poor's to warn Greek bondholders that they might eventually retrieve only thirty to fifty cents on the dollar on their bond holdings. Such calculations have also induced markets to assign a 75 percent probability to a Greek sovereign restructuring within the next five years despite the massive IMF-EU bailout package.
A substantial write-down of Greece's debt would have a major impact on western Europe's already-enfeebled banking system. While the Greek economy accounts for only 2 percent of Europe's GDP, Greece's sovereign debt amounts to around US$420 billion, and a large portion of this debt sits on the books of French and German banks. Furthermore, a Greek default would almost certainly turn the markets' full fury on Spain, Portugal, and Ireland, whose economies also suffer from serious internal and external imbalances. More worrying still, those economies among them have around US$1.5 trillion in sovereign external debt.
Spain's Balance-of-Payments Problem
Spain poses a much greater threat to the long-term survival of the eurozone in its present form than does Greece. After all, its economy is five times larger than Greece's, while at around US$1 trillion, its sovereign debt is three times larger. In addition, the Spanish economy is burdened by an excessively high level of public- and private-sector external debt, which makes it vulnerable to the whims of the international capital market.
Unlike the Greek case, the parlous state of the Spanish economy is not the result of years of government profligacy. Rather, it is the result of a massive housing boom, which over the past decade saw a trebling in Spanish home prices as well as an increase in its construction sector to a staggering 18 percent of the Spanish economy. It is also the result of an associated 20 percent loss in international competitiveness that contributed to a ballooning external current-account deficit and an increase in Spain's gross external debt to around 135 percent of GDP.
Since September 2008, the bursting of the Spanish housing bubble, together with the onset of a deep domestic recession, has revealed the weak underbelly of the Spanish economy. As housing-related tax collections plummeted, Spain's budget position swung dramatically from a small surplus to a deficit of 11.5 percent of GDP by 2009. At the same time, in large measure due to structural rigidities in the labor market, unemployment surged from less than 10 percent before the crisis to over 20 percent now.
More disturbing still, the incipient housing-market bust has drawn attention to the fact that Spain's banks in general, and its savings and loans (cajas) in particular, are overly exposed to its crumbling housing sector. Construction loans made by the Spanish banking system are approximately equal to 45 percent of the country's GDP. Unsettled by this large exposure, foreign banks have virtually stopped lending to Spanish banks and corporations. This has forced the ECB to rediscount around €125 billion in Spanish bank loans to forestall a full-blown Spanish funding crisis.
Spain now finds itself in a similar predicament to that of Greece. It is forced to engage in severe budget cutting to bring its budget deficit down to a more sustainable level without the benefit of a cheaper currency to boost exports and cushion the economic blow. Similarly, Spain is forced to go down the painful path of price deflation to restore competitiveness, even though that path will compound the country's public- and private-debt problems. Further complicating Spain's challenge, it will have to engage in serious budget tightening at a time when unemployment is already around 20 percent and the housing bust still has a long way to go. After running up threefold, Spanish home prices have only declined by around 15 percent to date.
Kicking the Can Forward
European policymakers fully understand that a default in any peripheral eurozone country would likely trigger contagion to the other peripheral members. They also understand that a series of defaults in the eurozone's periphery would have devastating consequences for the European banking system. After all, the combined sovereign debt of Greece, Spain, Portugal, and Ireland is around US$2 trillion, and a major part of that debt sits on the European banks' balance sheets. The Bank for International Settlements estimates that the French banks are particularly exposed to the troubles in the peripheral countries, since they have lent the equivalent of 37 percent of France's GDP to those countries.
Realizing the potential threat to Europe's banking system, European policymakers have put in place a €750 billion support system for the eurozone's periphery. They have done so in an attempt to convince markets that there is little risk of a sovereign-debt default anytime soon, since the financial needs of the periphery's public sector are being fully backstopped for the next three years. The main pillar of that support system is the European Stabilization Fund, which will raise €440 billion in the market on the basis of loan guarantees from the sixteen eurozone governments. Lending will be undertaken in conjunction with the IMF, which will set the conditions of any such lending and provide up to €250 billion of its own resources to the effort.
The ECB is also playing a major role in Europe's efforts to forestall a full-blown sovereign-debt crisis. Since May 2010, the ECB has been buying the periph-eral countries' bonds in the secondary market. Furthermore, the ECB has been substantially expanding its balance sheet by rediscounting the bonds of the eurozone periphery's banks. Spain in particular has benefitted from the ECB's largesse: the ECB has already lent €125 billion to the Spanish banks. As a result, as much as 37 percent of the ECB's vastly expanded loan book is made up of loans to Greece, Spain, Portugal, and Ireland.
The Eurozone's Endgame
The eurozone's sovereign-debt crisis casts a pall over today's already-fragile global economic outlook, since the recessions of the European peripheral countries will likely deepen considerably in the year ahead as they attempt to undertake major fiscal adjustment programs without the benefit of currency depreciations. Such deepening will undermine their public finances by eroding their tax bases and will raise questions about their ability to service their sovereign debt, which in turn will call into question the health of the European banking system.
Continued need for large amounts of financing will perpetuate the eurozone periphery's dependence on official financing in general and on access to the ECB's rediscount window in particular. In principle, large amounts of public financing could paper over the eurozone's sovereign-debt crisis indefinitely without resolving it--as has been occurring over the past six months. Politically, however, there are limits to the amount of financing that Europe's troubled southern countries can expect to receive from the financially stronger northern ones. Witness the May 2010 German state elections, in which the electorate sent a clear message to Chancellor Angela Merkel that it was not happy to see German taxes used to bail out Greece.
The more immediate threat to the continuation of the eurozone in its present form is the possible loss of political willingness in Europe's periphery to continue hewing to IMF-style austerity measures. At some point, as the recession deepens and unemployment rises with no end in sight, serious questions may arise in the periphery as to whether these countries would not be better served by restructuring their debt and exiting the euro. This is essentially what happened in Argentina in 2001 after several years of painful and not very fruitful austerity measures. There is little reason to expect a different outcome in the eurozone's peripheral countries, whose economic imbalances are far greater than Argentina's were.
Implications for the United States
Europe's periphery has a relatively small weight in the global economy, constituting only 15 percent of the eurozone economy. Its potential to cause severe damage to the European economy lies in the extent to which Europe's banks are exposed to it. European banks have lent approximately US$1.5 trillion to the eurozone's periphery, which suggests that a default there could deal another real body blow to the European banking system.
From a U.S. perspective, a deepening in the eurozone sovereign-debt crisis could threaten the rather feeble U.S. economic recovery now underway. In part, it would do so by weakening the euro against the dollar and by clouding European growth, both of which would diminish U.S. export prospects. The more threatening channel through which it could impact the U.S. economy would be by increasing overall global financial-market risk aversion and by precipitating another global credit-market crunch akin to what occurred in the aftermath of the Lehman bankruptcy in September 2008. This risk is underlined by the fact that global financial institutions are now closely integrated and that U.S. banks presently have around US$1.5 trillion in loans outstanding to Europe.
Desmond Lachman ([email protected]) is a resident fellow at AEI.
1. As measured by changes in the countries' relative unit labor costs.
2. "Internal devaluation" is a term commonly used in Europe to describe the restoration of competitiveness not through devaluation but rather through the country following the most stringent macroeconomic policies to bring domestic wage and price inflation below that of its competitors.