February 10, 2010 2:00 am
The financial crisis of 2009 is morphing into the fiscal anxieties of 2010. This is particularly true inside the eurozone. Spreads between rates of interest on Greek bonds and German bunds touched 3.86 percentage points in late January (see chart). The risk has emerged of a self-fulfilling confidence crisis that would have dire consequences for other vulnerable members. Much attention has focused on what might happen if the crisis were not resolved, with talk of bail-outs, defaults or even exits from the euro. But what would need to be done to resolve the crisis, without such a calamity? It is the demand, stupid.
Conventional wisdom in the eurozone is that the crises are the result of poor policy-making in peripheral countries. In particular, fiscal policy has been too loose and economies too inflexible. The wages of such sins are austerity. Then, after a lengthy penance, the lost sheep returns to the fold of stability.
Greece fills the role of such a sinner to perfection, as I noted three week ago : its government admits that the country has fabricated its figures. Yet Ireland and Spain have also experienced dramatic fiscal deteriorations, with the general government financial deficit forecast by the Organisation for Economic Co-operation and Development to deteriorate by more than 12 per cent and 10 per cent of gross domestic product, respectively, between 2007 and 2010. These countries were not long-term fiscal sinners.
The conventional wisdom also declares that once fiscal adjustments have been made and flexibility introduced, the affected economies can return to growth, as Germany did after painful adjustments in the early noughties. Furthermore, adds the conventional wisdom, the existence of huge current account imbalances within the zone has no bearing on either the problem or the solution. There is no more reason to worry about eurozone internal "imbalances" than one would about imbalances between US states.
This conventional wisdom is, alas, nonsense. Until policymakers recognise this, they are dooming the eurozone to huge tensions. There is no way to put this delicately. So long as the European Central Bank tolerates weak demand in the eurozone as a whole and core countries, above all Germany, continue to run vast trade surpluses, it will be nigh on impossible for weaker members to escape from their insolvency traps. Theirs is not a problem that can be resolved by fiscal austerity alone. They need a huge improvement in external demand for their output.
The common feature of countries in difficulty is that they enjoyed credit-fuelled booms. As I argued in another column their private sectors went into overdrive, spending far more than their incomes, driving up tax revenue, shrinking public spending and creating huge, but easily financed, trade deficits. This also benefited the exports and economic activity of trading partners.
Then came the crash. The domestic supply of creditworthy private borrowers in bubble-fuelled economies collapsed. So did private spending and, as a direct result, fiscal positions. Fiscal borrowing replaced private borrowing as the counterpart of large, albeit shrinking, external deficits.
What would happen if governments also slashed their spending? In an economy without monetary or exchange-rate offsets to austerity, any reduction in spending is likely to lead to at least an equivalent short-run reduction in output (a "multiplier" of one). An attempt to cut a fiscal deficit by 10 per cent of GDP, via cuts in spending, would require an actual reduction of 15 per cent of GDP, once one allows for falling fiscal revenue. GDP would also shrink 15 per cent. As Desmond Lachman of the American Enterprise Institute pointed out in FT.com's Economists' Forum, the decline could be even larger.
This looks dire - and it is. So what is one to make of comparisons with Germany's "competitive disinflation" of the early noughties? The answer is that they are irrelevant. First, Germany's fiscal deficit peaked at only 4 per cent of GDP in 2003. Second, Germany was able to offset extreme domestic demand weakness with robust external demand, from both inside and outside the eurozone. Indeed, as much as 70 per cent of the increase in Germany's GDP between 1999 and 2007 was accounted for by the increase in its net exports.
Germany needs to return the favour. More precisely, the only way for eurozone countries to slash huge fiscal deficits, without their economies collapsing, is to engineer another private-sector credit bubble or a huge expansion in net exports. The former is undesirable. The latter requires improved competitiveness and buoyant external demand. At present, none of this is available. It is difficult to regain competitiveness when the euro is strong, partly because Germany is so competitive, and eurozone inflation also so low.
Markets are right to question the will of governments and societies to take the deflationary strain. It is because I am sure the UK would never do so that I am certain the euro is not a sane option for that country. This is, of course, also why current account imbalances matter in the eurozone. It is not just that a current account deficit represents a drain on already weak demand. It is also that these are countries, not parts of one. Their electorates will care if their government is insolvent or their countries suffer decades of slump. Moreover, the US federal government will function whatever happens to California. Europe has no such federal government.
So what is to be done? If the aim is to avoid disaster, the answer is temporary fiscal support for the struggling countries, robust aggregate demand in the eurozone as a whole and a substantial rebalancing of that demand, led by Germany. The fiscal support would be designed to prevent a short-term confidence collapse from triggering a default. In return, weak countries would need to commit themselves to falling nominal wages and a programme of fiscal retrenchment. I can see no justification for bringing in the International Monetary Fund, other than for technical assistance. To do so would demonstrate that this is not a true union at all.
Alternatively, the vulnerable countries could be left to dangle in the wind. But a currency union whose core country not only exports deflation, but also stands aside as members collapse is in deep trouble. Germany alone can decide whether it wants this union to prosper, or not.
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