The Euro-Zone’s Inconsistent Adjustment
Posted by Charlie Fell in Market Commentary, tags: debt, ECB, eurozone, fiscal consolidation, gdp, italy, Monti, Sarkozy, sovereign debt, spain
It is only a matter of weeks since a number of European leaders, including the French President Nicholas Sarkozy and Italian Prime Minister Mario Monti, declared the euro-zone crisis to be “almost over.” Financial markets jumped to the same conclusion following the large provision of liquidity by the European Central Bank (ECB) in two large three-year long-term refinancing operations last December and late-February respectively.
The calm provided by the ECB’s unconventional liquidity facilities proved fragile however, and stress returned to the zone’s sovereign bond markets once data confirmed that economic conditions continue to deteriorate. The contraction in economic activity is frustrating efforts to meet ambitious fiscal goals, with both Spain and Italy indicating that they will not reach the initially projected deficit targets. The evidence confirms that the fiscal consolidation strategy is not working, and a less restrictive policy mix will ultimately be required to save the euro-zone’s troubled periphery.
The economic challenge facing the periphery is far more complex than simply reversing the large fiscal deficits and stabilising the outstanding stock of public debt relative to GDP. The sizable external deficits that persisted in the years before turmoil struck must be eliminated in order to stabilise the level of net external liabilities as a percentage of GDP.
The average current account deficit among the periphery increased from just four per cent of GDP in 2003 to almost eleven per cent by the time the crisis struck, which caused net external liabilities to rise to more than seventy per cent of GDP in Greece, Portugal and Spain. Meanwhile, net payments abroad averaged three per cent of GDP in Greece, Portugal and Spain by 2007, or one-quarter of the current account deficits in each country.
By 2007, external debt indicators all vastly exceeded levels that had previously triggered crises in developing countries, and continued to deteriorate in subsequent years. The latest available data indicates that net external liabilities exceed 100 per cent of GDP in both Greece and Portugal, are close to 100 per cent in Ireland, and more than 90 per cent in Spain. Not surprisingly, net payments abroad are capturing an ever greater share of GDP.
In order to return the external indicators to more sustainable levels and avert a balance of payments crisis, simply eliminating the current account deficits is unlikely to prove sufficient; large surpluses will be required over several years in order to paydown external debt. However, unlike previous balance of payments crises, this task cannot be accomplished via a substantial depreciation of the exchange rate, which means that the adjustment required can only be realistically achieved in the short-term through a reduction in domestic demand.
A decline in domestic demand however, is virtually certain to lead to a contraction in economic output in those peripheral countries including Greece, Portugal, and Spain, where trade openness is relatively low. A fall in the overall level of economic activity makes it all the more difficult to meet ambitious fiscal targets, which means that the upward pressure on borrowing costs is unlikely to abate. In turn, the external deficit is likely to prove more difficult to finance, increasing the pressure to effect the necessary adjustment more rapidly.
Further, the ability to run a current account surplus in the troubled countries – apart from Ireland – is constrained by the de-industrialisation of these economies in the recent past. This means that the economic structures of Greece, Portugal and Spain are such that they can be expected to run external deficits for a ‘normal’ level of domestic demand.
The bottom line is that a sizable contraction in domestic demand will be required to return external debt indicators to a more sustainable level. The cost in terms of higher unemployment however, is a cost that the sovereigns in difficulty may not be willing to pay. The rate of joblessness is already unacceptably high in the periphery, particularly among the young, and further declines in the numbers employed may well lead to social unrest and political upheaval.
The external position has already shown marked improvement in the euro-zone’s periphery – apart from Greece. The current account in Ireland has been close to balance since the beginning of 2010, while the deficits in both Spain and Portugal have narrowed considerably from almost ten per cent of GDP in 2007 to below four per cent last year. Nevertheless, despite the impressive progress, further adjustment is required and particularly so in the Iberian Peninsula where the incremental social costs may well prove to be too onerous.
The fiscal consolidation strategy currently being applied in the euro-zone’s periphery is not working, and will continue to fail so long as much-needed private sector deleveraging and a reversal of unsustainable external deficits continue to frustrate government’s best efforts. A less restrictive policy mix will ultimately prove necessary to save the euro.
Previously posted on www.charliefell.com
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