The Dual Debt Problem in the USA & in Europe; Are the Policy Makers Addressing the Right Issues?
The Dual
Debt Problem in the US & in Europe;
Are the Policy Makers addressing the Right Issues?
Are the Policy Makers addressing the Right Issues?
By
Dr. Michael Sakbani*
Published under INTERNATIONAL DEBT; Economic, Financial, Monetary, Political and Regulatory Aspects, Palgrave – Macmillan, London, 2012.
The title
indicates that the US and the heavily indebted countries in the Eurozone have
a dual debt problem: a balance of payment deficit, engendering the need to
borrow from other countries and a sovereign debt problem engendering a need to
borrow from anywhere.
The size of the debt problem
The size of
the US public debt may be assessed by relating it to the US’ GDP. At the end of 2010, the Public debt stood at $ 14.96
trillion whereas the GDP was $ 15.02 trillion resulting in a debt ratio of
99.6%. It is certain that by early 2012, this ratio had well passed 100%.
Excluding due payments to Social Security and Public Pensions, the privately
held public debt was 68% of the GDP[1].
Among the developed industrial countries, only 9 countries have a debt GDP
ratio higher than 100 % [2].
This sizable
debt has many consequences. The most immediate is the budgetary burden of the
debt service. The net interest service of the debt amounts to 9.5% of the
federal budget. At the state level, 43 states have budget deficits.
(Wikipedia, US debt,)[3].
According to the US’ Bureau of Budget, unless the debt trend is inflexed, it
will, on current trends, double between 2008 and 2015, (BOB, 2011)[4].
The EU 27
members had in 2010 a collective indebtedness of $ 12.9 trillion. Their
Combined GDP stood at $16.3 trillion resulting in a debt ratio of 80%. The Euro
monetary zone total GDP stood in 2010 at $12,458 trillion, while their debt
stood at little more than $ 9.1 trillion, thereby resulting in a debt GDP ratio
of 76 %. Seven members are indebted at more than this average ratio. If one
eliminates France (81%) and Austria (72.3%), Greece, Italy, Belgium, Ireland
and Portugal had in 2010 debt-GDP ratios between 142% and 93.0 %. For Greece
and Italy, the ratio is certainly higher in 2011 (EC Economic Statistics, 2011)[5].
Why is the burden of the public debt
troublesome?
There is
some demonstrative statistical confluence of a growth gap suffered by countries
whose debt ratio exceeds 100 %. According to Rogoff and Reinhart, these
countries showed average growth
of 1.3 % p.a. lower than those bellow their benchmark (Rogoff et al., 2010)[6].
Naturally, such is not a causation finding, and several factors in addition to
the deficit ratio might be responsible; one can marshal half a dozen reasons
why a country with a high debt ratio grows faster than one with a low one and
vis-a versa. More specifically, we do not know whether the ratio is high
because growth is slow or it is low because growth is high; At any rate, even
though such a ratio has no analytic meaning, deficits do put pressure on
interest rates and that cannot be helpful to income growth.
One of the staple arguments of modern
classical economists and monetarists is the crowding-out effect of financing
public deficits. This argument purports that private sector investors get
crowded out of financial markets by the public sector borrowings. This
theoretical possibility obtains if the financial markets were non-global or all
governments were financing deficits at the same time. During the Reagan era,
the US expanded its annual military spending by $400 billion and financed the
resultant deficits by borrowing from foreign savers. There was no evidence that
crowding out took place as a result of these Treasury borrowings.
A prominent
argument in the political- moral debate on debt is the burden shift to future
generations. Neoclassical economists gave a slant to this argument by an
economic hypothesis that holds that the debt would raise the level of
anticipated taxation in the future causing an equivalent cut in current
spending. This is known as the Sergeant-
Barrow equivalence hypothesis. In effect, the hypothesis negates the benefits
of any current stimulatory fiscal action by counterpoising the deflationary
consequences of cuts in current spending. This hypothesis, like much of recent
rational economic theory, has no known empirical validity. It is no more or
less than a hypothesis based on rational expectations of human behavior. In the
aftermath of the 2008 financial crisis, such models of behavior have come into
serious questioning (Sakbani, 2010; Kaletsky, 2009)[7].
A more valid
argument invokes the structural budgetary problems caused by heavy
indebtedness. In the case of the US, for example, the structural parts of the
deficit, namely, the Pentagon budget, social entitlements, income support and
debt service, leave a mere 20%, (19.3 % in 2010), of US’ expenditures as discretionary. That
means in effect, that necessary expenditures on education, development of new
technology and R and D, are starved of funds. Moreover, the limited margin of
discretionary spending removes fiscal policy as an available policy instrument.
The US heavy
indebtedness poses a grave problem to the international monetary system. Under
the current international arrangement, the US dollar is the major asset of the
system of international reserves. The dollar share in official international
reserves is about 60 percent, three times the weight of the US’ GDP in the
world economy. Most Central banks intervene also with US dollars. Indeed, the
dollar share in foreign exchange turnover is a staggering 80 percent. Neither
the Euro (26 % of official reserves), nor the Yen nor the Yuan has evolved
into valid alternatives. The size of US foreign official indebtedness has
become out of proportion to the US exports and the politically permissible
settlement by foreign holders of dollar balances. On more than one occasion, US
authorities have banned foreigners of acquiring real US assets. A case in point
is the Peninsular Steam Navigation Company, a Dubai owned firm, which was barred
from acquiring US real assets: New York and New Orleans port facilities[8i.
This creates an international reserve system problem and undermines the US
creditworthiness. Already China, a two trillion holder of dollar assets, has
expressed its interest in replacing its dollar assets through international
monetary reforms aimed at asset settlement in other than just US dollars (the
Economist, September 2011) [9].
And China is to be sure, not the only country which is putting in question the
US borrowing credibility.
On political
terms, the US dependence on foreign borrowing and its sizable foreseeable need
to finance its deficit by foreign borrowing creates political dependence. The
recent financial crisis in Europe has thrown into sharp relief the limitations
of political sovereignty of indebted countries; in a globalized setting, the
financial markets can rob a heavily indebted country of its economic
sovereignty.
Finally, the
pattern of use of global international savings is both an economic and a
development issue. That the richest country in the world borrows poorer country
savings because it does not or would not want to live within its means is a
drag on the growth of developing countries and on international productivity.
Why did the US get into a debt
Problem?
In one of
the political ironies of recent US history, the Conservative Administrations of
Ronald Reagan and George W. Bush, both elected on promises of fiscal
conservatism, each borrowed more than its predecessors put together; each of
the two Presidents added nearly $ 4 trillion to the stock of the received US
debt. Mr. Reagan borrowed principally to finance his expansion of military
expenditures near the end of the Cold War and to finance his tax reforms. Mr.
Bush borrowed to finance his tax cuts and the wars in Iraq and Afghanistan and
that on terror.
The
imbalance between US saving and national investment is the main cause of the
expansion of US indebtedness. This imbalance is partially the result of the US
payments deficit caused by a combination of factors: the decline in US exports of
manufactured goods and chemicals as well as strong demand for energy and
foreign goods such as cars and consumer electronics. Now for several decades,
the US trade account has been in chronic deficit. Only in a handful of years
since 1960 has the current account shown surplus. While services, especially
financial and cultural services, have paid for a part of the trade deficits,
the lagging US exports in many traditional industrial sectors, is the main cause
for US’ foreign indebtedness. And this has not been helped by the immigration
of US jobs from the US to foreign countries in pursuance of global comparative
cost reduction and new consumers.
Another
reason for the US debt problem is the structural problems of the US federal
budget. In the recent business cycle, this paper estimates that 58 percent of
the deficit is due to structural factors as opposed to 42 percent due to the
economic conditions (table below)[10].
The structural problem is the result of political failure in Washington to deal
with the underlying reasons. Since the Reagan Administration in the 1980’s
there has been demagogic political rhetoric in the US about taxes. Even though
the US taxpayers pay only 18.3 % of the GDP in taxes at the federal level, a share
by far lower than any industrial country, the public has been goaded by the
politicians to believe that taxes are much too high. And this stance of the
public is rooted in the reality that the US federal government does not provide
many services to the Public; it spends the tax dollars on the military, the
social entitlements programs, the debt service and the running the Federal
administration. At the same time, there is public resistance to cutting some of
these very programs. For example, acco4rding to all polls, those who consider
themselves small government advocate object to cutting their social security or
their medicare. The two main political parties have played demagogic games with
this public confusion. The Republican Party has elevated refusal to impose
taxes to a political sine qua non, while the Democrats have made preservation
of social entitlements its basic plank. Both parties, however, do not dare to
raise the question of the appropriate size of the military budget (US budget, Wikipedia, November,
2011.)[11].
In an
attempt to reach some common grounds, the President and Congressional leaders
formed the Bowles- Simpson Commission to propose measures to solve this
problem. The Commission worked hard for several months and issued a sensible
report which, on one side recommended raising taxes by three percent over three
years through a variety of reform measures and new taxes and cutting
expenditures by a similar amount( Bowels-Simpson, 2011.)[12].
Neither the President nor the Congressional leaders gave pursuit to this
sensible report. Little after the Simpson-Bowles report, a committee of six
senators from the two parties produced proposals along the same lines. But
again, no follow up was in evidence. The resultant gridlock has effectively
taken the real solutions out of the agenda. Instead, the budget compromise in
2011 committed the President to cut the Federal expenditures by 13 trillion
over ten years; which would be a disaster for the slowly recovering economy.
Moreover, this indiscriminate cutting would hit hardest the most useful Government
spending.
Examining
the Federal budget, the following picture emerges. The US Federal Budget in 2010 stood at $ 3.’5
trillion, of which 25 % was spent on the
military and on wars, 9 % on servicing
the net interest of the public debt, 52% on various mandatory entitlements and
19 % discretionary ((The Daily Bail,2012)[13].
This picture did not change in 2011.
The
deterioration of the US financial position since 2001
President
Clinton bequeathed to his successor George W. Bush a federal budget running $
232 billion surplus[xiv].
This surplus was due to the mid-nineties’ reforms in the welfare system, a non
interrupted buoyancy of the economy and peace. Early in his term, President
Bush decided to cut taxes, a move whose benefits accrued mostly to well off taxpayers and was to be responsible for 13 percent of the US budget deficit up to
2011. He was faced soon after by the events of 9/11, which launched the war on
terror. Those events led to the wars in Afghanistan and in Iraq, which in total
increased security expenditure. This increase has been responsible for 17 percent of the average deficit. The following table summarizes the contribution of
various factors to the deterioration of the financial position of the US since
2001.
Table 1
-
Cyclical
revenue decline (28%)
-
Increased
defense expenditure
-
War on terror (2%)
-
Bush
tax cut (13%)
-
Increase
in net interest payments (11%)
-
-Other tax cuts (8%)*
-Other tax cuts (8%)*
-
- Obama’s stimulus (6%)
- Obama’s stimulus (6%)
-
Increases
in Medicare costs (2%)
-
Other
reasons (8%).
*These tax cuts were made in a compromise deal by President
Obama and the Republican leadership in 2010.
Sources: Wikipedia, US budget, 2011; [http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-26042011-AP/EN/2-26042011-AP-
-------------------------------
The table breakdown shows that the US recession is
responsible for 42 % of the deficit, while the structural factors account for
58 %. It should be noted in this context, that 48% of Americans do not pay
Federal income tax. All of this means that a revision of the revenue and
expenditure pattern of the Federal budget is indeed overdue. A step in the
right direction was embodied in the 2012 budget which promises cutting the
deficit by $1.3 trillion over 10 years, but this was done as a part of a
bargain to cut spending but without any selectivity.
The orthodoxy on dealing with the debt problem in both Europe
and the US has been through budget austerity, emphasizing expenditure cuts. For
any country standing alone this view may be rather sensible. The IMF has
advocated such a view for most of its history. However, in the present global
situation, this view has a fallacy of composition. If all countries retrench at
the same time, the growth of international trade would be practically shut down.
Growth, not just austerity, is the appropriate way to fix the debt problem;
after all, is not the debt problem defined in terms of the GDP? How can open
economies like in Europe grow if all other trading partners retrench at
the same time? The lagging current performances in Britain, France, Spain, the
Netherlands and Italy, to cite a few examples, are testimony to the failure of
the stand-alone view of orthodoxy[15].
In late April 2012 the UK double dipped into recession and so did Spain. The
US administration under Mr. Obama has dissented from this view and advocated
the more coherent one that the debt problem must be attacked in the short run
by growth policies and in the long run, i.e., when the economy picks up steam,
with budget retrenchment. President Obama gave formal expression to this view
in his address to the G 20 (Toronto, June, 2010.)[16].
Unfortunately, this view has not received wide support by policymakers in
Europe, nor favorable response in the financial markets.
The US economy has not recovered fully from the 2008
recession. On the most recent official statistics of the US’ Bureau of Labor, It
is running an 8. 2 % unemployment[17].
Unemployment might be as high as 11-13
percent if one factor in part-timers, and people who dropped out of the
active labor force. Investment in plant and equipment and housing has not
recovered from the 2008 recession. Business is not investing because consumer
spending, which used to run at 67 percent of aggregate demand, is now only
about 62 % of AD. Today, the corporate sector in the US has profits twice its
size of 2007, but it produces 10% less in value added to the GDP. Above all the
US GDP grew at 1.6 % in 2011 and is only expected to grow at 2 % in 2012[18].
This vicious cycle will not be broken until consumers are relieved of their
massive debts. An appropriate strategy has to have multiple elements:
supporting investment by small and midsize businesses to create jobs,
rebuilding the US manufacturing industries, diversifying the export product
base, encouraging investments in new technologies and green energy, repairing
the US infrastructure and offering relief to the indebted households. If ever there
was a time to borrow for infrastructural and new energy substitutes, it is now
when nominal interest on long term US bonds is less than 2 %. Looking beyond
that, the US has to cut down the US federal deficit in the long run. Unfortunately,
Washington is inhabited by politicians and lobbyists, which renders rational
economic policymaking impossible. At this juncture, labor is practically ready
to employ and capital can be borrowed at a negative real interest rate, indexed
bonds carry – .8 percent. The US can break out of its economic slow pace by a
package combining a stimulus in the short run and a fiscal retrenchment in
the long run.
Conclusions:
1. The US public indebtedness is for the foreseeable
future out of control unless major changes in the tax and expenditure
structures are made; the US cannot afford the current levels of the entitlement
programs and the military spending.
2. The US
has hardly any room to use discretionary spending to steer its economy, or
undertake investments in infrastructure in new technologies and in any social
educational domains. This threatens future grow
3. The US economy has not satisfactorily recovered from the recession for reasons that
have yet to be dealt with effectively.
4. The
debate on dealing with the large deficits has had no strategic design; there is
a wide consensus on cutting the budget without factoring in the adverse impacts
on economic growth in the short run. Indeed, growth is more effective in
reducing the growth of debt than mere austerity.
5.
Washington is in a gridlock about what expenditures to cut and what
taxes to increase.
6. There is
massive need for investments in new technology, human resources, R &D and
infrastructure if the US wants to safeguard its leading economic position.
7. Large
segments of the public harbor a deep sense of social injustice, as the top 1
percent of income earners in the US have doubled their share in the GDP to 20 %
in the last decade.
8. US global
firms have moved away many jobs to garner global profits and these jobs have
not been replaced by more intensive skills jobs.
A statistical picture
The EU 27
members had in 2010 a collective indebtedness of $ 12.9 trillion. Their
Combined GDP stood at $16.3 trillion resulting in a debt ratio of 80%. The Euro
monetary zone total GDP stood in 2010 at $12,458 trillion, while their debt
stood at little more than $ 9.1 trillion, thereby resulting in a debt GDP ratio
of 76 %. Seven members of the Eurozone are indebted at more than this average
ratio. If one eliminates France (81%) and Austria (72.3%), Greece, Italy,
Belgium, Ireland and Portugal had in 2010 debt-GDP ratios between 142% and 93.0
%. For Greece and Italy, the ratio was certainly higher in 2011 (Wikipedia,
2012)[19].
Except for five
countries in the Eurozone, namely, Germany, Sweden, Slovakia, Poland and
Finland, other countries are either in recessionary conditions or are running
anemic growth. The eurozone combined growth over the three first quarters of
2011 was only .2 %. (Wikipedia, EC
Statistics, 2011)[20]
. According to the European Commission forecasts, Europe will have a mild
recession in 2012, dragged down by Spain, Italy, Greece, Portugal, Hungry and
the Netherlands.[21].
A dismal statistic is the level of unemployment; at 11 % average, it means that
17 million are out of work. The European economies are, in general, burdened by
social compacts involving a great measure of social solidarity. However,
without significant increases in productivity and human and other resources,
Europe cannot afford its social compacts. European countries have severe
demographic problems, which are not amenable to immigration solutions in as
much as the European society’s loath multiculturalism and the various states
have no immigration policies. As a result, European pension systems are in
stress and need significant adaptations and reforms. Similarly, the European
labor markets are rigid and in need of deep structural reforms. The reforms
introduced six years ago by Chancellor Gerhard Schröder in Germany and other
similar reforms in Poland and Slovakia; show that deep structural labor reforms
are a requisite for healthy growth. With a diversified export base and more
flexible markets, Germany, has been an exception to European arthritic growth.
In the honor role it is joined by Poland and Slovakia.
As was
mentioned above, macroeconomic policies in Europe have been restrictive all at
the same time. With intra-trade among EU members constituting the greater part
of their trade[22],
the orthodoxy of European policymakers is certainly not helpful for solving
Europe’s debt problems. Just like the US, Europe needs trade-led growth and
investment in productivity and new technologies out of its debt problems.
The Eurozone
The Euro was
launched as a political project without thinking carefully about its economic
design. It is a monetary union whose Central Bank (ECB) does not have a bank of
last resort function, and is barred from lending to its member states. The
fiscal policies of the member states have been until the new treaty signed in
February 2012, independent and, in recent years, nonconvergent. Although there
are common convergence criteria, there were no mechanisms of enforcement. There
was until the new treaty, no Union authority over sovereign fiscal decisions by
member states. With no federated authority, the Union has no sovereign
governmental authority to decide resource transfers when needed.
The Euro
zone incorporated, knowingly and purely on political grounds, states whose
economies are inefficient and uncompetitive (Portugal, Greece, Spain, Italy and
Ireland). The fulfillment of the convergence criteria was in many candidates
the result of creative accountings[23].
The internal balance of payments deficit of the weak countries shows up in
significant debt positions of their respective national central banks vis a vis
the ECB (Martin Wolf, 2011)[24].
In effect, the Eurozone is not an optimal currency area, in as much as labor,
capital and public transfers are, for a variety of sociological and political
reasons, not completely mobile. The European political reality is such that if
resources of capital, labor and firms were perfectly mobile, the public
opinions in most member states would not accept the national consequences of
such mobility.
The crisis
of the Euro-zone in the second half of 2011, revealed all these defects. The
European leaders faced the stark choice of either cutting loose weaker members
or furthering the integration of the Eurozone and putting in place enforcement
mechanisms in all domains, especially on the fiscal side. They opted for the
latter. Chancellor Merkel and President Sarkozy both brought up this issue by
end of November, 2011. In the summit of late January 2012, the Council of Europe
approved a draft treaty, in which 25 members indicated that they will sign. The
revision included: stronger fiscal integration and a modified common monetary
mandate for the ECB. It also created enforcement mechanisms for the Euro three
criteria (debt ratio, deficit ratio, BOP ratio). There is furthermore a veto
power in the hands of the Commission on budgetary decisions by member
states. Twenty-seven members agreed on 2
/3 /2012 to the revisions of the eurozone treaty proposed by Chancellor Merkel
and President Sarkozy. On the margin of the treaty, the EU leaders also doubled
the size of the European Financial Safety Facility (EFSF) to Euro 840 billion.
Together with the new Treaty, the European leaders agreed to deep structural
reforms and austerity measures in the affected countries. In return, Greece and
Italy received massive financial aid by the troika (see below) and they offered
written guarantees for the required measures by the political players in both
countries (Wall Street Journal, February 10, 2012.)[25]
Greece, Italy and Spain
The Euro
zone problematic countries include Italy, Greece, Spain, Portugal, Ireland
and Cyprus. Ireland seems to have done the right adjustments and is now
relatively clear of the danger zone. Portugal, a small economy, has an
inefficient and uncompetitive economy, but its problems are rather manageable
and do not have a chronic Government deficit; essentially Portugal is not
competitive. Spain has a major
unemployment problem; it is 23.6 % and more than 40% among the youth[26.
Spain has had large public deficits for more than a decade. Its banks are overstretched
and thinly capitalized. After the recent elections, the new government has
undertaken considerable austerity measures. But the solution to Spain’s
problems is to grow its economy and carry out the necessary labor market
reforms to tackle the massive unemployment problem. Unfortunately, the new Prime
Minister has not yet convinced the financial markets; Spain was downrated by
credit agencies in late April and it double dipped into recession as well. Spain‘s
is a large economy and if it falters, the Eurozone will have a massive problem
on hand.
Greece and
Italy are countries under crisis. We will take them up in this order.
The Greek
economy is little more than 2 percent of the economy of the Eurozone. It is an
economy that has been mismanaged for at least three decades. Since 2008, the
real GDP has declined by 12 percent and is expected to continue doing so in
2012. Greek public finances have been in shambles. The budget has been bloated
for decades; until 2010 the public sector used to pays higher salaries and
pensions than the private sector, and on a 14-month basis. Since 2007, the
general government balance has been negative; Greece’s budget deficit was – 9.8 -% of the GDP in 2008, - 16 % in 2009, - 11 % in 2010 and an estimated -8 % in
2012 (EU statistics, 2012)[27].
In addition to this budgetary deficit, Greece’ balance of payment is also in
current account deficit; it was 4 % of the GDP in 2006, 7 % in 2007, 6 % in
2008, 4% in 2009 and 2.5 % in 2010[28].
The CA deficit is a reflection of the poor competitiveness of Greece; the export
labor unit for the same goods costs 44% more to import from Greece than from
next door Turkey. From 2001 to 2009, unit labor cost increased by 20% relative
the EU. However, it has been going down since 2010 [29].The
export sector is dominated by tourism. Thus, domestic prices rule services sold
to foreigners. Outside maritime transport, Greece does not have world-class big
export firms
Greek banks
have weak capital positions and deteriorating assets. They are principally
owned by Greeks and thus cannot depend on outside sources. However, European
banks, in particular, French and Italians have substantial exposures to Greek
banks.
The crisis
hit Greece with full force in 2010. Mr. Papandreou’s government had to
undertake one-third cut in the budget and finance, on deteriorating revenues, a
massive public debt amounting to 168 % of the GDP. Greece needed outside help
to stave off default. The EU responded in August 2011 by loaning Greece some
Euro 126 billion. The EU imposed a troika of EU, IMF and the European Bank, to
supervise the required adjustment and fiscal management. The first loan, however, was not enough, and Greece needed another loan of Euro 130 billion before March
20, 2012. The troika demanded three things: further cuts in the budget and
meaningful guarantees for the adjustment measures, negotiating a restructuring
of euro 200 billion debts held by private creditors and written guarantees by
all leaders of the political parties that they will abide by governmental
promises to the EU. On the political side, Mr. Papandreou resigned and the government of technicians led by ECB vice Governor Lukas Papademos was
installed.
Greece did
all these things and in early March, it was given the second loan.
Does that
mean that the crisis is over?
Almost all
commentators doubt that for various reasons. The Euro rescue plan for Greece
formulated in October 2011, had several pillars. It established a European
Financial Safety Facility (Euro 840 billion with unexplained gearing
potential), approved a package of Euro 130 billion lending to Greece by the
IMF, the EB and member states under conditionality instituting performance and
monitoring clauses, forced specific austerity measure on Greece’s budget, and
forced restructuring of Greek private debts down to 50% of their book value. After
this hair cut, the Greek debt ratio will go down from 168% to 120% of the GDP.
Why is the
scepticism?
The first
reason is political; can Greek governments maintain the austerity and severe
cuts in the Greek standards of living and maintain power? That is doubtful no
matter what written promises signed. Secondly, can Greece eliminate its balance
of payment deficit by increasing its productivity and competitiveness in a
reasonable short time? The answer is perhaps no. The other alternative is a
decline in the unit labor cost by something in the neighborhood of 30%, a
grinding decline in the standard of living of Greek labor. Thirdly, the
interest yield on 10- year Greek bonds has passed 7 %, some 511 basis point
higher than the German comparable yield. At 2.1 % inflation, the real interest
rate is 4.9 %. To pay this interest on the stock of the debt without
deterioration in living standards, Greece should grow at about 5.88 % in real
terms. Greece has averaged only 1.5 over 2001-2007 and is now expected to shrink
in 2012 by 6.0 %. Under the Euro system, it cannot adjust its exchange rate; it
has to make income and price adjustment. Fourthly, if Italy or Spain falls,
then the EFSF will not be sufficient to whither that fall. Therefore, Greece
cannot on objective grounds be sure that it can continue in the Eurozone
without further help. And this help has become prohibitive to the politically
elected leaders of the EU.
Italy
Like Greece,
Italy has suffered macroeconomic mismanagement for at least two decades. But
unlike Greece, Italy has a diversified and large economy and its fiscal
management has been now and then short of a complete calamity. After three
governments and grave personal scandals, the long-serving Sr. Berlosconi
resigned by the end of 2011, and a government of technicians led by Ex EU
Commissioner Mario Monti was put in place.
The third
largest member in the Eurozone, Italy has a debt GDP ratio of 120%. Italy must
grow at 5.96 % per year to keep its debt burden steady. Italy has grown by 1.3
% in 2010 and is expected to shrink by 2.2 % in 2012. It has shrunk by 1.3 in
2008 and 5.2 in 2009. The Italian economy is not competitive and its exports
cannot be helped, as in the past, by currency devaluations. It needs
substantial income and price adjustment and deep structural reforms.
The good
thing is that the Italian state owns significant and viable assets, which can
be sold. Italy also does not run a significant budget deficit; its 4% deficit is
modest by European current standards. Moreover, the majority of its public debt
is domestically owned.
Italy’s main
problem, besides economic mismanagement, has been the deterioration of its
productivity. While Italy has some world-class export firms, its small and
medium-size firms dominate. This is not helpful in increasing productivity and
is a source of its large underground economy. Sr. Monti has performed quite well
and the financial markets are showing confidence expressed by the reduced yield
on Italian bonds and the successful sale of bond issues in March. However, Sr
Monti is an interim Prime Minister and the coming elections might bring back
the usual cast of non-serious politicians; the financial markets would certainly
not view that favorably.
Assessment of the Euro-zone
prospects
Italy,
Spain, Greece, Portugal, Ireland and Austria are all in need of structural
economic reforms. These include labor market liberalization, privatization of
some state assets, pension reforms, tax and expenditure adjustments and a
variety of other measures to improve competitiveness within and without the
Euro Zone. Despite its relative strength, France is also in need of such
reforms. The French presidential elections on six May might bring forth a
President with an economic platform different from that of Mr. Sarkozy. In some
respects, this program might be incongruous with the current conditions and
hostile to the Merkel-Sarkozy
package. But in respect of emphasizing growth in addition to austerity, it
might nudge Europe into thinking about growth instead of the solitary recipe of
austerity.
If not
treated, the Eurozone sovereign debt problems will feed into a global banking
crisis. Within the Eurozone, banks from France, Germany, Italy and Spain have
large Greek and Italian assets. This crisis will have two main dimensions,
deterioration of bank balance sheet assets, and capital inadequacy. It will
also result in erosion of the value of collaterals and mutual default insurance
contracts, as the value of these instruments fluctuates with the cycle.
Globalization of financial markets synchronizes this fluctuation globally and
renders banks everywhere simultaneously vulnerable.
There are five ways in which the Eurozone may
deal with its debt-deficits dual problems.
- First,
allow the European Central Bank to purchase bonds of member states, thereby
printing money and in effect distributing the burden of the severely indebted
countries to the strong economies. There is a little political prospect of that.
- Secondly,
keep lending to Greece and potentially to Italy, Portugal and Spain on an unlimited basis, a recipe of symptom suppression under the current Eurozone
arrangement. Besides, the funds required are beyond any feasible size of the
projected EFSF at any workable gearing ratio. This alternative renders the
Union a transfer union, which surely would be voted down by the Public.
Thirdly,
force adjustment in the form of structural reforms and austerity measures upon
the weak economies and stimulate the strong ones to act as locomotives. That
creates two-tier Eurozone at two speeds.
Fourthly,
force adjustment and austerity only on the weak deficit countries. In view of
the rather restrictive policies of the core countries, the price and income
adjustments therein would take a very long time; it took France close to ten
years to adjust to the 1981 payments problem through automatic price and real
income adjustment without a locomotive push from Germany.
Fifthly,
allow controlled default and possible exit from the Eurozone. This can be done
cooperatively and is perhaps easier than carrying on with the Euro Zone faulty
design.
The taboo of countries dropping out of the Euro is now broken. It is better in the long run to have fewer but more cohesive and stronger Eurozone than the present limping spectacle.
A possible process of devolution:
The crisis
of the Eurozone is now more than one year old and gives no signs of abetting.
The markets have no confidence in the promises of Greece and the others.
Moreover, there are five countries in question: Greece, Spain, Ireland,
Portugal and Cyprus. This threatens to make the Euro-zone one of alternating crises
from one country to another. Providing exit to all these countries is the
surest way of ending the problem. However,
that is costly. The Economist estimated that to be Euro 1.2 trillion[30].
No political leader in Europe can face his or her public with such a bill.
Dealing with Greece alone is one third that cost[31].
The balance of cost-benefit according to the Economist is clearly in favor of a
cooperative exit of Greece. Such an event must be done with utter
confidentiality, lest there will be running on the banks. It also has to be
secured in Greece by nothing less than the armed forces. Greece can revert to a
new Drahma for all contracts signed forthwith and for all government taxes and
payments under Greek law, thereby regaining its full monetary independence. Old
accounts denominated in Euros would continue on bank books. The exchange rate
of the new Drahma to the Euro would find its market rate at perhaps very low
levels. Europe can help in mitigating the impact on Greek debtors in Euro and
the deterioration of banks’ asset values. Greece would also be helped in coping
with its payments balance. There would be undoubtedly significant inflation
during the adjustment. The challenge is to contain inflation so as to assure
gains in real competitiveness as a
result of the fall in exchange rates. These developments are a tall order in
any democracy. But exit will be easier than staying within the Euro trying to
service the escalating cost of the debt and live with unending austerity.
A strong and healthy Euro is a common international good for the International Monetary System; a viable Euro is needed as an alternative to the US dollar in the IMS.
*Professor of Finance and Economics, the Herbert Walker School of Business, Webster University, Geneva; Former director of the divisions of Economic Cooperation, Poverty Alleviation and UNCTAD Special Programs, UNCTAD,Geneva; Senior consultant to the UN System, The EU and Swiss private banks .
[2.] Wikipedia
EC Economic statistics, Wikipedia, consulted on 11 November, 2011
.
[3] Wikipedia,
Op. Cit.
[4] Bureau
of Budget, US, 2011.
[5] EC
Economic Statistics, Wikipedia,
consulted in November 2011,
[6]
Carmen Reinhart and Kenneth S. Rogoff,
Growth in time of Debt, NBER working paper no. 15639, January 2010. .,
[7]
See for a discussion, Michael Sakbani, “The Global Economic Recession: Analysis; Evaluation and
Implications of Policy Response and System Reforms Proposals.”, Journal of
Studies in Economics and Finance”,
June 2010. Anatole Kaletsky,” Economists are the forgotten guilty men Academics - and their mad
theories - are to blame for the financial crisis. They too deserve to be hauled
into the dock”, The Financial Times, London, 6// 2/ /2009.
[8] Peninsular Steam Navigation Company, a
firm owned by a Dubai holding was barred from buying port facilities of New York
city and New Orleans in the US in 2010.
[10] US
budget, Wikipedia, November,
2011.
[11]
For a full discussion of the Washington gridlock sees: Michael Sakbani, the US Budget Impasse: Dogma v. Economic Sense, in michaelsakbani.blogspot.com, 1 August, 2011.
[12] Erskine Bowels and Allen Simpson, the National Commission on Fiscal
Responsibility and Reform,
Washington D.C., January 31, 2012.
[13]
The Daily Bail; Wake up America;: the
Real US Budget Problem: Defense and War Spending in OZHOUSE.org
, 2012.
[14]
Various sources, New York Times, the
Washington Post. December, 1999.
[15]
For detailed statistics on the performance of the European Union economies sestets
on faltering growth in Europe. [http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-26042011-AP/EN/2-26042011-AP-EN.PDF
[16]
The Administration views were expressed by President Obama’s statement before
the G20 in its meeting in Toronto on 27 June, 2010.
[17]
The Economist, “Economic and
Financial Indicators”, April 28, 2012, p.80.
[18]
The
Economist, “Economic and Financial Indicators”, Ibid.
[19] EU
Economic Statistics, Wikipedia, consulted in 1/10/2012
[20]
Europe economic statistics can be found in the source given in fn.12 above.
[21]
Stephen Castle, “Europe Forecasts
‘Mild Recession’ for Euro Zone in 2012”, The New York Times,
February 23, 2012.
[22]
The majority of European exports go through intra EU trade. In some case more
than 70 % is intra trade.
[23] At the inception of the Euro-zone,
the convergence criteria were a maximum budget deficit of 3 % of the GDP, no
more than 70% debt to GDP and exchange rate and interest convergence over the
past three years. Se E for details, Michael Sakbani, “The Euro on Schedule: Analysis of its
European and International Implications”, European
Monetary Integration, ed. M. Szalo-Pelsoczi, Avebury and the Robert Triffin
Foundation, spring 1998.
[24]
Martin Wolf, « Thinking through the Unthinkable », Financial Times, London, November
9, 2011, p 9.
[25] Wall Street Journal,” Greece
Sets Austerity Plan: Leaders Approve Unpopular Cuts; Europe Wants Vote to Secure Another
Bailout”, 10 February 2012.
[26]
The Economist, “Economic and
Financial Indicators”, Ibid
[27] E.C,
IMF and Bank of Greece statistics. Reported by Financial Times, London, February 15, 2012.
[28]
Ibid.
[29]
Ibid.
[30] The Economist, “the Merkel
Memorandum”, August 11, 2012, pp. 15-18.
[31]
Ibid.
The research of this paper was partially supported by a research gRant from Webster University – Geneva.
posted by michel sakbani | 1:06 AM
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