the Blog Papers of Dr. Michael Sakbani; Economics, Finance and Politics

Dr. Michael Sakbani is a professor of economics and Finance at the Geneva campus of Webster-Europe. He is a senior international consultant to the UN system, European Union and Swiss banks. His career began at the State university of NY at Stoney Brook,then the Federal Reserve Bank of New York followed by UNCTAD where he was Director of the divisions of Economic Cooperation, Poverty Alleviation, and UNCTAD`s Special Programs. Published over 100 professional papers.

Saturday, April 21, 2012

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?

                                                  By

                                    Dr. Michael Sakbani*


Published under INTERNATIONAL DEBTEconomic, 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%)*
-     
       -   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.

                                                    Europe: EU and Euro zone
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 .


NOTES
[i] Wikipedia, US debt, consulted on 12/11/11.
[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.
[9] The Economist, “Climbing Greenback Mountain”, September 24-30, 2011, pp.13-18.
[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.