miyuu yanagi:Collateral Damage （3）

The Euro Zone: Pouring Fuel on the Flames

The crisis of the euro zone makes dealing with the debt overhang even more difficult. The introduction of the euro was followed by two important developments:

Debt grew quickly in most countries of the euro zone because credit became cheap and, in many instances, negative real-interest rates fueled real estate bubbles. Consumers in the countries of the periphery, made confident by newly strong currencies and low interest rates, also embarked on a spending boom.

Competitiveness diverged between Germany and the Netherlands, on the one hand, and the countries of the south (the periphery), on the other, with the countries of the periphery failing to rein in excessive wage increases which, in the past, could be addressed through currency devaluation. Having lost the ability to adjust through exchange rate devaluations, the countries of the periphery can now only resort to painful internal devaluations (in short, salary cuts). (See Exhibit 3.)

December’s EU summit was supposed to restore confidence in the future of the euro zone. The European leaders made the following decisions:

1、The members of the EU will change their respective constitutions and national laws in order to impose limits on allowable budget deficits.

2、The members of the EU will accept stricter supervision of their budgets by EU institutions (such as the European courts), including quasiautomatic sanctions should their national budget deficits breach prescribed limits (a “structural deficit” of more than 0.5 percent of GDP—reflecting the impact of the business cycle).

3、The European Stability Mechanism (ESM) will be implemented a year earlier and run for some time in parallel with the European Financial Stability Facility (EFSF). EU leaders increased to a total of €500 billion the financial power that can be deployed to support the weaker countries of the euro zone.

4、The members of the EU will consider whether to provide funding of €200 billion to the International Monetary Fund (IMF) in order to help countries deal with a liquidity squeeze.

5、In future debt restructurings, private-sector bondholders will be treated according to the practice of the IMF, with no automatic haircuts. All government bonds will require collective-action clauses to facilitate restructurings.

The summit was predictably vague on the subject of imbalances within the euro zone, although the politicians expressed a wish for more coordination in the future.

With the U.K. opposed to an overall EU treaty change, the other EU leaders (all the euro zone countries, along with most other EU members outside the euro zone) aim to use an intragovernment treaty to implement these changes by March 2012. It remains to be seen if such a “treaty within the treaty” will be feasible in legal terms. Even more important, it is not yet certain that the individual governments will commit to the rules as decided at the summit. We may well see some pushback and efforts to soften those rules in the coming months. And even if the new rules are fully implemented, previous experience with the commitments made under the 1992 Maastricht Treaty does not necessarily give cause for optimism that they will be followed.

Before the summit, the European Central Bank (ECB) announced new measures to support European banks. It lowered the core refinancing rate to 1 percent; offered two new long-term refinancing operations that will last for three years; widened the range of acceptable collateral; and, for the first time, made loans to small and medium-size enterprises acceptable.（ECB:LTRO） The ECB also made clear that it does not plan to engage in a broad-scale program to buy up the debt of countries like Spain and Italy. Rather, it sees the responsibility for dealing with the debt crisis as lying with the individual governments of the euro zone. In other words, the ECB does not wish to act as a lender of last resort—the absence of which is one of the underlying causes of the continuing weakness of the combined EU response.

In our view, these are steps in the right direction but they are not sufficient, because they do not address the core issues of the debt overhang and diverging competitiveness. The plan that emerged from the summit is unlikely to be enough to stabilize financial markets. With the U.K. opting out and the uncertainty about legal enforcement, there is valid reason to question the plan’s credibility.

Any true solution of the crisis must, at a minimum, accomplish four things: buy time for fundamental reforms by introducing interest relief for the weaker countries of the euro zone, improve relative unit-labor-cost competitiveness, restructure excess debt, and establish a fiscal union. Overall, European leaders, while taking some steps in the right direction, again have not gone far enough.

Interest Relief. First, the financial markets need a credible commitment from the ECB to “ring fence” any member of the euro zone. It has become clear that only the ECB’s “big bazooka” (using the unlimited purchase of the debt of troubled countries to keep interest rates down) has the firepower and the credibility to keep interest rates below critical thresholds. The EFSF lacks the firepower to take on the refinancing needs of Spain and Italy over the next two years. Starting the ESM a year earlier and running it in parallel with the EFSF will increase the funds available, as will the potential provision of additional funding for the IMF. But even then, the available funds will not be sufficient to cover the weaker countries long enough to allow for fundamental reforms.

Even if the ECB stepped in, it could only buy time: in a “benign” scenario of only 4 percent interest on Spanish or Italian government debt, the debt-to-GDP ratio would continue to grow, from 60 percent in Spain and 119 percent in Italy today to 65 percent and 131 percent, respectively, in 2015. Any attempt to stabilize debt levels would lead to the vicious circle already described.

Diverging Competitiveness. The summit did not address the issue of diverging competitiveness and the resulting trade imbalances within the euro zone. The countries of the periphery (as well as France) have to regain competitiveness by lowering their unit-labor costs and introducing more flexibility into the labor markets. Gold-plated pensions (particularly in the public sector) and rigid job-security laws make progress here very unlikely.

In the case of Spain, unit labor costs would have to be reduced by more than 25 percent to restore competitiveness. In a system of fixed exchange rates, this can only be achieved by significantly increasing productivity (by requiring more working hours per week or making capital investments) and/or lowering salaries. Lower incomes would make it more difficult to service and reduce the high levels of debt (less revenue from taxes with which to pay back government debt and lower personal incomes with which to fuel growth or pay off private debt). Falling incomes, reduced tax revenues, and austerity programs would reduce growth and further reduce debt sustainability—leading to higher risk premiums in the capital markets.

The social cost of such an internal devaluation would be high and few people would accept it. A recent article in The Economist compared the implied adjustments for the periphery of Europe with developments during the 1930s leading to the Great Depression. Back then, adherence to the constraints of the gold standard prevented an adjustment, and Germany had to achieve an internal devaluation to regain competitiveness. Although very few expect a repetition of the tragedy of the 1930s, it is obvious that a strategy of saving our way out of the crisis will not only fail but will run the risk of triggering significant tensions in Europe.

The Debt Overhang. The summit made it clear that the governments of the periphery are expected to introduce austerity programs in order to balance their budgets and reduce their debt levels. Because many countries suffer from too much government debt and elevated private-sector debt (as shown in Exhibit 2), it is obvious that any attempt to deleverage both simultaneously will lead to a deep and long recession, as described above. We continue to believe that some kind of debt restructuring—and not only of public debt—is necessary to lay the foundation for future growth.

Establishment of a Fiscal Union. At the summit, European leaders moved toward closer fiscal coordination to ensure the euro zone’s future. A fiscal union would ultimately allow for the issue of joint Eurobonds and so enable the periphery to shelter behind the stronger north. This may be one cornerstone for a long-term solution to the euro zone’s problems, but it does not address the issues of diverging competitiveness and the debt overhang. Capital markets would rightly question whether the countries of the periphery would accept losing control of their budgets and of key political decisions.

Political tensions can be expected if Brussels—or even worse, Berlin—is to decide on retirement ages and pension levels. But one can also question the willingness of Germany and other countries of the north to continually fund the south. Will the German electorate accept higher taxes to support the countries of the south? And more important, will the capital markets? Some observers took the failed auction of ten-year German bonds in late November as an early-warning signal. And indeed, the German economy is not as healthy as is generally assumed. With government debt at 87 percent of GDP and interest rates of 3 percent, Germany needs nominal growth of 3 percent just to keep debt levels stable (assuming no primary surplus)—no easy task given the negative impact of demographics on future growth. The additional costs of rescue operations within the euro zone could cause the day of reckoning to arrive sooner than is generally expected.

In summary, the existing initiatives fall short. The new agreements essentially put in place some additional improvements to the existing stability and growth pact, which has not been successful to date. The politicians did not increase the size of the ring fence—the “big bazooka” necessary to avoid the viral spread of the sovereign-debt risk; there was no progress on debt mutualization through the issuance of common Eurobonds; there was no forceful monetary easing plan for the ECB; there were no tough calls made on how to address the problems of diverging competitiveness; and no strategy was articulated for reigniting growth in the euro zone—the absence of this last element perhaps not so surprising given that this is all about containment. Whatever our readers’ views on the stance adopted by the U.K., we can’t help but believe that the leaders of the other countries were thankful for the distraction provided by the U.K.’s position, which diverted attention from the lack of sufficient substantive progress on some of the most pressing issues.

The euro zone needs a comprehensive plan to deliver a combination of higher inflation (to reduce real debt and address diverging unit-labor costs), deleveraging in the periphery, and higher consumption in the northern countries. Employees in Italy, Spain, and Portugal—and also in France—would have to accept wage increases below the rate of inflation, while employees in Germany and the Netherlands would enjoy real-wage increases. Politicians in the north would also need to lower taxes and introduce stimulus programs to support domestic consumption. In addition, any successful strategy would need to include a restructuring of excess debt (partial defaults). Some observers believe that Germany would be unwilling to pursue such a strategy given fears of higher inflation and the moral hazard of overly indebted countries benefiting from broader cost sharing within the euro zone. We are more optimistic. We believe that Germany will—after long resistance—support such a strategy as the only way the euro zone can survive in its current form. The only real alternative, the breakup, would have major negative repercussions.