Thursday, November 27, 2014

Europe’s Next Moral Hazard

MUNICH – The euro crisis has passed through six phases so far. It is worth recalling them, because they show how policymakers stumbled along, trying to put out fires without keeping an eye on where their chosen path was leading them. Currently, markets remain calm, but this is only the beginning of a seventh phase of the crisis, during which Europe will become mired in debt. The sequence so far has been as follows:

  • The collapse in 2007 of the inflationary credit bubble caused by the euro’s introduction.
  • The southern eurozone countries’ reliance on the printing press to replace private international financing, an option enabled by a dramatic lowering of collateral standards for the refinancing credit provided to banks by the eurozone’s national central banks.
  • The European Central Bank’s purchases of public debt through its Securities Markets Program, aimed at maintaining the value of precisely this collateral.
  • Fiscal rescue mechanisms to bail out the stricken countries and the ECB.
  • The ECB’s promise to buy unlimited amounts of public debt within the framework of the outright monetary transactions (OMT) program, which was intended to encourage further private capital flows to southern Europe, given that the fiscal rescue measures were considered insufficient and politically too restrictive.
  • The limiting of creditors’ and investors’ liability to a mere 8% of the balance-sheet total of banks in the context of Europe’s new banking union – a measure aimed at ensuring more private international lending to stricken banks.

The seventh phase of the crisis is one of enhanced moral hazard, stemming from a run-up in debt. With investment risks largely collectivized by the bailout measures instituted by the ECB and the eurozone’s member governments, investors are once again accepting low yields, and borrowers are seizing the new opportunities.

To be sure, in 2011 a so-called fiscal compact was agreed in order to avoid precisely this consequence. The compact, signed by all European Union member states except the United Kingdom and the Czech Republic, obliges governments among other things to reduce their (smoothed) debt/GDP ratio annually by one-twentieth of the difference between the actual debt/GDP ratio and the Maastricht limit of 60%. However, the exceptions foreseen in the compact have effectively removed theses constraints.

Had the compact been enforced, Italy would have had to reduce its debt/GDP ratio from 121% in 2011 to 112% in 2014. Instead, Italy’s debt ratio has skyrocketed, with a forecast by the European Commission projecting it to reach 134% at the end of this year.

Likewise, Spain’s debt ratio should have fallen from 71% to 69%, but will probably increase to 99%. Greece’s debt ratio will rise from 170% to 177% (despite a 58-percentage-point debt-relief scheme in 2012), Portugal’s will surge from 108% to 127%, and France’s will rise from 86% to 96%. But, instead of ruefully admitting their failures, the governments in question are now going on the offensive by rejecting austerity categorically.

Italy’s new prime minister, Matteo Renzi, came to power on that platform. Greek Prime Minister Antonis Samaras is trying to counter his leftist rival Alexis Tsipras in the same way. Portugal’s Constitutional Court has thwarted the country’s fiscal-consolidation efforts. And France’s new prime minister, Manuel Valls, is also moving against austerity. Supposedly, everyone just wants more growth; unfortunately, when politicians talk about growth, what they usually mean is that they should be permitted to incur more public debt.

An increase in public debt causes a short-term surge in demand, helping to increase the degree of capacity utilization and keep unemployment in check. However, new debt is nothing but a form of dope, reducing pressure to take painful measures that would improve competitiveness and capacity growth.

This renewed decline in debt discipline reflects the socialization of potential bankruptcy costs among all eurozone countries by way of establishing joint-liability mechanisms. It is this de facto debt mutualization that has prompted creditors to accept lower interest rates, and it is only lower interest rates that have permitted Renzi, Samaras, Valls, and the others to distance themselves from austerity policies.

There is nothing surprising about this: When a decision-maker can claim full credit for a policy’s benefits and collectivize the costs, he will pursue the policy sooner, more quickly, and to a larger extent than he would if he had to bear the costs alone. What is remarkable is how matter-of-factly Europe’s transgressors succeed in cloaking themselves with the mantle of a new social breakthrough.

One only needs to look at the United States to see how dangerous – and indeed unsustainable – the eurozone’s path has become. When one of the US states runs up too much debt, creditors become jittery and austerity measures are introduced to avert the risk of bankruptcy – as has happened in the past few years in California, Illinois, and Minnesota.

But all of that occurs while the debt/GDP ratio is still minimal and clearly below 10%, because creditors know that no one will come to their aid. The Federal Reserve will not buy their government bonds, and the federal authorities will not issue any guarantees.

In Europe, by contrast, easy access to the local printing presses before and after the foundation of the ECB, together with the new fiscal rescue mechanisms, ensure that investors start to become nervous only when debt ratios are 10-20 times as high. As a result, the debt level rises until it spirals out of control.

The critical limit beyond which creditors become anxious has been raised significantly by the bailout architecture put in place over the last two years. This will bring a few years of calm as debt levels climb steadily to that limit. Then the storm will come, battering ordinary citizens, while today’s leaders remain high and dry, drawing pensions.

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    1. CommentedChristian Frace

      So what we really need is a transformation of the EU towards a ordoliberal rule. It is certainly useful to make way for that, in a smart way.

    2. CommentedDonald Lee

      I am not clearly sure if the writer’s main point is opposing to the idea of anti-austerity movements taken by the debt-laden countries or not, but I think this issue should not be dealt with a one-size-fits-all approach.

      Drawing upon the case of Japan, contrary to conventional wisdom, periods when the Japanese government undertook austerity measures, government budget deficit increased and tax collections dropped rather than rising. It was actually when the Japanese Treasury issued large amount of bonds to boost public investments, which they saw the budget deficit narrowing.

      But, as I implied in the first paragraph, I am not trying to say that all debt-ridden countries should incur more debt to get out of indebtedness. That being said, I completely agree with the writer’s uneasiness against the non-core European countries piling up new debt without implementing enough fiscal and structural reforms. Recent oversubscription of Greek bonds at a rate of some 3% is in that sense unbelievable to me.

      So, here is my thoughts on this problem. I think we need to divide countries into two categories : the ones that have competitive industries and that have had a track record of enjoying trade surpluses in the past and the others that lack competitiveness in their industries and never had that much of a success in experiencing trade surpluses.

      The former should immediately depart from the common currency zone, and regain competitiveness by devaluing their “national” currency. By doing so, they have prospects of growing out of debt without imposing rigid measures that can be counterproductive.

      The latter group should refinance their existing loans with the ones that are provided by the IMF, and should reform their whole economy under the surveillance under the institution who can really keep things in check. Currently, the money poured into these countries are either dumb money chasing yields enabled by the excess liquidity environment or money that lacks control mechanisms.

      However, the political agenda pushing for a more integrated Europe will always prevail over economic reasoning and, therefore, I see none of my suggestions being put into practice in the future. Effectively, the European politicians are once again sowing the seeds of another crisis.

    3. CommentedVal Samonis

      The crucial problem is that you cannot draw on future generations if they are not born or emigrate! So Europe risks becoming a desert (even literally!) with some cathedrals in it, e.g. Siemenses of this world. That is a sure way to further globalization of those cathedrals' trade (e.g. more trade with China/Asia, etc.) and the rest is Hinterland; you do not need translation of this term:)

      Val Samonis
      Vilnius U

    4. CommentedTomas Kurian

      Debt is not eating out the future generations, it is just inevitable supplementing of buying power in present so that the economy could be functioning at all.

      Economy based on profit needs additional resources so the planned sales can be realized at all. Otherwise only the part equal to the paid wages would be realized and that would mean no profit.

      Calling for debt reduction is nonsense, if you are not calling for the ceiling on savings at the same time.

      You cannot reduce state debt if you don´t reduce people´s savings.