Tuesday, April 23, 2013

23/4/2013: Ignore Europe's Debt Crisis at Your Own Peril

In recent days it became quite 'normal' to bash 'austerity' and talk about debt overhang as the contrived issue with no grounding in reality. Aside from the arguments of those worked up about Reinhrat & Rogoff (2010) paper (ignoring all other research showing qualitatively, and even quantitatively similar results to theirs), there is a pesky little problem:

  • Debt has physical manifestation (albeit an imperfect one) in the form of banks (lenders) balancesheets. 
As the result of this pesky problem, we can indeed gauge (again, an imperfect translation, but better than none) the effect of repairing these balancesheets on the supply of credit, thus on investment, and thus on real economic activity.

Here are 2012 IMF estimates of the effects of the euro area banks deleveraging on the real economy:

'Weak policies' in the above are what we currently pursuing - with monetary and fiscal policies mismatch. And the negative effect of the declines runs past 2017 in the case of the heavily-indebted peripheral states. Cumulated decline estimated, relative to baseline GDP forecasts, is almost 12% over 5 years. Which over 20 years (average duration of the debt crises episodes) runs closer to 0.7% of GDP loss per annum due to banks deleveraging, aka due to banks managing debt levels on their own balancesheets.

The above chart is based on banking sector lending alone, excluding effects from deleveraging by other investors and financial intermediaries, and excluding effects of non-EU banks deleveraging or effects of the non-EU banks exits from the euro area. With these in place, the adverse effects can probably reach beyond 1% mark.

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