21/6/2012: Few thoughts on G20 report on Euro Area

Joint G20 assessment of the euro area (emphasis and comments are mine):

"Efforts on several fronts  are still needed to build a stronger monetary union. Specifically: 

1. moving toward a pan-euro-area financial stability framework, which inter alia implies centralized powers in banking supervision and resolution, and common deposit insurance; [banking union, consistent with my view of what is required to shore banking sector, but absent a pan-European insolvency resolution regime, not sufficient condition for sustainable crisis resolution]
2. stronger fiscal integration, including national fiscal rules, as envisaged by the Fiscal Compact, complemented by fiscal risk sharing to ensure that economic dislocation in one country does not develop into a costly fiscal and financial crisis for the entire region; [Naive, or rather politically correct, statement. The Fiscal Compact can be expected to have any real effect on fiscal performance in the medium-long term. Precisely the time scale over which it will be most likely non-enforceable.]
3. structural reform to strengthen competitiveness and improve the  ability to adjust to shocks, including by a wage-setting mechanism that is more responsive to firm-level economic conditions, reducing labor market duality and in general barriers to hiring and firing, and lowering barriers to domestic and foreign competitions in product markets. [This is another weak policy orientation. Structural reforms are needed, beyond any argument, but these must start not from altering cost competitiveness but from creating institutional and operational platforms for entrepreneurship and investment. Europe lacks growth dynamics not because its labour costs are too high or there is a difficulty with hiring and laying off workers. These are important factors, but they are not primary ones. Europe lacks growth because the Governments take up 50% of the economy, because taxes are prohibitive to investment and jobs creation, consumption and saving, because the structure of European institutions favors incumbents over newcomers and thus retards fully social mobility and renewal.]

There is growing awareness among European policy makers to move along these lines and
active efforts are underway to build the necessary consensus."

Overall, G20 is still held hostage to:

1. Consensus policies represented by the IMF-think - of micro-fixing sub-structures of specific politically correct markets for inputs (labour) instead of focusing on the larger scale imbalances that lead to unsustainable expansion of the state over private sector opportunities and returns.
2. Politically correct 'non-interference' in specific solutions designed by the euro area - most visible in the acceptance of the Fiscal Compact framework as a 'sustainable' solution to the fiscal crisis.

I find it amazing that the G20 (or rather it is IMF who authored the document) is treating recent adjustments in the economic imbalances in the euro area as if it is something that is consistent with a functional adjustment.

"The global financial crisis has triggered a noticeable narrowing of external imbalances. As world trade collapsed, current account balances of deficit economies improved substantially—well in excess of what would have been expected given the fall in output based on standard trade elasticities (i.e., “residual” changes are large), despite a significant increase in interest costs on their external debt. Substantial demand compression following the collapse of credit, asset and housing booms and a decline in confidence in periphery economies, reinforced by fiscal consolidation, played an  important role in this wrenching adjustment. Many of the factors identified below as contributing to the imbalances—such as excessive optimism and easy financial conditions begetting consumption and construction booms—are out of the picture now. Hence, much of the adjustment observed so far is likely to be lasting."

Firstly, I agree that much of the adjustment outlined above is now engrained into consumer and investor behavior. Secondly, I disagree that the fiscal adjustments have been either significant or sustainable in the long run. Let us keep in mind that there is no decrease in government spending in 2011-2012. There is an increase. But what worries me most in the above is that the adjustments described would be consistent with the rates of growth into the future that are hardly sustainable given debt overhang. In other words, the environment of depressed consumer credit, consumer spending, high interest cost of capital, etc warrants growth expectation for euro area of 1-1.5 percent annually in real terms, if not lower. Working out debt of 90% to GDP (fiscal debt alone) and well in excess of 250% for the total debt at the above rates of growth, in my view, is simply not going to happen. Unless we are talking about double-digit inflation.

An interesting related chart: 

The above clearly shows how deep collapse of economy has driven 'improvements' in Irish external balance (purple area representing collapse in growth) and how our automatic fiscal policy destabilizers (income & transfers) have been a 'break' on the external balance improvements. (Note: I am not suggesting there is a positive value in driving income & transfers down, just observing the fact). As per my term of automatic fiscal destabilizers, here's the quote from the report:

"In some booming economies (e.g., Ireland and Spain), debt ratios declined, but given the extent to which ample fiscal revenues had been linked to unsustainable asset market developments, structural balances remained fundamentally weak. That weakness was unmasked by the crisis."

I'll blog on specific risk assessment report tomorrow, so stay tuned.