This is an unedited version of my Sunday Times article from May 13, 2012.
With Greek and French elections
results out last week, the European leadership is rapidly shifting gears into
neutral when it comes to austerity. Within two weeks surrounding the French elections,
the Commission has issued a set of statements pushing forward its ‘growth
budget’, and issued new proposals for enhancing European investment bank.
This, of course, is a classic
rhetoric of damage limitation, contrasted by the reality of the currency union that
is in the final stage of the crisis contagion. Having spread from economic to
financial and subsequently to fiscal domains of the euro area, the cancer of
Europe’s debt overhang has now metastasised to its political leadership. And
the financial pressures are back on. Since the late March, credit default swaps
spreads have widened for all but two core euro area states (excluding Greece),
with an average rate of increase of 10.6%, implying that the markets-priced
cumulative probability of the euro zone country default within the next 5 years
is now, on average, close to 24%.
Next stop is a period of extended
navel-gazing, with summits and ministerial dinners, contrasted by the European
electorate moving further away from the centre of power gravity.
By autumn we will be either in a selective
euro unwinding (Greece exiting) or in a desperate policies u-turn into mutualisation
of the national and banking debts, supported by a return to high pre-2011
deficits and an acceleration of the debt spiral.
The former is going to be extremely
disruptive in the short run. Portugal will be watching the Greeks closely,
while Spain and Italy will be sliding into unrest. If properly managed, Greek and,
later Portuguese exits will allow euro area to cut losses. With a stronger ESM
balancesheet, euro area will buy more time to deal with the markets panic, but
it will still require serious structural adjustments to shore up the failing
currency union. Mutualisation of debt will remain inevitable, but deficits run
up can be avoided in exchange for slower reduction in deficits.
The latter option of starting with
mutualising debt, while allowing for new deficit financing of growth stimuli will
be a road to either a collapse of the common currency within a decade or a
Japan-style stagnation. The central problem is that the current political dynamics
are forcing the euro area onto the path of growth stimulation amidst a severe
debt overhang. The lack of real catalysts for economic recovery means that a
temporary stimulus will have to be replaced by sustained debt accumulation. In
other words, the political cure to the crisis a-la Hollande, not the austerity,
will spell the end of the euro zone.
There are two sides to this
proposition.
Firstly, the villain of the European
austerity is a bogey. In 2011-2012, euro area fiscal deficits will average 3.7%
of GDP per annum, identical to those recorded in 2010-2014 and deeper than in any
five-year period from 1990 through 2009, including the period covering the
recession of the early 1990s. The ‘savage austerity’, as planned, is expected
to result in historically high five-year average deficits. At over 3.2% of GDP,
2012 forecast deficit for the common currency zone will be 6th
largest since 1990.
Instead of shrinking, euro area
governments over-spending will remain relatively static under the current
‘austerity’ path. Per IMF, general government revenues will account for 45.6%
of GDP in 2011-2012, well ahead of all five-year period averages since 1990
except for 1995-1999 when the comparable figure was 46% of GDP. The same
comparative dynamics apply to the government expenditure as a share of GDP.
In other words, euro area voters are
currently revolting against the austerity that, with exception of Greece and
Ireland, is hardly visible anywhere.
Secondly, the talk about Europe’s growth
stimulus is nothing more than a return to the policies that have led us into
this crisis in the first place. In 1990-1994, euro area public debt to GDP
ratio averaged 59%. By 2005-2009, the average has steadily risen to 71%. In 2010-2014,
the forecast average will stand at 89%, identical to the ratio in 2011-2012. Euro
area is now firmly stuck in the policy corner that required accumulation of
debt in order to sustain economic activity. Since the mid-1990s, the EU has
produced one growth policy platform after another that relied predominantly on
subsidies and public investment.
By the mid-2000s, the EU has
exhausted creative powers of conceiving new subsidies, just as the ECB was flooding
the banking system with cheap liquidity. At the peak of the subsequent sovereign
debt crisis, in March 2010, Brussels came up with Europe 2020 document – yet another
‘sustainable growth’ scheme through featuring more subsidies and public
investment.
At the member states’ level, private
debt-fuelled construction and banking bubbles were superimposed onto public
infrastructure investments schemes and elaborate R&D and smart economy
bureaucracies as the core drivers for jobs creation. State spending and re-distribution
were the creative force driving economic improvements in a number of countries.
Amidst all of this, euro area overall growth remained severely constrained. For
the entire period between 1992 and 2007, euro area real economic growth
averaged less than 2.1% per annum, while government deficits averaged over
2.5%. The only three years when public deficit financing was not the main
driver of growth were the peaks of two bubbles: 2000, and 2006-2007.
In brief, Europe had not had a model
for sustainable growth since 1992 and it is not about to discover one in the
next few months either.
Which brings us to the core problem facing
the European leadership – the problem of debt overhang.
As a research paper by Carmen M. Reinhart, Vincent R. Reinhart and Kenneth S.
Rogoff published last week clearly shows, “major public debt overhang episodes in the advanced
economies since the early 1800s [were] characterized by public debt to GDP
levels exceeding 90% for at least five years.” The study found “that public
debt overhang episodes are associated with growth over one percent lower than
during other periods.” Across all 26 episodes studied, “the average duration …is
about 23 years.”
Now, according to the IMF data, the euro area
will reach the 90% debt to GDP bound in 2012 and will remain there through
2015. Statistically, the euro area will be running debt levels in excess of 90%
through 2017. Between 2010 and 2017, IMF forecasts that seven core euro area
states will be facing debt to GDP ratios at or above 90%. Of the four largest
euro area economies, Germany is the only one that will remain outside the debt
overhang bound. Increasing deficits into such a severe debt scenario would risk
extending the crisis.
After two years of half-measures and
half-austerity, the euro as a currency system is now less sustainable. The
survival of the euro (even after Greek, Portuguese and, possibly other exits) will
depend on structural reforms, including change in the ECB mandate, political
federalisation and fiscal harmonisation beyond the current Fiscal Compact treaty.
The real problem Europe is facing in
the wake of the last week’s elections in Greece and France is that traditional
European elites are no longer capable of governing with the tools to which they
became accustomed over decades of deficits and debt accumulation, while the
European populations are no longer willing to be governed by the detached and
conservative elites. Not quite a classical revolutionary situation, yet, but
getting dangerously close to one.
CHARTS:
Box-out:
This
was supposed to be a boom year for car sales as the threat of getting an
unlucky ‘13’ stuck on your shiny new purchase for some years was supposed to
spell a resurgence in motor trade fortunes. Alas, the latest stats from the CSO
suggest that this hoped-for prediction is unlikely to materialise. In the first
four months of 2012, new registrations of all vehicles have fallen 8.5% year on
year and 60% on 2007. New private cars registrations have suffered an even
deeper annual fall, down 10.2% year on year although since the peak they are
down ‘only’ 56%. The news of the motor trade suffering is hardly surprising.
Unemployment stuck above 14%, fear of forthcoming tax increases in the Budget
2013, plus the dawning reality that sooner or later interest rates (and with
them mortgages costs) will climb sky-high are among the reasons Irish consumers
continue to stay away from purchasing large ticket items. Cyclical consumption
considerations are also coming into play. Over the last 4 years, Irish
households barely replaced their stocks of white goods. Given the life span of
necessary household appliances, the households are likely to prioritize
replacing ageing dishwasher or a fridge over buying a new vehicle. Families
compression with children returning back to parental homes to live and
grandparents taking over expensive crèche duties are also likely to depress
demand for cars. Lastly, there is a pesky consideration of the on-going
deleveraging. Irish households have paid down some €36 billion worth of
personal debts and mortgages in recent years. Still, Irish households remain
the second most indebted in the Euro area. New cars registrations fall off in
2012 shows that in the end, sanity prevails over vanity and superstition, at
the detriment to the car sales industry.
