UBS senior economic adviser George Magnus has laid his cards on the sovereign crisis table.
He, for one, does not think the European Union’s weekend rescue will be enough to resolve the situation or stop it from spiralling into a structural crisis for all large debtor nations in the industrialised world.
Not, at least, unless the eurozone can get over its existential crisis.
But this, he says, would involve EU leaders making a ‘big push’ towards political union.
It would also take establishing new treaty-changing institutions to build enduring confidence among private creditors.
And here are his three big issues:
First, there are grave questions about whether the assistance package for Greece will work, and whether the contagion into the rest of the Eurozone and other nations can be stopped without further radical policy initiatives.
Second, the sovereign crisis reflects a serious fracture in the relationship between markets on the one hand and political authority and sovereign control on the other. We have already seen strong evidence of this in the wake of the banking crisis. The sovereign crisis will also bring forth a strong political and institutional response. Or, financial and economic tensions and turbulence will increase in severity, possibly leading to less palatable ‘solutions’, not to mention doubts about the survival of the Euro-system as it stands.
Third, the crisis casts a dark shadow over the production rebound that is currently under way in Western economies. As discussed in previous Economic Insights (Fixing Public Finance, November 2009, and The Return of Political Economy, January 2010), it was always going to run headlong into a public debt crisis. And here we are. We look at what the sovereign crisis and debt management actually mean in several countries, and what the implications are for economic growth. This is important because while budgetary retrenchment is the sine qua non for bringing public finance back on to a stable path, GDP growth is the elixir for escaping a debt crisis over the medium- to long-term.
To which, he adds, there are only three possible solutions.
One is to print money, aka quantitative easing, to ensure there is enough liquidity available to finance new debt and refinance maturing debt.
The other is calling on your creditors, including the IMF, for a bailout to buy time for economic adjustment to occur.
The third is debt restructuring.
In extreme circumstances, he says, all three have to be deployed.
But even then, they don’t guarantee resolution. That is dependent on GDP recovery.
As he points out:
But while these options can stabilise financial markets, build confidence among creditors, and allow debtors to honour their obligations, they will not resolve the crisis, per se. That requires a credible structural economic adjustment programme that fulfils two important functions: the stabilisation and reversal of public debt accumulation and, often neglected in contemporary discussion, the regeneration of economic growth over the medium-term.
And the problem with the Greek rescue package is:
The Greek rescue package only addressed the second escape route. It followed a well-known script in the handling of national and regional debt crises where lender of last resort financing has been employed to contain capital flight, and balance of payments and debt financing breakdowns.
Many will be familiar and some are quite recent.
They include:
- the Latin American debt crisis in the 1980s that began in Mexico in 1982 and eventually necessitated IMF programmes for Mexico (1984 and 1987), Brazil, Venezuela and Argentina, and widespread debt restructuring via the Brady bond plan;
- the Asian crisis that started in Thailand in 1997 but spread rapidly to other Asian countries, and forced the IMF to come to the aid of Thailand, Indonesia, and South Korea (all 1997), and later to Russia (1998), Brazil (1998), Turkey (2000) and Argentina (2001); and
- the financial and economic crisis of 2007-08 that has brought the IMF, so far, into Hungary, Pakistan and the Ukraine, and now Greece.
With the exception of Greece, so far, all of these incidents entailed large-scale currency devaluations and some combination of default or extensive debt restructuring. Clearly, as a member of the Eurozone, Greece is a much more complicated case, but it ranks as one of the most serious by comparison, when measured by the size of its government debt, external debt and current account deficit in relation to GDP, and by the size of the bail-out in US dollar terms and as a share of GDP. Yet, bail-outs alone have never settled the issue of debt sustainability, and the IMF and the EU have ruled out the options of default and restructuring, for the immediate future at least.
So can the plan work? It will work, to the extent that Greece is now fully funded for the next 2-3 years and does not have to return to private markets for financing. During this time, the country has the opportunity to implement, if it can, fiscal stabilisation measures worth about 11% of GDP over three years, designed to cut the budget deficit to 3% of GDP by 2014. This is all very well on paper, but the chances of this happening are not good. It will not stop Greek public debt rising, however, to 150% of GDP by 2013. And it will have to be carried out as the Greek economy contracts by at least 10% over the next three years.
Which happens also to be a point echoed by former IMF chief economist Simon Johnson and Peter Boone, economist at the Centre for Economic Performance, in a Tuesday editorial in the FT.
According to their calculations, Greece might very well need a primary surplus of 8 per cent of GDP just to keep the debt/GDP ratio stable:
Greece is a complete fiscal disaster. Under the new IMF programme, Greece needs to grow soon out of its debt problem. Greece’s debt/gross domestic product ratio will be 145 per cent of GDP at the end of 2011. Using more realistic growth figures – eg, with GDP down 12 per cent to the end of 2011 – then the debt/GDP ratio may hit 155 per cent. At that level, with a 5 per cent real interest rate and no growth, it needs a mind-boggling primary surplus of 8 per cent of GDP to keep the debt/GDP ratio stable.
Which of course is hard to imagine.
Magnus adds more colour – and on a slightly wider scale:
If Greece had to get its public debt-to- GDP ratio back to 60% by 2020, its structural primary balance would need to improve by about 9% of GDP. Spain and Ireland would have to improve theirs by 11% and 12%, respectively, facing a rather bigger task than do Portugal and France (7% of GDP) on this criterion. The US has a similar challenge to Greece, while the UK and Japan confront the largest hurdle of all advanced countries, with a demanding 13% of GDP adjustment. Some of the above-mentioned debt crisis adjustments were as big or bigger, but none occurred in a generic context and when the economic growth outlook globally was so uncertain.
Which is hugely bleak to say the least.
Another thought-provoking highlight from the 28 page report:
However tempting it is to want to see the dissimilarities between Greece and Iberia, the roots of the debt crisis are identical. They all had an ‘emerging markets moment’ when monetary union was created. Open capital accounts and fixed exchange rates generated a significant increase in capital availability, and simultaneous reduction in cost, in turn fuelling a surge in private and public borrowing. They all failed to address the evolution of rising cost inflation and of growing structural imbalances in their economies. Self-evidently, the boom has now turned to bust, and financial stress is spreading.
Full note — which really is worth reading from top to bottom– is available in the usual place.
Related links:
Behold the debt spiral - FT Alphaville
Towards a United States of Europe – FT Alphaville
What happens when the world defaults? – FT Alphaville