European Debt Depression - The State versus the Market

The consequent decline in the profit level cuts back trade volume when households feel less confident about spending and investors worry about the future. At the macro-level, trade and output falls while unemployment grows, causing more market pessimism. As the public begins to hoard cash, the velocity of circulation slows down further. This causes a fall in nominal rates, but since inflation may be falling faster, the rise in real rates worsens the debt burden of the borrowers. 

The euro zone is in the grip of this depressing state of affairs. 

Having just returned from a visit to Paris, London and Dublin, I heard only gloom and doom, with a normally unflappable Euro-technocrat even accusing the media of trying to kill the euro by fanning more fear.  

The options for saving the euro appear to be more and more limited by the day. There is no doubt in my mind that that the German proposal of fiscal union is the sensible solution for the euro, because it addresses the structural defect of not having a fiscal mechanism to deal with the side-effects of a single currency union. The markets had a temporary rally, even as the new Italian prime minister announced austerity measures to restore confidence in Italian bonds. The interest rate on 10-year Italian bonds duly fell from 7.3 per cent per annum to 6 per cent, but even at that level, the real interest rate (after deducting inflation of 3.3 per cent) is 2.7 per cent. With the economy growing at near zero and a debt/GDP ratio of over 100 per cent of GDP, it is not surprising that the markets feel that the Italian debt situation is unsustainable. 

Thus, the package agreed by German Chancellor Angela Merkel and French President Nicolas Sarkozy may have staved off for the moment the barbarians at the gate. But the financial markets still consider that they cannot fix a plane in mid-flight. 

The arithmetic of debt deflation is relentless. High real interest rates deflate asset prices, but bank liabilities in the form of deposits are fixed nominally. So the pressure is on European bank balance sheets. The banks are in a bind because they hold a lot of European sovereign debt papers, which are deflating in value as real interest rates rise. So the European problem is a twin bank-fiscal bind, in which the governments have to bail out the banks, but their own fiscal debt overhang is now the root of further deflation.

The financial consensus seems to insist that the European Central Bank (ECB) must print money and go for zero interest rates like the US Fed.  The ECB has resisted this because of the German fear of inflation. The new ECB chairman, Mario Draghi, is already preparing the ground for this action by cutting interest rates slightly, but the European banking system is going through a liquidity crunch because banks are scared of lending to each other, and there are signs that there is an internal flight to quality, as depositors shift their savings to higher quality bonds within the euro zone. So the surplus countries like Germany are flush with inflows, whereas illiquidity plagues the deficit countries like Italy. 

Visiting Dublin for the first time, it was noticeable that there were many commercial properties for sale. My host remarked that his property, which was worth 1.3 million euros before the crisis is now worth less than 500,000 euros. Ireland has certainly undertaken a Hong Kong-style deflation in the wake of the euro-zone crisis. Hong Kong’s experience with the link to the US dollar meant the economy must be flexible to maintain the fixed exchange rate. Ireland had to do the same. The Irish authorities understand that restoring growth and confidence is the only viable way out of a debt deflation. 

 The World Bank ranks Ireland as the 10th easiest place in the world to do business. Unit labour costs have fallen by 12 per cent and exports grew more than 24 per cent in the last 12 months, bringing the current account into balance. The economy is now back to 1 per cent growth in 2011, after suffering negative growth since 2007. Thus, Ireland is best poised for growth in the event the ECB goes for quantitative easing and if the euro depreciates. 

The euro-zone crisis must be seen in its proper context. The euro zone is not a poor economic bloc. A survey of household debt showed that the Italians have the lowest household debt relative to the other euro-zone households.  This means that the Italian people are rich, whilst the government may be in hock. Hence, it is well within the means of the under-taxed Italian people to solve their government’s fiscal problems. This is not a question of using the savings of poorer Asians to rescue richer Europeans. 

Before the crisis, the financial markets underpriced European sovereign debt risks. Now, they demand usurious real interest rates that can only mean eventual default, which would also destroy the value of their investments. Companies can go bankrupt, but countries do not disappear. The political reality is that the state cannot afford to satisfy its relatively few creditors by destroying the jobs and security of its many citizens. The real issue is whether ultimately the power of the market wins over the will of the state. In August 1998, the Hong Kong government had to intervene in the markets to restore stability. This battle is being fought in Europe today. Whichever side wins, the outcome is likely to be ugly.   

 

Andrew Sheng is president of the Fung Global Institute (www.fungglobalinstitute.org).