Monday, 18 July 2011

Debt crises: US Dollar and the Eurozone

At the moment in the UK there's almost nothing in the news, especially on TV, except for the latest updates on the phone hacking crisis, linked to News International and the Metropolitan Police. It's all rather dispiriting, I find, particularly as immensely more important things are going on in the world, some of which I suspect the British people would like to be hearing more about.

What I have in mind here, are the rapidly worsening Euro crisis and the US debates about lifting their legal debt limit to avoid a US default in early August. Taken together, these two things are seriously frightening and threaten a major financial/economic crisis quite soon if our politicians in Europe and the US fail to reach constructive agreement on the way forward. Given the importance of all this, I have decided to take a break from my usual writing about higher education to comment here on the current financial mess facing the (so called) advanced countries.

As a result of the 2007-8 world financial crisis, many advanced country governments injected huge amounts of public money into their financial institutions - mainly the major banks - to prevent their collapse; this converted a good deal of private debt into public debt. The subsequent recession led to falls in tax revenues and increases in public spending (social welfare spending, etc.), further increasing both government deficits and the accumulated public debts. The incidence of these phenomena varied a good deal between countries, with Greece and Ireland, later Portugal, being especially hard hit, to the extent of requiring financial rescue operations supported by the EU and the IMF. Last week, for the first time, financial market concerns extended to Italy, and later this week there is due to be a Eurozone summit meeting to agree on a second bailout package for Greece. As I write this, the chances of getting a good agreement do not look too promising. Let me offer a few observations about the difficult situation we now face:

1. When the Eurozone was set up it was understood that, in the absence of a central (EU-level) fiscal authority, member countries needed to exercise a sensible degree of fiscal discipline. In fact certain 'rules of the game', the Stability and Growth Pact (SGP), were established with this in mind. Unfortunately, SGP rules were broken first by Germany and France, without penalty, setting a terrible example for the rest of the zone. Thus the Eurozone has always been a monetary union with no corresponding central fiscal authority (unlike the US, for instance).

2. Within the Eurozone, financial markets treated the debt of each member state pretty much as equivalent to the very safe German debt, with bond rates low and almost identical across the Eurozone. I presume that all these bond issues were assumed to enjoy some sort of collective guarantee, though to my knowledge there is nothing in the Eurozone rules to say that. In effect investors treated all Eurozone governments as equally safe, with virtually no risk of default. As a result, countries like Greece (which later turned out to have been less than wholly honest about their national accounts, in order to meet the initial conditions for Euro entry) enjoyed a massive investment boom for at least a decade, with quite modest debt servicing costs.

3. Shortly after the start of the financial crisis in 2007, the incoming Greek government revealed that the national accounts had not been presented correctly (this is putting it kindly!), revealing a much larger deficit than previously reported, and larger accumulated debt. This was the real start of the present troubles, attention shifting from banks to countries, and the financial markets starting to differentiate more between the debt of different countries in the zone. But Eurozone policymakers have not proved able to come up with a solution that lasts for long.

4. The problem is partly one of diagnosis, in that Eurozone policymakers have treated the crisis for Greece as one of liquidity, hence requiring temporary injections of cash while the country makes needed changes to various domestic policies; rather than one of solvency, requiring some form of default to get the country's debt back down to manageable and sustainable levels.

5. The liquidity approach has not worked, so belatedly, policymakers are realising that there is indeed a solvency issue for Greece. However, a formal default is a bit awkward within the Eurozone, partly because default for Greece might well make the financial markets very nervous about other members of the zone, as has already been happening with Ireland, Portugal, and now Italy and Spain; and also because under current rules, the European Central Bank could no longer officially accept Greek debt as collateral for lending to the Greek banks (though I think this is a technical rule that could be changed). So Eurozone members are trying to find new ways of helping Greece that do not amount to a technical default, but which acknowledge the situation. Our leaders are busy tying themselves in knots as a result, not a pretty sight! Will they find a solution later this week? We shall see.

6. The other problem for Greece is that it has become uncompetitive, and can't easily adjust within the Eurozone. It needs to get costs down so its exports can do better, but like most countries finds it hard to get folk to agree to wage cuts. Devaluation might provide a less painful route if its impact were not immediately offset by domestic wage increases, but in any case this is not an option while Greece remains in the Eurozone.

7. For the moment, therefore, Greece is being offered a period of severe austerity - public spending cuts and tax rises - which is so far not working and which is proving a political nightmare. And the country lacks the means to devalue to restore competitiveness, or the resources to stimulate renewed economic growth. So what is to be done?

8. At the EU level, I expect there will be some sort of package offered this week. But it might well be more of the same, more austerity, tougher conditions, not much prospect of growth. For the Greeks themselves, it must no longer seem so crazy to think of leaving the Eurozone, introduce a new currency (the new Drachma?), default on debts, and go it alone. This is a tough option, too, but it might seem increasingly appealing to many Greeks.

US dollar
The immediate problem here is that the US has a legally set limit on the accumulated public debt, and if no action is taken very soon, that limit is likely to be breached in early August 2011. Politicians of both parties, together with President Obama, are trying to find a resolution to this difficulty, but rather than simply raising the legal limit they are arguing about mixes of spending cuts and tax increases that would also bring the current government budget deficit under control. Sooner or later the deficit does need to be dealt with, of course, but it seems to me that need not be the immediate priority, and need not be linked to the legal debt limit. That aside, I would offer the following points on the US situation:

1. It's not smart to have a legal limit on a country's debt at all, no other countries that I know of have such a limit. Perhaps in the US it's a constitutional requirement, but in that event I would be rushing to get the constitution amended. If there has to be a limit, why not just multiply it by ten so no one has to think about it for a few decades, if ever! In a sense the current crisis is a purely artificial, technical one, since the US clearly has the economic capacity to service a much larger debt. The country does not face a liquidity crisis and is a million miles from being insolvent.

2. The US federal government currently has the lowest tax take of any advanced country, around 15-16 % of GDP. But its spending is about 25% of GDP, hence the current deficit of around 10% of GDP. With such low tax rates, it's got to be easy to balance the books with quite modest tax hikes - but many leading US politicians are dead against such an obvious solution. If taxes were already high, that would be understandable, but they're not.

3. Point 2 means that if the US gets to a formal default, federal spending has to fall - instantly, because the country won't be legally able to borrow - to be in line with tax revenues. Thus federal spending would have to fall by 40% overnight, and if the government decided to use some revenues to service existing debt, federal spending on services to the American people will fall even more, say by 50%. That would not be politically popular even if the problem only lasted a few days. It raises the question, who would be blamed by the voters? My heart sinks when I see the silly and dangerous games about this that US politicians are currently playing.

4. Last, if the US does get to a position of default, the international reputation of the country will sink like a stone and huge damage will be done to the sense of trust and reliability associated with US assets in world financial circles. More concretely, because US creditors will not have the same trust in the US as they have had hitherto, they will assign a non-zero probability of default to US assets in the future. Hence the cost of servicing the existing sovereign debt - and any future increases in it - will rise. It seems to me that some leading US politicians are nowhere near as scared as they ought to be about prospect of a default!

5. On the other hand, while it does nothing for the legal debt limit, a spell of inflation at 4-6% per annum, say for five years, would do wonders for the real debt burden. The debt-to-GDP ratio would fall perceptibly (by at least 25%, even if there is little or no real economic growth) and worries about the debt would subside quite fast. This is a feasible policy for the US since all its debt is denominated in its own currency, though it is not a policy the Fed would officially advocate, I imagine.

6. Likewise, getting economic growth going at a decent rate, say 3-4% per annum, let's say, would equally ameliorate the perceived debt burden after a few years. Hence there is good reason to think about policies that could start to stimulate growth.

7. The worst case, therefore is when we get no growth and no inflation, for then the debt burden remains high and will be seen as a constraint on lots of good things the government might like to do. Meanwhile, however, let us hope that the US politicians manage to step back from the brink and reach an agreement of some sort to avoid any sort of damaging default.

So, we have two interesting and rather different stories, both pointing to the danger of quite a major financial crisis rather soon. It's time for some serious finger crossing right now, and let us hope that political leaders on both side of the pond will find a sensible and workable way through the problems outlined above.

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