A week ago eurocrats launched their campaign of overwhelming force designed to shock and awe the “wolf pack” of professional speculators and institutional investors (hedge funds and pension fund managers) into a more docile, subservient position. In the currency market, the shock and awe wore off after the first 48 hours, while by the end of the week, it also appeared to be wearing off from the equity markets.
Some of this is undoubtedly just the innate brazenness of the wolf pack being expressed. As a general rule, they do not take kindly to being cowed or constrained in any fashion. It simply is not in their genetic make-up. Consequently, they have no choice but to follow their instincts to call the bluff of the eurocrats, and that is part of the reason we are seeing, for example, the wolf pack dragging the euro exchange rate down to the ground in recent trading sessions.
But this is about more than just testosterone counts. Some wing of the professional investing world is beginning to see the design flaws built into the eurozone from day one. And once they spy these flaws, they begin to realize that the nature of the solution is something utterly different than what they are witnessing being rolled out before their very eyes. In the following 11 points, we highlight some of the key aspects of the eurozone predicament using the financial balance approach developed by the late Wynne Godley which we have explored in previous blog submissions, papers, and book chapters. Until more investors and policy makers can understand the true nature of the various predicaments facing the eurozone, and the inherent design flaws exhibited in the European Monetary Union and the (In)Stability and (Lack of) Growth Pact, odds are that precious time will simply be wasted trying to make people believe the shock and awe fix is already in.
- Underlying the eurozone predicament is a missing adjustment mechanism. There is neither a price nor a policy mechanism that encourages the current account surplus nations to recycle their surpluses in a win/win, pro-growth fashion. Keynes tried to design such a mechanism into the Bretton Woods agreement, but the American negotiators scotched it. This same pro-growth adjustment mechanism is missing at the global level with regard to China (although they did report a trade deficit in March).
- An ostensibly moral stance advocating balanced government budgets is revealing a profound ignorance of the simple accounting of sector financial balances. Those preferring to impose a “fiscally correct” policy on the peripheral nations should best recognize these accounting realities, and soon. If we are correct that domestic income deflation will be the end result of fiscal retrenchment colliding with private sector attempts to net save, then surely more desperate citizens will turn to even more desperate acts. Rather perversely, the combined effects of fiscal retrenchment, private income deflation, and rising private debt distress are likely to make moral considerations a second or third order concern for many eurozone citizens.
- Ultimately, current account surpluses need to be recycled into chronic deficit nations in a sustainable fashion. Such a mechanism could be set up under the auspices of the European Investment Bank very quickly. Effective incentives to recycle current account surpluses via foreign direct investment or equity flows should be crafted at once.
- Such an approach is likely to prove superior to funneling financial assistance through the IMF or other multinational arrangements. The IMF will undoubtedly ensure that fiscal retrenchment gets imposed across the region. Any fiscal assistance is likely to be imposed with conditionality – a conditionality that fails to recognize that sector financial balances are interlinked, both within and between nations. IMF conditionality is bound to set off the twin contagion vectors of falling trade surpluses and rising bank loan losses in the core nations. Surely, this is not what Dutch and German policymakers intended, nor is it any way to hold the eurozone together.
- Rapidly cutting fiscal deficits without considering the impact of such moves on private sector financial balances is a short-sighted, if not dangerous policy direction. Sector financial balances – the difference between saving and investment, or income and expenditures – are interconnected, and cannot be treated in isolation.
- Hiking taxes and slashing government expenditures will suck cash flow out of the private sectors of the peripheral eurozone nations. These private sectors have been rebuilding their net saving positions in the wake of sharp and prolonged recessions. Companies have been conserving cash by slicing investment spending, inventories, and employment. Households have already drastically reduced home purchases and consumer spending.
- It is an elementary fact of accounting that the private sector as a whole can only spend less than it earns if some other sector spends more than it earns. That sector has tended to be the government, usually as automatic stabilizers kicked in while recessions deepened. Indeed, most of the dramatic widening of government deficits is due to a collapse in tax revenues, not to discretionary stimulus. Pursuing fiscal retrenchment in order to reduce government debt default risk will merely raise the odds of private sector debt defaults. Cash flow will be taken from households and firms attempting to rebuild their net saving positions, and private debt servicing will falter.
- The only way to avoid this outcome is if the nations undertaking fiscal retrenchment can swing their trade deficits around in a fully offsetting fashion. Otherwise, domestic income deflation is the likely result; indeed, this is the madness behind the method of “internal devaluation” so evident in Latvia’s economic implosion. There is no guarantee that trade swings will be large enough to overcome fiscal drag. A return to debt deflation dynamics like those engaged after the Lehman debacle is not out of the question.
- Furthermore, since the current account surplus of the eurozone has remained between +1 and -1 per cent of GDP for quite some time, there is every reason to believe that attempts by the periphery to achieve trade surpluses will undermine the export-led growth of Germany and the Netherlands.
- It would therefore appear that fiscal retrenchment is about to set off two related contagion effects. First, the loans on the books of German, Dutch and French banks are likely to sour as private sector cash flows are squeezed in the periphery. Bank holdings of government debt issued by the periphery may not default, but the mortgages and corporate loans these banks have outstanding to the periphery will experience rising loan losses.
- Second, the export sales of German and Dutch companies will fade with the falling import demand of the periphery. As their domestic incomes fall, they will import less. In other words, the fiscal retrenchment the core nations are insisting upon is highly likely to boomerang right back on them.
As it stands, investors have started to recognize that banks in the region are at risk. CDS for Spanish and Portuguese debt have started to widen more dramatically over the past two weeks, although investors still appear overly focused on government debt CDS. Policy makers have also begun to realize that Greece is unlikely to be the last country requiring a bail-out, while they, at the same time, sign on for rapid fiscal “consolidation” (read retrenchment) in order to ostensibly avoid becoming the next Greece.
Yet we continue to find that many of the points detailed above are not yet recognized by professional investors or policy decision makers. Absent this coherent framework, it will indeed prove very difficult to sidestep an economic and financial implosion in the eurozone, following on the heels of an already historically deep recession, and burst property bubbles in a number of eurozone nations. May wiser heads prevail.
Jan Kregel: Former professor of economics at Università degli Studi di Bologna and Johns Hopkins, and currently a senior scholar at The Levy Economics Institute
Rob Parenteau, CFA: Sole proprietor of Macro Strategy Edge, editor of The Richebacher Letter, and a research associate at The Levy Economics Institute