Normally I don’t like to write about European prospects in the midst of a very rough patch in the market because in that case there isn’t much I can say that isn’t already being said. I find it more useful to wait for those recurring periods in which the markets recover and optimism rises. Still, given the conjunction of political uncertainty in Beijing, low Chinese growth numbers, and another round of deteriorating circumstances in Europe, I will spend most of this issue of the newsletter trying to outline the possible paths countries like Spain must face.
For several years I have been saying that Spain would leave the euro and restructure its external debt. I should say that I specify Spain because it is the country in which I was born and grew up, and so it is also the country I know best. When I say Spain, however, I really mean all the peripheral European countries that, like Spain, are uncompetitive, have high debt levels, and suffer from low savings rates that had been forced down in the past decade to dangerous levels.
Spain had a stronger fiscal position and healthier bank balance sheets than many of its peers when the crisis began, so any argument that applies to Spain is likely to apply more forcefully to its peers. As an aside I will add that France is for me the dividing line between countries that will be forced into devaluation and restructuring and those that won’t – in my opinion France could go either way and we will get a much better sense of this in the first year of Hollande’s presidency.
There are two reasons why I was and am fairly sure that Spain cannot stay in the euro (or, which amounts to the same thing, that Germany will leave the euro instead of Spain). The first has to do with the logic of Spain’s balance of payments position, and the second has to do with the internal dynamics that drive the process of financial crisis.
To address the first, I would start by noting that thanks to excessively loose monetary policies driven primarily by German needs over the past decade, Spain has made itself wholly uncompetitive in the global markets and in so doing has run large current account deficits for nearly the entire past decade. Its fundamental problem, in other words, has been the process by which its savings rate has collapsed, its cost structure forced up, its debt levels soared, and a great deal of investment directed into projects, mostly real estate, that were not economically viable. As I have discussed often enough in previous issues of this newsletter, I think all of these problems are related and are the automatic consequences of the same set of policy distortions implemented in Spain and in Germany.
Until Spain reverses its savings and consumption balance and drives down its current account deficit into surplus, which is what a reversal of these distortions would imply, it should be pretty clear that Spain will continue struggling with growth and will continue to see debt levels rise unsustainably. But the balance of payments mechanism imposes pretty clear constraints on the process of adjustment. In that sense there are really only three ways Spain can regain competitiveness sufficiently to raise savings and reverse the current account:
- Germany and the other core countries can take steps to reverse the policies that led to the European crisis. They can cut consumption and income taxes sharply in order to reduce domestic savings and increase domestic consumption. These would lead to a reversal of the German trade surpluses and higher inflation in Germany, the combination of which would allow Spain to reverse its trade deficit and regain competitiveness via lower inflation relative to that of Germany and a weaker euro.
- Spain can force austerity and tolerate high unemployment for many more years as wages are slowly pushed down and pricing excesses are ground away. It can also take measures to reduce costs by making it easier to start businesses, reducing business taxes, and by improving infrastructure, but these latter provide too little relief except over a very long period, especially given the difficulty Spain will face in financing infrastructure and reducing taxes.
- Spain can leave the euro and devalue. This would leave it with a problem of euro-denominated debt, whose value would soar relative to GDP denominated in a weakening currency. In that case Spain would almost certainly be forced to halt debt payments and restructure its debt.
I want to stress that these are, practically speaking, the only three ways for Spain to regain competitiveness. There are other ways that could in theory also work, but they are too unlikely to consider. One could assume for example that the rest of the non-European world – most importantly the US, China and Japan – take steps to stimulate their domestic economies sufficiently to force up consumption and run in the aggregate large and growing trade deficits. These deficits, whose counterpart would be a very large European trade surplus, would then bail out the whole eurozone by generating GDP growth rates that exceed the debt refinancing rates.
I think most of my readers will however agree that this is pretty unlikely. The rest of the world is also struggling with growth and in no hurry to run large trade deficits. Another possibility is that we suddenly see a rapid and dramatic move towards full fiscal union in Europe, in which sovereignty, for all practical purposes, is fully transferred to Brussels (or Berlin). But that probably won’t happen either – the rise of nationalism throughout Europe has made this always-unlikely prospect even less likely.
So we are left largely with these three ways of allowing Spain to regain a cost structure that makes it competitive and allows it to amortize its debt while growing. Anyone who rules out two of the three ways listed above must automatically imply that Spain will follow the third way. So which will it be?
Humpty Dumpty economics
The first way is for Germany to reverse its surplus and begin running large deficits. This is by far the best way, but I think it is very unlikely. Berlin has made no indication that it is prepared to do what would be necessary for it to run large deficits and, on the contrary, it is even talking about the need for more austerity.
In part this is because Germany has a potentially huge debt problem on its balance sheet. As a consequence of its consumption-repressing policies during the decade before the crisis, Germany’s domestic savings rate was forced up to much higher than it otherwise would have been and Germany has had to export the excess capital. Not surprisingly, given European monetary dynamics, this capital has been exported largely to the rest of Europe in order to fund the current account deficits of peripheral Europe that corresponded to the surpluses Germany so badly needed to grow.
It did this not by accumulating euro reserves, which it could not do anyway, but rather by accumulating loans to peripheral Europe through the banking system. As a result of all of these loans, Germany is rightly terrified that a wave of defaults in Europe will cause its own banking system to require a state bailout if it is not to collapse, and so it does not want to cut taxes and reduce savings because it believes (wrongly) that austerity will make it easier to protect its creditworthiness.
But German’s anti-consumption policies are leading it towards a debt problem in the same way that similar US policies in the late 1920s created an American debt crisis during the next decade. In that light I thought this very illuminating quote from then-presidential candidate Franklin Delano Roosevelt might be apposite:
A puzzled, somewhat skeptical Alice asked the Republican leadership some simple questions:
“Will not the printing and selling of more stocks and bonds the building of new plants and the increase of efficiency produce more goods than we can buy?”
“No,” shouted Humpty Dumpty, “the more we produce the more we can buy.”
“What if we produce a surplus?”
“Oh, we can sell it to foreign consumers.”
“How can the foreigners pay for it?”
“Why, we will lend them the money.”
“I see,” said little Alice, “they will buy our surplus with our money. Of course these foreigners will pay us back by selling us their goods.”
“Oh not at all, “said Humpty Dumpty. “We set up a high wall called the tariff.”
“And,” said Alice at last, “how will the foreigners pay off these loans?”
“That is easy, said Humpty Dumpty. “Did you ever hear of a moratorium?”
And so alas, my friends, we have reached the heart of the magic formula of 1928.
Humpty Dumpty’s grasp of the balance of payments, it turns out, is no more naïve than that of many European policymakers, and I suppose Germany will follow the historical precedent set by the US – and so many other countries that confuse trade surpluses with moral vigor. By refusing to take steps that seem on the surface to undermine its creditworthiness, Berlin will only ensure the debt moratorium that will probably demolish its creditworthiness anyway.
And of course without a major reversal of German’s current account position the balance of payments constraint absolutely prevents net repayments from peripheral Europe. This game will go on as long as the core countries continue financing the periphery, but once they finally stop, the peripheral countries will almost certainly default or restructure their debt.
To take a brief detour before returning to discussing the three paths Spain can take, I think Berlin is betting that if they can prolong the crisis long enough, while pretending that the problem is one of liquidity, not solvency, they can recapitalize the German (and other European) banks to the point where they eventually are able to recognize the obvious and take the losses. This was, after all, the strategy followed by the US during the LDC Crisis of the 1980s, when it waited until 1989, seven or eight years after the crisis began, to arrange the first formal debt forgiveness (the Mexican Brady Bond). During that time a steep yield curve engineered by the Fed allowed the US banks to earn sufficient profits to recapitalize themselves to the point where they could finally formally recognize what had long been obvious.
There are at least two reasons however why this strategy won’t work for the European banks. First, the hole in the European banks’ balance sheets dwarves the equivalent hole in the balance sheets of the American banks during the LDC crisis. It would take them much longer then seven or eight years to fix the problem.
Second, postponing resolution of the debt crisis is extremely painful for the debtor countries, who have to bear the full brunt of the adjustment that both debtor and creditor countries really need to make together. This reduces maneuvering space for Europe because the political system in Europe is less able than that of Latin America during the 1980s to accommodate this very painful process. Well-functioning democracies, after all, make it harder for bankers and elites to force the cost of the adjustment onto the middle and working classes.
Can Spain adjust by itself?
This is also the reason why Spain cannot follow the second of the three paths described above. The second path requires that Spain bear the full brunt of the economic adjustment, which in reality Spain and Germany should bear together. Spanish voters, however, will not permit (and rightly so) that Madrid force such economic pain on its citizens in the name of an ideal of “responsible behavior” (i.e. remaining within the euro) that is both mistaken and extremely painful.
The adjustment will require that Spanish wages and prices are forced down substantially until Spain can reverse the higher price differential relative to Germany from which it suffers. Figuring out how to do this is not very hard – we have plenty of historical precedents upon which to draw. To simplify substantially, there are basically two things that have to happen in order to force a relative decline in prices. First, unemployment must remain very high for many years so that wages either decline, or rise by less than inflation and relative productivity growth. This is pretty straightforward.
Second, there must be some way to deal with the real increase in the domestic debt burden. Why? Because there are two ways relative prices can be forced down, and both of these result in a real increase in the debt burden. First, high inflation in Germany can exceed lower Spanish inflation, and second, Spain can deflate. In both cases the real cost of debt must increase substantially – in the former case because high German inflation will force up euro interest rates so that Spain’s refinancing cost will exceed its domestic growth rate, and in the latter case because deflation automatically increases the real debt burden.
How will we deal with the rising debt burden? Typically we do so by confiscating the wealth of small and medium enterprises or by confiscating the savings of the middle classes, and usually we do both.
So for Spain to adjust we need both very high unemployment for many years and we need to undermine the middle classes. Any policy that requires an enormous and unfair burden on both the workers and the middle classes is unlikely to be rewarded at the polling booths.
The huge unpopularity of the newly elected Prime Minister Mariano Rajoy, in that context, should not be a surprise. I wrote last year just after the election that this would happen, although I thought it would take a year or two before the population really turned on him and made it impossible for him to govern. But Spaniards, from business leaders down to workers, are furious at the Rajoy government and this anger will continue until either the two major parties eject those of their leaders who continue to demand that Spain behave in a “responsible” way, or harder line extremist parties replace the two parties themselves.
I place the word “responsible” in quotation marks not because I am opposed to responsible behavior but rather because the attempt to tighten the budget and impose austerity in the name of remaining on the euro is being presented as the “responsible” thing to do. It is, however, no more responsible than the policies France used in the 1920s to revalue the franc to pre-War parity, which were also sold to the French public as the “responsible” thing to do.
In both cases (and in many other deluded attempts to protect hopelessly overvalued currencies underpinned by rising eternal debt), policymakers did not understand that their policies were guaranteed to fail and were based on a misunderstanding of the causes of the underlying crisis. The responsible thing to do is to acknowledge that the euro is indefensible and that Germany’s refusal to share the adjustment burden, after it absorbed most of the benefits of the mismanaged monetary position it imposed on the rest of Europe, means that Spain will be forced to take on far more than its share of the cost.
But whether or not everyone agrees with my analysis of what really is “responsible” behavior, I think it most people will agree that, rightly or wrongly, Spanish voters are unlikely to accept high unemployment and an assault of middle class savings for many years without rebelling at the polls. Spain simply cannot accept the full burden of adjustment.
This means that the first two of the three paths I listed above cannot be followed. If I am right, we are automatically left with the third. Spain (and by extension many other countries) must leave the euro. It will be very painful and chaotic for them to abandon the euro, but the sooner they do it the less painful it will be.
The death spiral
I said at the beginning of this newsletter that there were two reasons why I was certain Spain would leave the euro, the first of which has to do with the logic of Spain’s balance of payments position and the second with the internal dynamics that drive the process of financial crisis why I was certain that Spain would leave the euro. To address the second, I think Spain will leave the euro because it seems to me that the country has already started on the self-reinforcing downward spiral that leads to a crisis, and there is no one big enough to reverse the spiral.
How does this process work? It turns out that it is pretty straightforward, and occurs during every one of the sovereign financial crises we have seen in modern history. When a sufficient level of doubt arises about sovereign credibility, all the major economic stakeholders in that country begin to change their behavior in ways that exacerbate the problem of credibility.
Of course as credibility is eroded, this further exacerbates the behavior of these stakeholders. In that case bankruptcy comes, as Hemingway is reported to have said, at first slowly, and then all of a sudden, as the country moves slowly at first and then rapidly towards a breakdown in its debt capacity.
What is key to understanding the process is to see that stakeholders will behave for perfectly rational reasons in ways that politicians and moralists will decry as wholly irrational. Rather however than respond to appeals that they stop behaving irrationally, stakeholders will continue making conditions worse by their behavior as they respond the distorted incentives created by the erosion of sovereign credibility. To do otherwise would almost surely expose them to disaster.
To summarize what the self-destructive and automatic behavior of the stakeholders is likely to be, it is worth identifying some of the major stakeholders and to suggest how they typically react to a rise in the sovereign’s default risk:
- Private creditors. As Spain’s credibility deteriorates, private creditors will demand higher yields on their loans to Spain even as they change the form of their lending to reduce their own risk, for example by shortening maturities. This has a double impact on making conditions worse. First, higher interest rates mean that debt rises more quickly than it otherwise would. Second, shorter maturities and other changes in the loan structure mean greater balance sheet fragility and a rising probability of default.
- Official lenders. As they are forced into providing liquidity facilities, official creditors typically demand and receive seniority. This of course increases the riskiness for other lenders and creditors by pushing risk downwards, and so worsens balance sheet fragility and increases private sector reluctance to lend.
- Depositors. As the probability rises that Spain will leave the euro, and that bank deposits will be frozen and redenominated in the weaker currency before any abandonment of the euro is announced, depositors respond rationally by taking money out of the banking system. As they do, banks are forced to contract lending, to increase balance sheet liquidity, and to reduce risk, all of which act as a drag on economic growth.
- Workers. Rising unemployment and the prospects for an unequal sharing of the burden of adjustment cause unions to become increasingly militant and to engage more often in various forms of industrial action, which, by raising uncertainty and costs for businesses, force them to cut output and employment.
- Small and medium businesses. One of the sectors most likely to be penalized in a debt crisis is the small and medium enterprise sector. Owners of small and medium businesses know that they are vulnerable during a crisis to an expropriation of their wealth through taxes, price and wage controls, and other forms of indirect expropriation. They try to forestall this by disinvesting, cutting back on expenses, and taking money out of the country.
- Political leaders. As time horizons shorten and politics becomes increasingly radicalized, policymakers shift their behavior in ways that reduce credibility further, increase business uncertainty, and raise national antagonisms.
It is important to recognize the almost wholly mechanical nature of credit deterioration once a country is caught in this kind of spiral. Deteriorating creditworthiness forces stakeholders to adjust. Their adjustment causes debt to rise and/or growth to slow, thus eroding creditworthiness further.
The combination of these and other actions by stakeholders, in other words, can’t help but reduce GDP growth, increase debt, and increase the fragility of the balance sheet, all of which of course undermines credibility further, so reinforcing the suboptimal behavior of stakeholders. All of the exhortations by politicians, the church, public intellectuals, bankers, etc. – and there will be many – that stakeholders put personal self-interest aside and act in the best interests of the nation will be useless. Slowing this behavior is not enough. It must be reversed.
But how can it be reversed? No one is big enough credibly to guarantee the creditworthiness of all the afflicted countries, and without a credible guarantee the downward spiral will occur, more or less quickly, until it is clearly unstoppable.
Only connect…
It is pretty clear that all of this is already happening in Spain and it is also pretty clear that every few months when the government announces the latest batch of economic and debt data, these numbers always turn out to be worse than expected and much worse than originally projected, which is, ironically, exactly what we should expect under the circumstances. Here is an article from Saturday’s Financial Times that shows just how bad it is:
Nearly one Spaniard in four is unemployed, according to data released on Friday, as the country’s economic and financial predicament prompted a government minister to talk of a “crisis of enormous proportions”. The data from the National Statistics Institute showed 367,000 people lost their jobs in the first three months of the year. That means more than 5.6m Spaniards or 24.4 per cent of the workforce are unemployed, close to a record high set in 1994.
The data, which follow a sovereign credit rating downgrade, prompted José Manuel García-Margallo, foreign minister, to say that they were “terrible for everyone and terrible for the government”. He compared the European Union to the doomed liner Titanic, saying that passengers would be saved only if all worked together to find a solution.
It is interesting that Garcia-Magallo is openly discussing the possibility of the “passengers” not being saved. Usually in the beginning of a sovereign debt crisis we spend an unfortunately long time in which policymakers insist that the market is overreacting to bad news and that the problem – inevitably a short-term problem driven largely by illiquidity – can be resolved with patience and hard work. There is no discussion of contingency plans because the contingency is unimaginable.
At some point however it becomes possible at least to acknowledge formally that policymakers might be forced into the contingency. Once this happens, the debate becomes much more intelligent and the resolution of the crisis is speeded up. I have no idea if we have reached that stage in Spain, but in that light I found an article last month, by Ambrose Evans-Pritchard of the Telegraph, both very worrying and, at the same time, comforting. In the article he says:
Articles calling for Spain to withdraw from EMU – or at least exploring the idea – are no longer rare. They are appearing every day.
…What is striking is the response on the comment threads of such pieces. My impression over the last month is that a large bloc of informed Spanish opinion has reached the conclusion that EMU is dysfunctional, and increasingly destructive for Spain. Many posters seem extremely well-informed, using terminology such as “debt-traps”, “internal devaluations”, and “relative unit labour costs”.
Many point the finger directly at Germany, correctly stating that Berlin seems to think it can lock in a current account surplus with Club Med in perpetuity. Clearly, such as an arrangement is mathematically impossible within a currency union – unless Germany is willing to offset the surplus with flows of money for ever, either through fiscal transfers or loans or investment. These flows have been cut off.
Opinion is divided, of course. The pro-euro camp is still a majority. But the smothering conformity of past years has been obliterated.
As recently as six months ago one didn’t discuss in polite company in Madrid the possibility that Spain would leave the euro and restructure its debt. The prospect was unthinkable and like many unthinkable things it could not be discussed.
This made it very unlikely that anyone except the radical parties of the left or right would be able to control the discussion and of course this was likely to lead to a more disorderly resolution. But now perhaps things have changed. If responsible policymakers, advisors, the press, and public intellectuals are indeed discussing and debating the future of the euro now, I am pretty sure that a real and open debate about Spain’s prospects will quickly move the consensus towards abandoning the euro.
And that is why the article is comforting. The historical precedents suggest that typically policymakers postpone the decision to reverse the monetary straightjacket for as long as they can, and in the process they erect barriers towards such a reversal in the name of shoring up credibility. These barriers work by increasing the cost of a policy reversal, and the point of this is to improve credibility in investors’ eyes by increasing the cost of “misbehavior” by policymakers.
Mexico did this for example in 1994 when, in order to convince an increasingly skeptical investor base that the central bank would not devalue the peso against the dollar, the Ministry of Finance shifted its domestic borrowing from peso-denominated funding to dollar-denominated funding, which of course would increase the debt-servicing cost of a devaluation for the government. Unfortunately, when policy is reversed anyway, as was the case in Mexico in 1994, the cost indeed ends up being much higher, and it takes longer for the economy to recover. In that sense the sooner Spain prepares for an abandonment of the euro the less painful it will be.
But of course it won’t be painless. Whenever an analyst predicts that Spain will soon leave the euro he is almost always countered by someone who earnestly explains that Spain cannot leave the euro because the process will be too painful. In 1993-94 of course we were told that this was why Mexico could not possibly devalue, and in 2000 and 2001 this was why Argentina could not possibly break the currency board. It would have been too painful to devalue.
But of course Mexico and Argentina both did devalue and, yes, it was a very painful experience but they did it because the alternative was worse. And likewise while it is true that Spain cannot leave the euro without experiencing a very painful process, the point is not that anyone is arguing that Spain should willingly and irrationally choose to endure pain. Spain will leave the euro because the alternative is worse.
This is an abbreviated version of the newsletter that went out last week. Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at chinfinpettis@yahoo.com, stating your affiliation, please. Investors who want to buy a subscription should write to me, also at that address.
Yes, this is unavoidably grim and your analysis is brilliant. Thankyou. You do not touch upon one pathyway which was common coin until about 8 years ago – the creation of the United States of Europe. It was always thought currency union without mechanisms to allow for correction of imbalances would prompt waves of crisis, each crisis empowering the center more and more until union was achieved. That subsidiarity was a milk sop to be replaced with a full federalist democratic Europe. Well, the Monnet folks have their crisis in spades but strangely the United States of Europe has disappeared. Schroeders have been replaced wigh mendacious Merkel with petty mandarins in Brussels doing all to maintIn their percs. All very sad.
If one considers that federalism is impossible then the only three paths are as you say.
But
But Europe’s unique 50 years of the treaty evolution were not only to provide economic framing for Europe but more importantly was the Peace for WWII with additional duty to secure Europe from the USSR. It was to “keep Germany down and Russia out”. Well the Russian part of the Peace is gone and I think Germany is doing all it can to slip the traces of the Peace by moving from a evolution as one state amongst 17 to federalism, towards the hegemon foe the region.
Brilliant and very convincing, Professor Pettis. I wish you would write mote widely, for example about the US, India, Russia and Latin America. Your analysis is both extremely sophisticated and extremely clear. I really think you might be the best writer in the world about macroeconomics, and I am an economics professor who reads nearly everything. Thanks very much for doing this.
If Spain remains in the Euro, it will be interesting to see how it does it.
If Spain leaves the Euro, it will be interesting to see how it leaves.
I am Spaniard too. Out of pride, I prefer Spain to remain within the Eurozone, but the perspectives are indeed grim.
And what is worst, if Spain leaves the Euro, it will be a long and grueling process too, taking several years.
Fortunately I am now in a safer place in northen Europe. Switzerland.
I hope the Euro zone remains, with the posible exception of Greece. If that is achieved it will be a great success for the EU, but I am afraid Europe, and specially Germany, it is not up to the task.
It will be interesting to see the political evolution of Europe after a major Eurozone breakdown.
Interesting times.
Thanks for the great insights as always. One correction: in the fifth paragraph, I think you meant to say “Spain has made itself wholly uncompetitive in the global markets and in so doing has run large current account DEFICITS” instead of surpluses.
“Spain has made itself wholly uncompetitive in the global markets and in so doing has run large current account surpluses”.
Is this a typo? [deficit?]
You said: “A puzzled, somewhat skeptical Alice asked the Republican leadership some simple questions:”
FDR was a Democrat not a Republican.
A very clear and thoughtful analysis of where we are now. But one prospect that you don’t address is: What if the ECB is given leave to buy bonds? It already has via the three year lending facility with banks, but what if it was given a free hand to backstop all state debt? This could result in inflation, but that would be a short term balm anyway. It would not address the structural problems that you have described, but it would buy more time – perhaps even several years. Faced with a breakup of the euro, don’t you think the Germans could hold their nose and allow the ECB to print money?
A long article but one that seems to leave out the obvious. i.e. the whole of Spain seems to be living beyond its means on government funded handouts. Any attempt to roll back these entitlements is derided by the author as a “attack” on the middle class. Perhaps if the entitlements were slashed and people actually forced to work, that might solve the problem? When an entire country has no incentive to work, why would productivity go up? When no one can be fired, why would any private business ever hire?
This article overlooks the role of the free market and the consequences of socialistic governmental interference. Plenty of illegal immigrants are finding jobs in Spain because the average spaniard won’t clean a hotel room, won’t work in agriculture field labor, won’t collect trash. Why should they, when the government hands out never ending checks.
If it’s only about Spain’s current account deficit, the adjustment is complete. This is because the export growth, despite all of Spain’s problems (or because of them?), has been terrific.
Bloomberg writes:
“…the current account deficit, which was 10 percent of gross domestic product at the height of the boom in 2007, will decline to 0.9 percent this year…”
I think the central understated reason why internal devaluation won’t work is because the cost of producing expert/experienced workers has gone up. The costs of living and transport to the workplace has gone up. All of these costs are underpinned by debt. School debt. Housing debt. Car debt in some cases. All of whom has to be restructured at the fine-grained level, if you can’t depreciate the currency. You could try internal devaluation anyways, especially in places where people have low debt loads on education at least, but what you will find is labor flight, of your best and most productive workers, and turning the places where they were in to sinks of ineffective labor transfers to old people. China, when you compare pre-1987 and post-1998, is a classic example of the disruption of labor immiseration. Rural farm labor is never modernized, and horribly inefficient services underpin whole villages of grandparents and grandkids, while working aged people are in the major cities that has a prayer of paying back the educational costs growing up. This can’t last forever, and good labor seems to be more willing to take on overseas living, especially if the move up the value chain isn’t successful (and I don’t think it will, because it requires more independent institutions than the Party is willing to accept).
Nice constructed argumentation:)
The post certainly contains its own lot of valuable argumentation and it (the argumentation) should not be discarded or belittled. As always on this blog!
However I do not buy it all. Only part of it! Why?
1 -Calling for A-E-P argumentation whose political biases are obvious, is as much a bad point as a good one. A good one, since Ambrose is a great journalist. One many respect for his skills at grasping macro-economics and complex monetary issues. His early calls on the current situation are famous. Including on the old Continent. It has been a daily read by many. Including here in Paris… But A-E-P political agenda – now clearly more on the UKIP than the Tory side – is as much a bias as as the one we have all inside the Eurozone.
I am a citizen of the Eurozone. With vested interests of course. But conversely, A-E-P has his ones. And has clearly underestimated the European sentiment for a few years. I can certainly understand it and accept it. But, his feelings are certainly not shared by MOST current the young Europeans taken as a generation. Take a plane and check it up in our universities.
2- Your argumentation contains its proper twists. Here, for example :
“Mexico and Argentina both did devalue and, yes, it was a very painful experience but they did it because the alternative was worse”. The Euro strength – still over 1.25 as I speak – is clearly part of the problem. But, because of this, calling for the South America monetary history is not exactly fitting the situation.
IMHO quite a number of analysts and economists underestimate the pain that the Eurozone is able to endure to avoid the destruction of the common currency. This is a political decision. And, whatever the consequences, I expect the Eurozone to survive. The earlier Greece is out the better. For them as much as for the rest of the Eurozone.
Will Spain quit?
I expect the Euro to be below 1.0 within a reasonable time frame and parts of Italy and North of Spain to regain some of their historical economic muscle? Inflation well above 10% in the North of Europe and continuous mild deflation in South of the zone except for real estate (that needs a crash). Harsh discussions and massive monetary transfers. Essentially to rescue banks. I mean the ones kept private.
Will that be enough to keep the Euro boat at sea. I have some doubt. But may I say that I have some doubt as well on the governance of Washington and Beijing on the very same issues.
Both Washington and Beijing are certainly not optimal management structures… Including in the way they handle macro-economic maladjustments monetary issues and financial issues. I prefer reading German economists à la Wilhelm Röpke than Keynes.
IMHO the jury is still out. On the euro experiment. Not on Keynes. And I certainly do not believe that one should consider intra-Euro-zone issues in the way you treat them. As typical international monetary imbalances. They are not.
Brilliant analysis !!!
Like an earlier commentator, I also assumed that eventually Germany would be forced to approve of the ECB printing all the Euros necessary to secure the loans of any country in danger of leaving the Euro, and that THIS would be the least painful scenario for all involved and safeguard the Euro in its present form.
If Spain does indeed leave the Euro, what are the prospects for the value of the currency?
I agree that it is inevitable that Spain, along with Greece, Ireland, Protugal, and Italy will leave the Euro. What I find most interesting is that the cost, which as you mention are currently paid for by the debtor nations, will set in motion a dynamic that will reverberate long after the death of the Eruo. If the above countires leave the Euro, in effect the Euro becomes the new DM. As such, its favour as a safe haven (cemented by the bank runs in the debtor nations) will over inflate its value for the countires that continue to use it for a long time. By this I mean it will rise to irrational levels. Its long term suppression will quikly reverse. Germany will be facing loses on its balance sheet and will quickly be priced out of its export markets.
Wouldn’t it be a whole lot simpler to just throw Germany out of the Eurozone?
Nice change of pace this is, especially when all you read about is “Grexit” in the news.
If Greece goes, everyone goes. There’s no way the ECB can say that Greece was a one-off. They going to backstop Spanish debt but not Greek debt?
If the Euro survives the end of the year, I’ll be surprised. This is also going to sour relations between Germany and everyone else in the EU. So Germany will have that working against them, along with an expensive New Mark. Not a good combination. Do you think if Germany goes back to the mark, they will immediately start running trade deficits? I know pre-Euro they did, and if no one can afford Made in Germany anymore, it seems like it’s right around the corner.
It’s all very depressing. Germans can’t be convinced that a little inflation just might save the Euro. I don’t know if another leader could have done a better job, but Merkel has been disappointing in this whole episode.
While it may seem “too unlikely” to be worthy of consideration, I believe it would be possible to construct a mechanism that could adjust for differences in productivity among the Eurozone nations: specifically, by adjusting all wages on a yearly or quarterly basis according to the national or regional unemployment rate.
President Hollande of France has taken what could be a step in this direction by cutting cabinet salaries by 30%. Now if this were to be applied across the board, France would, at a stroke, be largely free of her economic difficulties. The cost of living would fall, unemployment and with it the cost of welfare programs would fall, the government deficit would fall, while international competitiveness would increase.
Add to an automatic wage rate adjustment mechanism, a wage subsidy program, which avoids the problems associated with a negative income tax, and full employment could be restored, while the small and medium enterprise sector would have the benefit of a level, or more nearly level, global playing field, so far as labor costs are concerned.
Together these measures should initiate a virtuous cycle of rising output and declining costs able to restore Europe to prosperity without importing millions from the third world to provide cheap labor for jobs “Europeans won’t do.”
Prof. Pettis,
You mentioned that when you talk about Spain you are really referring to many of the peripheral countries in Eurozone. What do you therefore think of Ireland’s prospects for remaining in the Eurozone? The country appear to have been making real progress on labor cost competitiveness. If that trend continues, do they have a real incentive for leaving the Euro? If the sovereign nevertheless restructures its debt, can Ireland remain in the Eurozone?
Another economist who thinks people act like macro economists. He will be wrong on China and on Spain. They will all print. The alternative is political suicide.
http://www.marketoracle.co.uk/Article34544.html#comment181967
Excellent article. Are there policy alternatives before devaluation? If the problem is confidence and confidence is caused by too much debt what if the banks were bailed out in a different way then lending them money at low interest? Instead of 1% LTRO money to banks, the government borrows the 1% money and makes it available to citizens under a Homestead Act. Under the Homestead Act the citizen borrows at 1% under certain conditions including: 1. the money must be paid to Spanish banks to pay down debt; 2. The citizen gives a charge on their homestead which is protected from foreclosure if the existing mortgages are paid off using the government financing. 3. The government mortgage is long term 30 years low rate 1% with a provision that social security payments may be attached in default to enforce repayment 4. the homestead mortgage payments which are defaulted upon become tax debts. The effect is that interest burden will drop for citizens and homesteads will be protected raising confidence. Those in default on homestead payments will soon be stripped of all assets other than their homestead if the tax collectors are efficient. The contingent liabilities of government will fall as social security payments are attached. Only the government can safely hold mortgages larger than the value of the home and expect repayment because they will pay the social security payments in the future and can attach those payments. Limiting the government mortgages to homesteads increases the likelihood that the debtor will choose to remain in the home despite holding a mortgage far in excess of market value. The no foreclosure rule increases the willingness of the underwater debtor to hold because he or she knows that he will not lose his home and can therefore wait for the good times to return. Demand for foreclosed non-homestead homes held by Spanish banks could be stimulated by allowing non-homestead owning citizens to buy these foreclosed homes using these homestead mortgages and rules. And why not let the citizens of governments whom allow their citizen’s social security to be attached to take advantage of the homestead act, buy one of the foreclosed homes and retire in sunny Spain? If you can’t get the Germans to create more domestic demand at least you can attract the demand from Germany. While you are at it let these Germans ex-pats be treated by Spanish doctors and hospitals paid for by the German taxpayer.
Michael,
You are an absolute superstar. Such cutting insight into the real nature of the problems in the world instead of the spin that we are being constantly spoon-fed.
I have watched incredulously in Perth as the populace and the opinion makers have fallen hook, line and sinker for the 21st Century belongs to China meme and how Australia is on a path of never ending prosperity.
Furthermore, especially in negative-geared real estate investments, you had access to the Golden Goose herself.
There are going to some very sore rectums as never-ending resource and real estate booms unravel.
The Germans were only the second largest beneficiaries of the peripheral spending epidemic you described as you well know the EU trade deficit with China exceeded that of the US.
Spain & Greece do no boast companies such as Siemens, BMW etc to claw back some of EU trade deficit.
Australia and China are both hurtling towards the edge of an environmental precipice.
Economic Rationalists somehow never seem to include the risks and cost of environmental degradation and the cost of environmental remediation (think Fukushima) into their crude GDP calculations.
Sincerely, and in deep appreciation for your mighty labours,
Robert
Many thanks for another clear, cogent explanation of a complex situation.
You say Spain’s leaving the euro amounts to the same thing as Germany’s leaving the euro, but it seems different in a crucial way. Spain’s debt is euro debt (is it not?). If Germany leaves the euro, Spain and other countries that stick with the Euro can inflate the euro and relieve their debt burden without (explicit) default. But if Spain leaves the euro, they’re stuck with their expensive euro debt unless they default (explicitly). Big difference, no?
Spain does not have low savings rates. Spain has much higher savings rates than the US, UK, Ireland or Italy. Spanish savings rates are similar to French levels, and have often exceeded French levels:
http://www.imf.org/external/pubs/ft/weo/2012/01/weodata/weorept.aspx?pr.x=45&pr.y=5&sy=1998&ey=2012&scsm=1&ssd=1&sort=country&ds=.&br=1&c=158%2C124%2C138%2C132%2C134%2C184%2C144%2C112%2C136%2C111&s=NID_NGDP%2CNGSD_NGDP&grp=0&a=
Spain had a large current account deficit because it enjoyed exceptionally high investment rates – especially in housing, but also by firms. Most of this investment was in fact sound – Spain suffers liquidity crisis, but seems to have fewer bad debts than the US or Ireland.
Of course, investment has just crashed wiping out 8% of GDP directly, with a still wider impact on tax revenue and general demand. This was a massive structural shock requiring massive readjustment. In that context, high unemployment is inevitable with or without a competitiveness problem.
That begs the question: does Spain really have a competitiveness problem?
Just look at Spanish export growth (exports in constant 2011 euros per capita):
https://docs.google.com/spreadsheet/ccc?key=0AqtCUOT5AqgCdDhlRW1XcU1FXy1vTXdZWFB5Um82Rnc
With exports growing this rapidly, there is clearly a massive structural shift underway, which will soon begin to cut at unemployment levels. What about the wider budget balance?:
https://docs.google.com/spreadsheet/ccc?key=0AqtCUOT5AqgCdFU2S0stSjNrUWZnN1ozNUtFd2JhQUE
Ah, it’s already gone. Imports have nearly recovered to pre-recession levels, but haven’t soared to the extent that exports have. The trade deficit has almost completely been eliminated – it is now smaller than it was in the years prior to Spain’s joining the eurozone.
Spain is clearly very competitive within the eurozone at current real exchange rates. Spain clearly benefits from rapid productivity catch up, and from the benefits of high trade and trade arbitrage that eurozone membership facilitates (compare eurozone trade volumes to those of non-eurozone countries). It just takes time to shift the world’s largest army of construction workers to export industries.
What’s different between Spain and Mexico/Argentina is the mechanics: the latter both had their currencies in circulation. This is the point that Paul Krugman has made: Spain will not only have to devalue, but also reintroduce its own currency, bringing a much harder adjustment. But of course it’s going to happen anyway.
By the way: at the height of the GFC, in 2008/09, I heard EU civil servants talk of the possibility of “Northern Euro” and “Southern Euro.” I don’t think it was seriously discussed, and don’t know whether it is now, but such ideas were floating in the EU circles at one point.
Thanks for the great analysis!
Absolutely excellent analysis Prof. Pettis!
I echo the sentiments above about clarity of writing, structure of argument and persuasiveness of your conclusions! Brilliant!
I hope you are invited to put together an Op-ed for the FT on this topic, your background in the Latin American fields adds an extra spice to this post that reminds us of the “history repeating” truth.
Thank you!
Love the FDR quote. I’d like to ask Wen Jia Bao the same questions Alice asked Humpty.
Dear Prof. Pettis,
I really enjoy reading your posts very much. But isn’t it a little bit too simple to relate everything about competitiveness of a country solely to the currency exchange rates? What about the structure of exports, quality issues, existing supply chains, etc.?
One other option. Though the Germans won’t allow this either, so maybe that’s why it’s OK to ignore it. The ECB could give (give, not loan) each Eurozone country 10,000 Euros for each citizen with the requirement that the money only be used for debt paydown. The effect would eliminate probably 20% of overall debt and create some inflation. My guess is that this combination would be sufficient to get all the countries except Greece out of this death spiral. Maybe someone could do some better calculations and say, “No, this needs to be only 6,000 Euro” or “No, it would have to be 25,000 Euro”. I’m open to suggestion and not fixated on the precise number of Euros. But I do think a plan like this could work.
Excellent piece. Basically, I have to agree that this is the most likely scenario.
Calls for Euro devaluation like the one above seem unlikely to me, both because the ECB is institutionally unable to accommodate the inflation that would imply and because Germany is not likely to accommodate that politically. Further as an investor I don’t see a great deal of pressure for an overall Euro devaluation; the current account is close to balance, Spanish Euros are not leaving the Eurozone for the most part they’re becoming German bank Euros, and as long as it seems likely that Greece and Spain leave the Euro the prospects are for the currency to get stronger. As soon as Greece/Spain leaves the the remaining Eurozone’s current account moves further toward surplus and a stronger currency.
@32 OGT,
How can it stop after Greece and Spain? When Italy sees that Greek and Spanish debt/unemployment are dropping because they can devalue and print their own currencies, they will want to leave too. The only people left at the end of the day might be Germany, Austria, and the Netherlands.
I think it’s impossible for the ECB to credibly say “Greece and Spain are out, but the next time there’s a debt crisis, we promise to backstop all sovereign debt”. “Next time” might be even worse that this, why would the ECB take that gamble?
“I want to stress that these are, practically speaking, the only three ways for Spain to regain competitiveness. There are other ways that could in theory also work, but they are too unlikely to consider.”
But as none of the three ways discussed is “likely” at all, might one not as well discuss the other “unlikely” options too?
Is it not, for instance, possible, relatively simple, and politically feasible to construct a mechanism that would adjust for differences in productivity among the Eurozone nation by adjusting all wages on a yearly or quarterly basis according to the national or regional unemployment rate?
President Hollande of France has taken what could be a step in this direction by cutting cabinet salaries by 30%. Now if this were to be applied across the board, France would, at a stroke, be largely free of her economic difficulties. The cost of living would fall, unemployment, and with it the cost of welfare programs, would fall, the government deficit would fall, while international competitiveness would increase.
Add to an automatic wage rate adjustment mechanism, a wage subsidy program, which avoids the problems associated with a negative income tax, and full employment could be restored, while the small and medium enterprise sector would have the benefit of a level, or more nearly level, global playing field, so far as labor costs are concerned.
Together these measures should initiate a virtuous cycle of rising output and declining costs able to restore Europe to prosperity without importing millions from the third world to provide cheap labor for jobs “Europeans won’t do.”
PS, is there censorship here of discussion of “too unlikely” alternatives, or have my comments been place in indefinite moderation because they contained hyperlinks?
Oops, sorry, missed it. Please delete my last two comments “in moderation.”
If Spain and Italy get out of the euro, France will go too. Not only because of market pressures, but mostly because they will sudenly find the prospect of living under a currency union where the weight of Germany will be huge to be very, very unanpealling…So, I think that either Spain stays or the euro is over…
Carlos,
I think you missed the point of the quote.
Adam- Let me be clearer. I was responding to Daniel above, who seemed to be calling for a Euro wide depreciation and questioning its current strength. I believe that a Euro break up is likely, but that Euro’s in Germany or the Netherlands will become a stronger currency. So there is no market pressure on the overall Euro, just on Spanish/Greek banks.
Excelente análisis. Muy necesario políticamente para luchar contra el papanatismo europeista que aún domina la escena política en España. Gracias desde Madrid!
Excellent analysis. Very useful from a political viewpoint to fight against the legion of pro-european zombies that still dominate the political scene in Spain. Thanks from Madrid!
Spanish. We need to convert the economic crisis in a political fight. Germany’s policy is pretty obvious: total domination. They couldn’t care less about the rest of Europe. I’m not against austerity. We’ve been real sinners, living in a phantasy of false prosperity and economic bubbles. But the brutal and endless austerity that Germany is dictating now is politically motivated, will bring nothing at all for us and must be fought. We urgently need an anti-european party in Spain
The author makes some very valid points,but unfortunately it manifest much political bias. 1)The Rajoy gov’t has an absolute majority and although less popular-having to confront the disasters of the Socialist-would still win again if elections where held tomorrow. 2)The new gov’t is engaged in the most drastic
spending cuts and labour reforms in Spanish history(painful,but necessary). 3)The
author’s supposed “war on the middle class” is a smoke screen for an attack on the
Partido Polpular which he clearly opposes! Give the reforms time.
The Germans do understand one thing,if Spain abandons the euro,so too will Italy.And with the 4th and 5th largest European economies no longer in the monetary union,for what purpose does the Union exist?
CS , Cutting salaries will deflate the economy and will increase the debt like the Prof
said. Europe ,except maybe for Greece, has a competitive problem not liquidity problem. Humpty -Dumpty canot be saved. I know, you all want to preserve it like it is but that economic model has reached it end.
I voted for Rajoy and I would do it again, even after all these dramatic months. The Spanish voters agree with the idea that we must clean up the house. The reforms are not “popular” but there is a wide consensus that we need to change, reform the state and be more responsible. Unfortunately, there is also a growing feeling that no matter what we can do, “the markets” will punish us anyway. That somehow we’ve been financially condemned and nobody will do anything about it. ECB, Germany… Nobody. The side effect of this realization is the death of the “europhilia” in Spain. At last. Better late than never. What we have to do now is to transform this new feeling in a political force or we will have our local version of the greek Golden Dawn in less than two years
Great analysis, as always. But Germany leaving the Euro should be treated as a separate (and highly preferable) option, not as just the equivalent of Spain leaving–any more than Germany inflating is just the equivalent of Spain deflating. In theory, all else being equal, the effect on current account balances may be the same, but in practice the mechanism and collateral effects would be very different, e.g. with respect to deposit runs, to ongoing trade among the periphery states, and to whether a legal default on Euro obligations was required.
@Stan,
“Cutting salaries will deflate the economy and will increase the debt like the Prof
said.”
I don’t believe the Prof. did say that. He said that devaluation would raise debt to GDP, which is something else.
Cutting salaries should reduce unemployment and thus increase output, which will raise GDP and lower the debt to GDP ratio.
What Professor Pettis does assume is that wages can only be lowered through austerity measures that raise unemployment and thus cut output. But if you look at my proposal you will see that it would reduce unemployment while lowering wage costs (at the bottom end of the scale) without reducing wages below whatever the EU minimum rate may be. In so doing it would provide an investment incentive to the small and medium enterprise sectors, as they acquired a cheaper source of indigenous labour.
But what about the peace that concluded WWII? Has everything changed and the US to guarantee perpetual security? What about Poland? How will Europe rearm once the USA leaves? The current crisis is a manifestation of the breakdown of the peace of Europe, it is not debt or economics.
@48 CS,
But then these lower paid workers have lower purchasing power, from imports especially but also in domestic goods. It will take some time for prices to drop on everything from produce to clothes to reflect the lower wage base, and in the meantime low paid workers are spending a huge percentage of their income on food and housing instead of other consumables. Their ability to service personal debts is also diminished. So their efficacy as consumers is greatly reduced, reducing their usefulness for tax extraction and supporting domestic manufacturing and services. It’s a cyclical trap then where workers are too poor to buy goods, and factories are too poor to hire workers.
How can you increase output while lowering salaries? It would have to be strictly export led growth, which only benefits a specific segment of the Spanish economy. Spaniards buying for use in Spain wouldn’t have the purchasing power to sustain the recovery.
Your idea of wage controls in your blog is intriguing, but that would mean enormous intervention of the state in the economy, something like the Soviet Union. Reducing benefits when unemployment is high runs the risk of the consumption-production trap I mentioned above.
Reduce spaniards’ salary by half and let them work 12 hours instead of 6H will resolve all the crisis in spain. Blaming germany for being too competitive is not a solution. Imagine what would happen if we were living in the middle age? All spaniards would be working as slaves for their german masters.
Thank you for the great analysis. Interesting to hear that you grew up in Spain, as we’ve been living there for a couple years now, and your mentions of Spain always seemed a bit too close to the mark for most international commentators.
I think there are two factors that you didn’t mention that might change the dynamics significantly:
One is the political control of the ECB, which given the current voting structure, an outnumbered Germany would not be able to put the brakes on inflation.
The second, is the beginnings of a property boom in Germany. Talking to friends back in Germany, I’m starting to see a big surge in interest in real estate. Some of this is driving by the idea that it might be an inflation hedge, in additon to record low interest rates, and the fact that Germany sat out the last European property boom (perhaps indigestion from reunification). If Germans start to go crazy about real estate investment and see the values of their homes skyrocket, I wonder how hardcore they would be about keeping inflation down.
@santcugat
And indeed, how many Germans would cash out on their rising home values to buy cheap Spanish property? Especially with a falling German population and a record number of people retiring.
With German wage growth above 4% in the past year, and the German economy booming, there might be a recovery in tourism in Spain/ Italy/ Greece.
Other upside trends include booming Spanish exports, supported by very good Spanish productivity performance and falling unit labour costs. By Eurostat figures Spain will be a net exporter of goods and services either this year or next.
Things will be bad this year because of the increased pace of fiscal tightening – but Spain’s long term future in the eurozone looks both secure and strong. Spain took one hell of a structural hit – losing 10% of GDP through the direct effect of reduced investment alone (with wider implications for tax revenue and aggregate demand).
Yet Spanish GDP is only 3.2% down on its pre-recession peak – whilst a massive structural shift away from investment created high unemployment (worse than in other countries with far deeper loss of output), Spain has successfully rebalanced (and continues to rebalance) towards exports and other economic activity.
“In 1993-94 of curse we were told that this was why Mexico could not possibly devalue, and in 2000 and 2001 this was why Argentina could not possibly break the currency board.”
Perhaps more interestingly, am sure this is what was being said before Spain’s devaluations within the ERM in 1992 and 1993 . Is there a more relevant analogy out there?
An excellent synopsis.
What is amusing – in a grimly ironic sort of way – is that I and my fellow Austrians have been saying for the past four years that the losses had already been irrevocably been incurred DURING THE BOOM and that the proper response to the crisis was for both debtors and creditors to recognise this as soon as possible, to take their lumps, to roll up their sleeves, and to get on with rebuilding their wealth, aided by the removal of as many microeconomic impediments as possible and absent ANY and ALL macroeconomic fiscal/monetary conjuring tricks, designed as they were merely to camouflage the bitter truth and to perpetuate the illusion that all was not as bad as feared.
The dominant, Keynes-influenced mindset among the Nomenklatura (yes, Mr Krugman, this means you), of course found this to be utterly unpalatable (principally, one suspects, because it did not leave its proponents with much of a role in explaining or enacting such a grown-up policy).
Having seen our no-nonsense approach initially parodied as being ‘Austerian’ – and having endured the insinuation that we were the new Brunings, all set to usher in the next incarnation of the German Reich by mindlessly refusing to implement what are palpably Hitlerian (or, at least, Schachtian) economic policies – we see that the truth is at last beginning to percolate through the semi-permeable mental well-springs of the punditocracy.
It may well be that, as Mr Pettis makes plain here, the prevailing political orthodoxy is such that its practitioners had to exhaust all other courses before beginning to countenance this, the only choice to offer any hope of relief, but, if we are to limit the cost to no more than the already appalling, post-Lehman reckoning of trillions of wasted dollars and 100s of millions of blighted lives and livelihoods, we can at least move from its belated contemplation to its rapid and resolute implementation with as little further delay as possible!
Another excellent piece Mr. Pettis.
I would argue that there is a fourth way that can help to reduce de current account imbalance. Spain could use fiscal policy to drive changes in consumptiom that have a primary effect on imported goods, for instance: fossil fuels. Increasing taxes on gasoline (sharply) would reduce gasoline imports. Other taxes on energy consumption would also help. For instance taxes that could reduce electricity consumptiom in summer (too many refrigerators indeed). Although gas-guzzlers pay higher taxes than more efficient cars, there is room for increasing them more.
These days, the balance of goods of Spain would be neutral if we excluded energy goods (fossil fuel imports). Actually the problem these days is the balance of rents which is deteriorating a lot.
Cutting salaries by 30% would cut tax receipts which in turn would skyrocket the debt. The mortgage defaults would increase and would break the Spanish Banks which are up their neck in sovereign bonds. In turn would create more layoffs
in banking and financial services which would further cut receipts. The Banks would need to be bailout. And you still
have no resolution to the debt problem or forgiveness. But it would bring the crises
to a more speedy resolution.
@ ecodelta 4
Please, could you explain why you see that euro exit would be a long and grueling process? In my opinion if the exchange to a “neopeseta” was to be done, it had to be done overnigth! If you meant to say that the effects would linger… of course! the effects would be permanent! Nevertheless, I believe that the euro exit would have a sharp and sudden effect, not a long grueling one as you seem to believe. The long and grueling path is the one we are following hopelessly rigth now.
Ignacio.
I mean long and grueling until the final decision is taken.
A really brilliant analysis …
“Perhaps the greatest irony of a “euro (crisis) made in Germany” is that failure to prevent asymmetric shocks potentially arising from wage divergences, amounting to nothing else but following through the original thrust of monetary cooperation in Europe directed at forestalling competitive devaluations, has much increased the required scope for fiscal union in ensuring the euro’s future survival. There is a non-negligible risk that the political process may not produce timely decisions before ECB liquidity runs dry.”
Here is more on “The Euro Debt Crisis and Germany’s Euro Trilemma”, just published by Joerg Bibow as Working Paper No. 721, Levy Economics Institute of Bard College:
Research Associate Joerg Bibow argues that the eurozone crisis is not primarily a “sovereign debt crisis” but rather a twin banking and balance-of-payments crisis. Intra-area competitiveness and current account imbalances, and the corresponding debt flows that such imbalances give rise to, are at the heart of the matter, and they ultimately go back to competitive wage deflation on Germany’s part since the late 1990s. Germany faces a trilemma of its own making and must make a critical choice, since it cannot have perpetual export surpluses, a no transfer / no bailout monetary union, and a “clean,” independent central bank. Austerity, says Bibow, has made the situation worse by adding a growth crisis to the potpourri of internal stresses that threaten the euro’s survival.
http://www.levyinstitute.org/pubs/wp_721.pdf
Could you please allow us to Like your articles on Facebook so that our friends can educate themselves on the realities of economics, can understand the situation better, and can then make properly informed choices at the ballot box?
I have learned everything I know about how the world works from your articles, and they (and you) are MUCH appreciated.
Spain’s problem is the Euro and the austerity being forced on it, basically as part of neo-liberal economics (amplified by the Germans), which has to be considered a religion at this point. And one that empirically has it all wrong. Without the Euro, Spain could deficit-spend in its own currency to support the demand-shock from the housing bubble. The fearsome bond traders would be irrelevant. Spain could live at a level consistent with its productivity, which at full employment would be pretty high. It really is painful watching people torturing themselves because the monetary system is screwed up, which frankly has nothing to do with technology, natural resources, education of the population, etc., which are the real sources of ‘wealth’.
@ ecodelta
Spain will have still a long and grueling process even if goes to “neopeseta.” because it has an external debt which the creditors cannot cut without having a bailout of their banks approved by their respective countries. It is not easy to have say Germans, Dutch etc vote to bail out their banks to give a cut to Spain. In addition,Spain will have a new debt created by support for unemployed, shore up their banks and provide the stimulus for growth. Once creditors are burned, it will be difficult to obtain monies from abroad. Who will pay in Spain for the remnant of existing loans and new loans will determine the length of grueling process.
Maybe there is another way, the beg thy neighbour way.
They will play this endless and frustrating game within the Eurozone until the EUR becomes way weaker.
This event must be accompanied by price controls, nominal growth, higher wages in Germany which are coming, higher inflation that should be obtained by the devaluation and wage control in non-German countries.
Of course this doesn’t solve the internal imbalances within the Eurozone. But no need they’ll keep most alive and kicking until they achieved their target of a much weaker EUR.
@ STAN 67
The money you need to pay unemployment benefits is printed by the new monetary authority if needed and stored in its balance sheet until it is time were a surplus can be acomplished without pain.
@Adam 51
“But then these lower paid workers have lower purchasing power, from imports especially but also in domestic goods. …”
Well, what’s the alternative? Would raising wages solve all problems!
Cutting wages seems a better bet than devaluation which is what and exit from the Euro will mean, since not only will real wages fall but import costs will immediately rise.
“How can you increase output while lowering salaries? It would have to be strictly export led growth”
There would be import substitution also.
“Your idea of wage controls in your blog is intriguing, but that would mean enormous intervention of the state in the economy, something like the Soviet Union”
Why “enormous intervention”? Why like the “Soviet Union”? Temporary wage and price controls have been applied repeatedly in the US and elsewhere in the West during the last 50 years.
If all wages, from those of cabinet ministers and judges to those of minimum wage worjers, are raised or lowered by a small percentage each quarter to reflect the current unemployment rate, it would require only some rather minor clerical measures to implement.
Some employers might fail to cooperate, but only if they face a labor shortage, and in that case their non-compliance would be harmless.
Can a restructuring of debts not take place within the EU? It seems automatically implied that a restructuring of debts can only occur once the Euro is abandoned. I am not sure this is the case. Or does this have something to do with avoiding triggering CDS’s?
On anther note, as per Bloomberg…….
When German banks pulled money out of Greece, the other national central banks of the euro area collectively offset the outflow with loans to the Greek central bank. These loans appeared on the balance sheet of the Bundesbank, Germany’s central bank, as claims on the rest of the euro area. This mechanism, designed to keep the currency area’s accounts in balance, made it easier for the German banks to exit their positions.
Now for the tricky part: As opposed to the claims of the private banks, the Bundesbank’s claims were only partly the responsibility of Germany. If Greece reneged on its debt, the losses would be shared among all euro-area countries, according to their shareholding in the ECB. Germany’s stake would be about 28 percent. In short, over the last couple of years, much of the risk sitting on German banks’ balance sheets shifted to the taxpayers of the entire currency union.
——–
If it is Spain to leave the Euro, then this would drastically increase Germany’s ECB stake. In addition, France, who’s banks did not follow Germany in exiting would be exposed by both their domestic banks holdings if Spanish debt and there responsiblilites to the ECB. France, and it goes without saying Italy before them, would suddenly have to face the question of staying or leaving the EU. In light of domestic and ECB exposure membership in the Euro club is going to become a real hot potato. Germany might even preempt the exit of Greece, Spain, Italy, France, Ireland and Portugal by leaving first as a means to limit exposure.
I love that article, it will stand the test of time.
CS, can you give government that power and expect it to be relinquished? You cited a few Examples like minimum wage, however that and any other cases are populist cases. Either wages are being regulated UP or prices are being regulated DOWN. The reverse can not be swallowed by a democracy, except a phony democracy like the Soviets had.
@ Ignacio,
Every debt has to covered by a bond bearing interest, even unemployment compensation. Otherwise, you could print your pesetas yourself and see who will
take them. Who will buy your bonds and at what interest. I do agree that some
of the debt can delayed for repayment. But ,you all will have a Big debt that just
thinking of this drives me to drinking. And at every end of economic cycle, anything
you do has very diminished returns until the cycle is reversed.
“… Germany might even preempt the exit of Greece, Spain, Italy, France, Ireland and Portugal by leaving first as a means to limit exposure.”
That would be a good solution…
Let the “neue DM” go skyrocket in value, and many imbalances in the EU will be automatically corrected.
@71 CS
I don’t have a perfect or even “good” solution for this. I think taking away people’s ability to service debts is bad business though. How do you resolve that problem with low wages?
I am more pro-inflation than pro-austerity, since inflation benefits the debtors, and there are certainly a ton of those in the PIGS countries. Imports would become very expensive, yes. Oil would be problematic of course, but domestic industry would be stimulated as a result. It goes against the principles of a globalized free market economy, sure, but I don’t know what other choices they have. I also don’t think the constant adjustment of wages based on unemployment rate is good because it removes economic certainty. People might suppress the desire to buy new houses or machinery because wages and prices might be lower next month. The whole idea seems like a deflationary death spiral. At least with a low, stable rate of inflation there’s some incentive to consume, and some predictability.
@76 ecodelta
This is what makes me wonder why so many Germans talk tough on Greece. If they left the Euro they’d be running account deficits before you know it. If Germany left, it would give a lot more breathing room for inflation in the Euro, but if Germany stays, it’s going to keep pushing austerity on nearly every country in the EZ. More countries would benefit from inflation than would be harmed by it, but majority doesn’t rule here.
I think the problem with Germany is that it suffers from “Inflation Paranoia”.
Something happened in the lates 20s and early 30s, in the past century, triggered by hyperinflation, that eventually ended very badly for the country……
But paranoia, whatever the source that provoked it, is not a trustful counselor. Better go to the psychiatrist, follow some treatment, than making others suffer the consequences of Germanys inflation paranoia.
@ecodata
“Inflation Paranoia”. I like that one.
Runaway inflation can have two sources imo: first it is induced willingly by the government (as in Germany in the twenties) or the consequence of utter corruption and incompetence (Zimbabwe).
The German elite succeeded in brainwashing the German public that inflation is bad and must be avoided at all cost. Well who’s the beneficiary of such belief?
Or another kind of Selbstunterwerpung by the German common guy.
Professor,
Looks like The Economist dedicated a whole issue to refuting your beliefs. Just got this week’s issue and it looks like they are very eager to win that bet
Two questions:
1) what difference would it make if germany agreed to eurobonds? Let’s assume it is on the basis of the bruegel blue bond proposal with eurobonds ranking senior and capped at 60% of gdp. http://www.bruegel.org/publications/publication-detail/publication/509-eurobonds-the-blue-bond-concept-and-its-implications/
2) if the crisis is strung out until the end of next year, what difference will the european elections make? Note that the elections will choose the european commission president for the first time. Any scope for an fdr figure to come to the fore? http://en.wikipedia.org/wiki/European_Parliament_election,_2014
@ STAN
OK, the debt must finally be paid but it is wise to dely it until growth reduces the debt burden. That will only work if during the private deleveraging period, public spending keeps things going. Austerity just makes the burden of debt to worsen, particularly private debt (unemployment rises, salaries tend to go down faster etc…) and at the end, you have a high debt/income ratio both ways: spending or being austere. If you follow the “spending route” it is possible to inflate your way out of the debt trap although the state will have to end being austere one day. The other way will surely end in an impoverished country and a default. I just prefer to try the first.
Two problems in Spain: 1) banks have not been keen on facilitating private deleverage and haven’t been forced until recently. 2) now that private deleveraging is beign forced is when we should stop cutting public spending until the private sector can recover.
Nevertheless it is interesting to me to see that people in general tend to be very restrictive with public spending while completely liberal to what any particular or corporate can do as if private spending could never be harmful for the aggregate. Even worse, it is generally accepted that goverments can or will become indebted in the rescue of banks, or in the worst scenario, the rescue of banks has to be done at the cost of expenses in education, health and any kind of investment. I am astonished to see that rescuing the banks at expense of the taxpayer (bondholders seem to be sacred cows) is seen as necessary as to cut any other public service.
Dear Prof Pettis,
I’ve long been an avid reader of your blog, even though I unfortunately don’t have the time to catch up on every entry, and I’m a huge fan of your way of argumentation that so many people seem to lack.
Given that I find that Germany is the only country in the EU whose current account balance is positively correlated with the Euro, I was wondering if you have any explanation as insightful as your blog entires, and if you think that a depreciating Euro (to $1.1 or parity) would be enough to reverse this imbalance in Europe in the medium term?
Oh, the Germans this, the Germans that… Of course it is always good to have someone else who is guilty.
We had easing for quite a long time. Since Greece is in the euro zone it is basically on QE because before the Greek government was paying well above 15% on the 10Y back in 95. This was the natural backstop for the politicians and the cheap money brought us into this mess in the first place. And now they will bring us out right?! Because …. don’t see the arguments folks!
It is not the inflation paranoia that I am seeing (1trillion in LTRO just recently … hello! ). It is a deflation paranoia what I actually see! Everybody seems to want inflation incl. ze germans (the bundesbank governor spoke of higher inflation rates commeing just recently)
The economic data presented by Schaun actually are very promising. We had easing for so many years and after 2 years of austerity everybody thinks ze germans are as bad as in the WWII movies and deliberately are aiming at everybody else by not willing to pay the bill for the next doses of free money. Guess what, it is not clear that this is the remedy! So far is clear – look no further than the new NFP data in the US.
http://www.afr.com/p/opinion/give_austerity_chance_6samDqB1QvlwmVz7iIoDAI
ps Kind of like the idea of Bill for 10,000 for everybody to pay down debt. It is probably not the final solution but saves the day. Most importantly after this we should have real backstops for not running into so much debt again.
@ Ignacio,
We in US rescue the banks because we love them, but others say because private industry contributes over 80% of national GDP. So in order to stimulate the economy the small, big enterprises need some source of funding and the banks do a good job to manage a risk when profits are not extreme. Otherwise small enterprises would have to forgo expansion or innovation or would seek foreign investment and risk foreign takeover. We even rescue big insurance companies.
Besides, someone might want to buy a Spanish hacienda, who will finance it?
“Another possibility is that we suddenly see a rapid and dramatic move towards full fiscal union in Europe, in which sovereignty, for all practical purposes, is fully transferred to Brussels”
They are trying!
Mpettis.com’s depressingly infrequent updates.
@ STAN 86. So, you are telling me that american taxpayers love to rescue their banks and bondholders at the cost of their taxes and employment because the banks are so essential to the economy… and you want me to believe that?
Oh, come on. By the way, I suspect that you work in or for a bank.
I find this article a bit biased. This may be due to author’s spanish backround. The article lays the fault of Spanish problems on Germany. Overspending, increasing costs and bad investment decisions are done by spaniards themselves. It is true that economic environment created mainly by Germany has contributed to this behaviour. So there is a bit fault on us all.
It’s not time to blame any nation. It’s time to consider what is the best option for the Europe as whole. Europe needs strong german economy to be competitive. The first option presented here means depressing German economy, which is not good for Europe.
We all acknowledge the German excellency in technology and production, which is a basis for strong german economy. This could serve as a basis for still another solution:
1. using internal devaluation as a basis for regaining competitiveness of troubled countries
2. using excessive german savings as investments in real production facilities in troubled countries
3. speading best german practices and knowhow to these countries.
Current austerity solutions have had only the first. This way troubled nations would get means to pay back debs and regaining their competitiveness. This would also mean a new role for Germany inside European Union. In this way every country inside EU would gain and the competitiveness of the whole Europe would improve.
Tarmo Lindvall,
Helsinki, Finland
Maybe I missed it in the comments, but what will happen to economic conditions in the United States when the euro-zone collapses? Will we see another financial downturn circa 2008? Rapidly rising interest rates? What should one do to prepare for such event?
Spain CA deficit was 10% in 2008, 4.5% in 2010 and 3.5% in 2011. This I would think is almost equal to the interest it pays on its debt. What if it can finance this debt (ECB funding via its banks or otherwise) to say c 1-2%. This alone could reduce the CA deficit to 1-2%.
Then Germany is now allowing wage increases – may not be massive, but certainly higher than whats going in Spain. So a continuing trend of improving CA with Germany is in the cards.
Finally EZone is at 0.5% CA deficit. What if some lax monetary policy drives euro down a bit, and whole EZone goes into a small surplus.
All in all doesnt seem that hard to get positive CA for Spain. Cannot see why you are so grim!
“How does this process work? It turns out that it is pretty straightforward, and occurs during every one of the sovereign financial crises we have seen in modern history. When a sufficient level of doubt arises about sovereign credibility, all the major economic stakeholders in that country begin to change their behavior in ways that exacerbate the problem of credibility.”
I remembered these words of yours today while reading someone else’s article. Fantastic! I usually take two or three visits to muster the attention span to gety through each post, but the effort is consistently worth it.
Thanks.
The Euro will be saved at all costs, or it will be reborn in the same way the dollar has been transformed many times during America’s history, but they will never split up the union.