Europe's Catch-22 Situation Finally Losing Its Edge?

by: Shareholders Unite

Kenneth Rogoff argues that there is no simple Keynesian solution to the long recession in Europe:

There is no magic Keynesian bullet for the eurozone's woes. But the spectacularly muddle-headed argument nowadays that too much austerity is killing Europe is not surprising. Commentators are consumed by politics, flailing away at any available target, while the "anti-austerity" masses apparently believe that there are easy cyclical solutions to tough structural problems.

This recession has now lasted longer than the depression in the 1930s. Rogoff is right, of course, the economic problems in the eurozone largely result from the euro, which is functioning as the Gold Standard in the 1930s which leaves the periphery without policy levers to pull them out of the mess.

Even if the peripheral countries would want to stimulate their economies, they can't. They can't devalue, they cannot inject a monetary stimulus and the money supply is barely growing or contracting without them being able to do much, if anything, about that. Many of their banks are woefully under-capitalized and therefore they are not lending, exerting further deflationary pressure on the economy.

By virtue of rescue programs and ECB standby programs, they cannot inject fiscal stimulus either. But it really isn't that simple. Rogoff catches an essential element of the eurozone predicament:

Temporary Keynesian demand measures may help to sustain short-run internal growth, but they will not solve France's long-run competitiveness problems. [Rogoff]

Indeed. However, not only France suffers from this problem, the whole eurozone periphery does, and this problem was in large part a creation of the euro itself. The removal of exchange rate risk and increased credibility of monetary policy led to an inflow of capital from the center (banks) to the periphery, where it created a boom and inflation differentials started to build up as a result.

The end result is a rather intractable problem leading to some very awkward policy choices. We formulated it as follows all the way back in September 2011:

And here is where a nasty catch-22 euro problem lies. To regain competitiveness, wages should fall by roughly 30% (and considerable efforts are made in this direction in various countries, in effect). However, the resulting deflation (which has not really materialized yet) would increase the real value of their debt burden.

This really is an awkward problem, more than one and a half years later, were do we stand? Basically the policy choice was to repair the competitiveness problem in the periphery by 'internal devaluation' (that is, reducing unit labor cost in absolute terms, or at least relative to the core countries).

Whilst real deflation hasn't (yet?) arrived (apart from a little in Greece), but the economic contraction which was a result of this policy choice has wreaked havoc on real debt burdens:

nominal GDP - tracked by monetarists as the key indicator in sovereign debt crises - fell 1.8pc in Spain and 1.2pc in Italy last year. This means that the debt burden is rising fast on a contracting base [Telegraph]

Italy's debt/GDP ratio was already high but is rising again now they are forced to embark on austerity and the result is that the ratio is now approaching 130% of GDP.

What's happening in Greece (or Portugal, or Spain, or France, or the Netherlands even) isn't more encouraging. After an unprecedented 100B euro write-down of public debt and an almost 30B euro buy-back (with bail-out money):

From €355 billion or 170.3% of GDP in 2011, Greece's debt fell to around €303 billion in 2012 or 156.9% of GDP, according to the Greek statistics agency. But it could climb to 175.2% of GDP this year according to EU estimates as Greece's recession-hit economy continues to shrink. [eNCA]

You see that the effects even drastic measures like writing down and retiring 130B euro in debt is quickly annihilated by a shrinking economy. The eurozone is chasing its own tail here.

Was there a better way?
Well, that's debatable. It is sort of understandable that, given the very awkward trade-off between deflationary policies that would restore competitiveness but increase debt burdens, or inflationary policies that would do the opposite, the periphery 'chose' (that is, was forced by Brussels and Berlin) to chose the deflationary route.

Inflationary policies in the perhiphery would have worsened competitiveness. As long as the competitiveness problem isn't solved, the euro crisis remains so it was a logical choice. Also, not everybody was aware of the large size of the fiscal multiplier under the present conditions (deleveraging, liquidity trap), and some still believed in the 'confidence fairy,' the mythical expansionary effect due to 'increased confidence' as a result of public belt tightening.

Also, despite "Rogoff and Reinhart," we know from historical evidence that debt levels can be significantly higher still. The UK build up debt upwards of 140% of GDP post world war I (ERO, ULE, URR, EUO, DRR, EUFX) and even higher after WWII). Debt levels usually melt away with economic growth and a modicum of inflation, as the Japanese are now trying to melt away their 230% public debt/GDP ratio.

However, from the UK post WWI, we also know what not to do. Sean Whealan summarizes an IMF survey on how countries dealt with high debt post WWI:

Britain's post-war policy of returning the pound to the Gold Standard at pre-war parity to restore trade prosperity and prestige, and pay off debt to preserve creditworthiness, proved disastrous. The government imposed savage spending cuts, ran a budget surplus of 7%, and continued the high tax levels introduced during the war.

The Bank of England raised interest rates to 7%, to return the pound to pre-war parity, while severe deflation led to very high real interest rates. Economic growth was very weak, averaging 0.5% a year, well below competitor countries. Economic output in 1938 was barely higher than in 1918. And that was not the fault of the great depression - in 1928 output was actually lower than in 1918...

This leads him to conclude:

The warning of Britain then is that countries attempting a so called "internal devaluation" - an effort to bring down prices to
become more competitive - do so at considerable risk. High unemployment, low growth and rising debt were the outcome.

Difficult to disagree with that. So to answer the question above, yes, there was a better way. The center, not the periphery had to embark on inflationary policies. This would have lessened the demand shock from deleveraging and made the relative adjustment of unit labor cost across the eurozone that much easier. Here is Kate Mackenzie from FTAlphaville:

Internal devaluations tend to only be successful against the backdrop of higher inflation elsewhere.

Indeed. What's worse, the periphery could have used the breathing room to implement structural reforms that increases their competitiveness as well, now most political capital has been gambled away on austerity efforts that have proven rather futile. How long their populations will tolerate the resulting situation is anyone's guess.

Has competitiveness improved?
Well, yes. Trade balances have improved quite rapidly in the periphery, but this is mostly a function of austerity reducing growth, which also depresses imports. There is even fairly convincing research out there (by Gaulier et al.) that suggested that the bulk of the wage inflation in the eurozone periphery occurred in the non-traded sector, that is, competitiveness was never so badly affected by euro induced capital inflows in the first place.

Some adjustment has taken place, trade balances of the peripheral eurozone countries have improved a lot, although that is mostly the result of the depressed state of their economies. But unit labor cost are also coming down:

Together with Gaulier (et. al)'s analysis, we should perhaps slowly arrive at a conclusion that competitiveness is less of a problem, which means that the Catch-22 trade-off is losing it's sharp edge. Now that the center is also losing a great deal of economic steam, it becomes all the more urgent to reflate the eurozone economies from the center, and most notably from Frankfurt.

Apparently, the ECB is considering buying asset-backed securities in order to improve credit provision to small and medium sized companies. Excellent idea. What are they waiting for...

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.