Why the Eurozone Is Heading for a Double Dip

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 |  Includes: EWG, EWP, SNF
by: Edward Harrison

The Bloomberg video is a bit sensationalist in my opinion. But it gets to the heart of the problem in Europe, namely Spain. Spain has an economy and debt which is an order of magnitude larger than Greece. That means that problems in Spain are more critical than in Greece. But it also means that an EU bailout would simply not be feasible.

Watch the video and I will make a few other remarks below.

The first thing to realize is that government deficits are balanced by imports and private savings. I’m talking here about the financial sector balances, of course.

financial-sector-balances-eu

The chart to the left from the FT shows you that the collective financial balances in each individual eurozone country must sum to zero. Where there is a government surplus it is matched by either the capital account or private balances. The same is true for deficits. Take Spain, for example. There, the government’s budget was in surplus in 2006 and it had a very large capital account surplus (the financial sector equivalent of a current account/trade deficit). This was matched by a substantial private sector deficit. By 2009, due in large part to an unprecedented housing bust, the government’s finances were in tatters. Look at the chart. This is matched by net private sector savings and a capital account surplus. The financial sectors must balance.

This brings me to the second thing to realize. Spain is to Germany as the United States is to China. In a fixed exchange rate environment, the U.S. is running an astonishing current account deficit while China runs an equally outsized surplus. Similarly, you can’t have Germany and Spain both running current account surpluses, unless the EU as a whole runs a current account surplus. So, if Germany (or the Netherlands) wants to be the export juggernaut and run a massive current account surplus, this has intra-EU ramifications. The most important is that Germany’s (or the Netherlands’) current account surplus (capital account deficit) is matched by current account deficits (capital account surpluses) in Spain (Portugal, Greece, Ireland and Italy). That’s how it works, folks. You sell more to me than I do to you and I get more cash than you do. There are always two sides to every transaction. It’s right there in the data.

The FT’s Martin Wolf is on to this and notes in his column:

In the short run, it is impossible to shift external balances quickly, particularly when domestic demand in the surplus countries is so weak.

Now Germany insists that every country should eliminate its excess fiscal deficit as quickly as possible. But that can only happen if current account balances improve or private balances deteriorate. If it is to be the latter, there needs to be a resurgence in private, presumably debt-financed, spending. If it is to be the former, there are two choices: first, current account balances must deteriorate elsewhere in the eurozone, entailing a move to smaller private surpluses in countries like Germany. Or, second, the overall balance of the eurozone must shift towards surplus – a “beggar my neighbour” policy.

In practice, the most likely outcome of such fiscal retrenchment would be a slump in countries with large external and fiscal deficits. Given the lack of competitiveness of such external deficit countries and the weakness of demand elsewhere in the eurozone, such slumps might become very long-lasting. The question is whether populations would put up with this. If not, political crises will emerge, with inherently uncertain consequences.

I would add to this by running a brief two-stage analysis of what happens under austerity (sorry, no charts yet). In stage one, we have the FT chart for 2009. Spain has an enormous budget deficit, which is offset by private savings and a capital surplus (more imports than exports). Germany has a smaller deficit and a capital deficit (more exports than imports) matched by a huge private sector savings.

If Spain is forced to run austerity measures as seems likely, in stage two, this shifts their government deficit markedly down. Given Spain’s poor labour competitiveness, sticky wage prices and inability to depreciate the currency, all of the adjustment falls onto the private sector in the form of reduced net savings (which could include larger debt burdens). But, the thing to realize is that total GDP in Spain is lower in this scenario, which means total imports are lower, which means Germany’s total export volume is lower. This is a deflationary scenario.

I know for a fact that Germany and Austria (another net exporter) are already cutting back their deficits, Austria via higher taxes. We see Ireland, Spain, Greece and Portugal doing ‘austerity’ measures to rein in government deficits too. Meanwhile, having seen the financial sector balances chart, you know that austerity means higher debt burdens in those countries, but also lower exports in Germany, which is also cutting back its own Government spending. So, austerity not only kills the Spanish economy and makes it prone to a debt deflation scenario, it also hurts the German export economy while they themselves are cutting back on government deficits.

What you have here is a perfect recipe for a double dip and a serious economic nightmare. Unless Germany can get its consumers to start spending more, the eurozone is going to double dip.

Source

Germany’s eurozone crisis nightmare – Martin Wolf, FT