Revisiting The PIIGS: Victims Or Perpetrators?

Oct.12.11 | About: iShares MSCI (EUFN)

The euro crisis has gone systemic, argued Jean-Claude Trichet, the parting director of the European Central Bank (ECB). Well, with bank liquidity drying up in many places, that's probably a fair assessment. But the causes of the euro crisis were also much more systemic than many care to admit.

The usual line about the euro crisis is that it's profligate governments that have caused the crisis. On first sight, yes, as the manifestation of the crisis has been ballooning deficits and debts, then bond markets balking and subsequently banks holding those bonds getting in trouble.

However, this view sits awkwardly with a number of facts:

  • At the outset of the crisis, countries like Spain and Ireland had very low public debt and budget surpluses.
  • Despite having no worse public finance situation compared to Britain or the US, the euro area taken together faces a near existential crisis which neither Britain nor the US faces.
  • Italy and Spain, despite having no worse public finances compared to Britain or the US, pay 3x the interest rates on 10 year bonds.

We've already previously argued that much of this can be explained by the fact that debt of a country that doesn't issue its own currency inherently faces a higher default risk. So there is indeed an important systemic component to the euro crisis. Further evidence of this is that interest rates on Italian and Spanish debt began to creep up when a Greek haircut or default were mentioned, and shot up when this was instigated as policy in June, the latter is clearly visible in the graph below:
One-Year Chart for ITALY 10 - GERMANY 10 SPREAD (.ITAGER10:IND)

Apart from its manifestations, the origin of the euro crisis was also systemic to a considerable degree. In joining the euro, countries in the periphery like Greece, Ireland, Spain, Portugal, and Italy were infused by a one-off boost in their monetary credibility as monetary policy was now set by the more credible ECB and any exchange rate risk was eliminated.

This boost in credibility and elimination of a devaluation risk caused large capital inflows. Kash Mansori argues in The New Republic that this was deliberate policy. The thought (or hope, or both) was that this would be one of the forces that would produce greater economic convergence.

The periphery were poorer, less well-developed so relatively capital-poor in relation to the core countries but these capital flows that the euro unleashed would redress that. The effects accumulated over time:

click to enlarge
Click to enlarge

The mirror image of capital flows causing a positive capital account is a negative current account, and in the figure above you see the current account of the peripheral countries steadily deteriorate. Now, this led to a boom in most of these countries, and to a growing misalignment of unit labour cost, as the first graph below shows.
If you compare the unit labour cost development with those in Germany, the picture becomes even considerably worse. Now, Mansori's thesis is important, and there is a good deal of systemic origin to the euro crisis, but bad behaviour has also been part of it, especially in Greece.

That divergence of unit labour cost has been around for some time, and with the absence of a possibility to devalue, it should have been redressed much, much earlier. Also, unlike Ireland and Spain, Greek public finances were a mess long before the explosion of the euro crisis. In fact they cooked the books.

Spain and Ireland experienced a property bubble that was unsustainable, that too could have been prevented to a considerable degree with better regulation.

However, what Mansori' is right about is that these large capital inflows are often associated with financial crisis, as can change direction on a whim. This is exactly what happened. The debt associated with the inflows of capital will have a hard time being rolled over when the inflows suddenly stop (or even reverse, as is now the case).

Apart from the Greek and Portuguese public finance situation, capital inflows stopped as a result of the financial crisis, in which a flight to safety became paramount.

So yes, the PIIGS are as much victim as perpetrator, and now rather than capital inflows, they're suffering hefty capital outflows that is presently being recycled by the ECB back into these countries, either via buying their bonds, or recycling the deposit and investor flight from the banks back in to the banks in the form of liquidity provisions.

Will the capital return anytime soon? Not very likely. Not before the euro crisis is 'solved' and we're not particularly optimistic about that one. One can also raise legitimate questions about the costs and benefits of these large international capital flows. They have a tendency to cause havoc both on their way in (creating asset bubbles), and on their sudden stop, let alone on their way out.

There are really only two answers to these problems, either one lets the exchange rate absorb much of the capital flows (although this itself can be hugely destabilizing, as the Asian countries found out in the mid 1990s Asian crisis), or some sand is thrown into the wheels of these flows.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.