Fiscal treaty could trigger a debt explosion

Financial Times - Wolfgang Münchau

I recently had a conversation in which everybody seemed to agree that the new European fiscal pact was quite mad. The conversation was overheard by a former policymaker, who turned to us and said that he agreed in principle – but he then added that if the treaty encouraged the European Central Bank to become more flexible, it might still be worthwhile. Later I spoke to a central banker, who also agreed that the treaty was irrelevant, but he was nevertheless in favour of it because it served as a signal to the financial markets. When I spoke to my contacts in the financial markets, I was told that the treaty was quite mad.The best thing that one could say about the treaty is that it is not necessary. Everything we are likely to see in the final version is either in existing treaties or in legislation, notably the so-called “six-pack”, a set of policy surveillance measures passed earlier this year. The rest could easily be introduced through new secondary legislation.

While I have yet to meet anybody who can explain what good the treaty will do – except as part of some circular logic – the damage it will do is more evident. Just think of the entirely unnecessary fight with David Cameron, UK prime minister. But the British problem pales in comparison with the treaty’s truly destructive powers. It will encourage eurozone member states to adopt extremely pro-cyclical policies.

This is already happening in Spain. Until last week, the government said it would not keep piling one austerity measure on top of another to meet the agreed deficit targets. That seemed a sensible policy. Spain’s economy is shrinking at a faster rate than forecast for reasons outside the country’s control. Under these circumstances, it would be sensible to let the automatic stabilisers work. That is what the eurozone member states did in 2009. It ensured that the recession, while very deep, was at least not excessively long.

The International Monetary Fund also agreed with the position of the Spanish government as of early last week. The Spanish newspaper El País quoted an IMF official as saying that further adjustment of the deficit would be undesirable because it would exacerbate, rather than alleviate, market tensions. The IMF forecast a two-year recession, with the deficit falling from 8 per cent of gross domestic product last year, to 6.8 per cent this year and 6.3 per cent next year. So even with a significant deficit target overshoot, Spain would still have a recession – almost as bad as the one in 2009.

But no. Last week on a visit to Berlin, Mariano Rajoy, Spain’s new prime minister, duly reiterated his government’s commitment to the agreed deficit targets – 4.4 per cent of GDP in 2012, and 3 per cent in 2013. This year, he wants to cut the deficit by a further 2.2 percentage points, relative to the IMF baseline, and by another 3.3 per cent next year – all while the economy is contracting.

Spain is following the same path taken by Greece. Spain is a much healthier economy, of course. But it also has a problem that Greece did not – a deeply indebted private sector. This is the reason why a policy of excessive deficit reduction could become so toxic.

Richard Koo, chief economist at the Nomura Research Institute, recently took a look* at the impact of the deleveraging in the US, the UK and the eurozone. Spain is experiencing an extreme version of what he calls a “balance sheet recession”, on a much greater scale than the US or the UK. Since the third quarter of 2007, the Spanish private sector has reduced its debts by 17.2 per cent as a ratio of GDP, while the public sector partially compensated the private sector’s deleveraging with an increase in debt of 11.8 per cent of GDP. The difference came in the form of a positive contribution from the external sector – in other words, from a fall in the current account deficit.

Mr Koo makes the point that – as in Japan during the 1990s – it is essential that European governments support the economy during a phase of private-sector deleveraging to avoid what would otherwise lead to a deep depression.

So if Spain were to follow the example of Greece, and ignore what happened in Japan, the most likely result would be a severe and prolonged recession. To me, that is a much larger threat to the eurozone than any of the various crisis offshoots that excite us momentarily. In the big scheme of things, it really does not matter whether Greek bondholders agree on a voluntary participation. If Spain were to fall down a black hole, no rescue fund, however large, would be able to drag it out.

The irony is that a fiscal treaty that set out to reduce the eurozone’s debt could be the cause of a debt explosion, because it greatly increases the risks of a semi-permanent slump in large parts of southern Europe. If that were to happen, nothing could save the eurozone.

*‘The world in balance sheet recession: causes, cure, and politics’

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