The euro zone wobbles don’t stop. On November 30, Italy was added to the list of countries diagnosed with ISS (increased spread syndrome). These increased spreads are a symptom of an economic problem, as I will argue in the following.A very simple exercise for economists to understand the general position of a country is to take a look at the balance of payments (BoP). You have net exports, net capital flows and other positions that can tell you a lot about a country. If you take the ex-post identities (this is no model) from the BoP and play around a little, you’ll get to the following equation:
(I – Sp) + (G – T) + (EX – IM) = 0
(I – Sp) is investment minus private saving, (G – T) is government spending minus taxes and (EX – IM) is exports minus imports. Alternatively, you could call (I – Sp) the private sector balance, (G – T) the government balance and (EX – IM) the external balance. Since this is all about accounting, we talk debt here. An example should clarify things.
Some say that if Ireland is to come out of its troubles, the private sector has to repair its balance sheets: people repaying (mortgage) debt, financial institutions and even other firms repaying external debt. This will surely mean that Sp>I. The private sector is saving, which – given I=S – should translate into lending. Since the private sector saves, there is money available in the banking system for investment. Now according to the above identity three possibilities arise how this will play out. When (I – Sp) turns more negative, then …
- (G – T) must turn more positive, or
- (EX – IM) must turn more positive, or
- (I – Sp) cannot turn more negative – oh.
Options one and two can in principle be influenced by government policy. In case 1, government spending can go up or taxes can go down if the government wants that. In case 2, a change in the real exchange rate can influence the trade balance. This can be done via the nominal exchange rate, or the price level… if you have control over monetary policy, that is. Ireland is part of the euro zone, so that option is not on the table. The change in the price level has to do the trick, and cutting wages and whatnot is the way to do that. The question is one of timing.
If markets believe that because of high spreads now and deficit rules later an increase in government spending will not happen, than adjustment must come via the external sector. This means that the price level has to fall quick enough for Ireland to start running an external surplus large enough to make investors believe that Ireland can honor its debts – at least in the long run. (Since I don’t know the balance sheets of Ireland I don’t feel like guessing here.)
However, policy intervention is not strictly needed to bring about adjustment. Remember that this is an ex-post identity. Maybe increasing savings won’t work. If internal devaluation is very slow and nevertheless the private sector starts saving, a lot of money will be pulled out of the economy and sit idle in banks. As a liquidity cushion banks wouldn’t be sad about it, and if nobody in Ireland or outside is willing to borrow this money we enter the paradox of thrift world. Saving increases, consumption decreases (nobody has borrowed the savings available and transformed them into investment, as would happen in normal times), unemployment rises, income declines, saving declines. Along the way, falling incomes reduce imports, so (EX – IM) increases and taxes are falling, so (G – T) increases as well. Government debt and external debt will increase until additional savings – which are shrinking all the while – are absorbed. The problem is, though, that this is done while income and output are falling.
Also, there might be pressure on the financial side. An internal devaluation might lead to a debt-deflation as described by Irving Fisher. Incomes are falling, but the level of nominal debt is not. It gets harder to repay your debts over time, and every try to increase savings ends in reduced output.
The big question in the euro zone is: can the economies adjust quick enough without a catastrophic event on the financial side? That depends on balance sheets of all the players, which are partly unknown. Right now, markets seem to think that adjustment will not be smooth enough. That’s my take on the euro’s troubles.
On the left, you find a spread sheet containing the values for the identities above (divided by GDP, so as %). They are taken from Eurostat, and should be handled with care: (I-Sp) is a line computed from the BoP equation above since I did not find any data. Therefore, all statistical errors are probably included in (I-Sp). (That is also why everything sums up so neatly to 0,0, mmmkay?)
Looking at Germany, Ireland, Greece and Spain (should have been Italy, but I prepared this for a lecture yesterday) you can see which and how sectors borrowed in the last 10 years, and what options we have for turning the whole thing around. Since the in the short-run markets and in the medium run the growth and stability pact is in the way of increasing (G – T), this at least for now seems to be impossible.
Two options are left on the table for deficit countries: start exporting through internal devaluation, or let changes in income do the adjustment and depression reign – which is no guarantee for things to get better in the future (recent EU unemployment rates available at Eurostat[pdf]). The first option will make you unpopular with Germans (but not all of them), the second one unpopular with your own people (maybe all of them). In the mean time, all financing holes will be filled by the ECB, the €750 billion crisis shield and whatever institutions are necessary to do the job. This has been done for some years already. Whether this will work depends on balance sheets, expectations and the international arena.
“Abwarten und Tee trinken.” (German proverb, literally: “Wait and drink tea“.)
Will Europe Face Defaults? by Michael Pettis
(Un)Happiness in the Euro Zone by Dirk Ehnts