The pain in Spain will test the euro
One definition of insanity is to do the same thing over and over again and expect different results. Germany’s determination to impose a fiscal hair shirt on its eurozone partners did not work in the “stability and growth pact”. Is it going to work in the “treaty on stability, co-ordination and governance” agreed last week? I doubt it. The treaty reflects the view that the crisis was due to fiscal indiscipline and that the solution is more discipline. This is far from the whole truth. Rigorous application of such a misleading idea is dangerous.
Such concerns may now seem remote. The longer-term refinancing operations of the European Central Bank have relieved pressure both on banks and financial markets, including the markets for sovereign debt. In the two tranches of this completed operation, banks have borrowed more than €1tn for three years at just 1 per cent. Italian and Spanish 10-year government bond yields have fallen below 5 per cent, from peaks of 7.3 per cent for Italy and 6.7 per cent for Spain late last year. As important have been declines in credit default swaps on banks: the spread on Italy’s Intesa Sanpaolo has fallen from 623 basis points in November 2011 to 321 points this Monday.
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Yet the crisis has not passed. To varying degrees, the vulnerable countries are in lasting difficulties. Would these fiscal disciplines have saved the eurozone from its wave of crises? Will they pull afflicted countries out of these crises now? The answer to both questions is: no.
The fundamental new rule is that a member’s structural fiscal deficit should not exceed 0.5 per cent of gross domestic product. In effect, this would require countries to run structural surpluses.
Moreover, if a country has debt over 60 per cent of GDP, the excess shall be eliminated at an average rate of a 20th of the excess each year. A country such as Italy, with debt at about 120 per cent of GDP, would lower the ratio at a rate of 3 per cent of GDP each year. This framework is the one to which all eurozone members must accede. These rules are to be embedded in law, preferably constitutional law. This treaty raises deep legal, political and economic questions.
It does make economic sense to target cyclically adjusted rather than actual deficits. But the improvement in economics is at the cost of a reduction in precision. Nobody knows what a structural deficit is.
This is no quibble. Consider the structural fiscal positions for 2007, the last largely pre-crisis year, estimated by the International Monetary Fund in October 2007 – in “real time”, as it were. This was a year when the indicator needed to scream “crisis”. Yet it showed Spain with a large structural surplus and Ireland in structural balance (see chart). Both were even in better shape than Germany. Greece did have a sizeable structural deficit. But the French deficit was worse than that of Portugal. The rule would not have discriminated between vulnerable countries and immune ones because it ignores asset bubbles and financial manias.
The IMF then had second thoughts. By October 2011, it had concluded that Greece’s structural fiscal deficit in 2007 had been 10.4 per cent of GDP, not 4 per cent, and Ireland’s 8.4 per cent, not 0.1 per cent. This is not a criticism of the IMF. It merely shows that the concept the eurozone wishes to embed in a new treaty will fail when accuracy is most needed. The true structural deficit is unknowable.
Consider the political and legal implications. Would elected governments accept the guesstimates of unaccountable technocrats? How, moreover, are judges to reach a decision? Are they to evaluate the merits of alternative econometric models? Since huge changes in estimates of structural deficits are likely, how is a government to adapt? Putting an unmeasurable concept into the law seems mad.
Right now, a row is brewing between the European institutions and the newly elected Spanish government of Mariano Rajoy. The latter has stated that his government is going to target a fiscal deficit of 5.8 per cent of GDP, down from the 8.5 per cent achieved in 2011, but well above the 4.4 per cent it agreed with the Commission. The latter will huff. But it cannot compel a sovereign government to do what it wants. Spain’s partners can refuse help. But that might redound on themselves.
Spain’s fiscal difficulties are a consequence of the crisis, not a cause. The country experienced huge rises in private debt after 1990, particularly among non-financial corporations (see chart). The overhang of residential construction also rules out substantial household borrowing. Given this, a sharp reduction in government borrowing is most unlikely to be offset by more private borrowing and spending. The result is more likely to be a far deeper recession, along with little progress in reducing actual fiscal deficits. At worst, a vicious downward spiral may occur. Instead of forcing Spain into rapid fiscal retrenchment, it would be far more sensible to give the country the time it needs to let the bold reform of its labour markets work through. This is going to take a number of years.
Yet if the eurozone is to be willing to provide the time needed for such adjustments to occur, the surplus countries need to be aware of their own role. Without doubt, the parallel emergence of current-account surpluses and deficits, the flow of cross-border finance and the folly of cross-border lenders played huge roles in causing today’s crisis.
In a paper published last month, the Commission indicated its intention to examine a number of countries running external deficits. These sinners are even named. Parallel analysis is needed of the surplus countries. The paper even raises the issue. But it does not dare to pick out specific surplus countries for close analysis. The eurozone is at war with double-entry bookkeeping.
So, yes, the ECB has bought the eurozone some time. But little yet suggests that a way has been found towards the necessary rebalancing of the eurozone economy and, above all, towards achieving the desired mix of reform, adjustment and a swift return to growth. The chosen way looks instead to go via years of one-sided adjustment and painful austerity. Will that work? I very much doubt it. At best, we can expect many bumps along that road.
Copyright The Financial Times Limited 2012.