Peter Boone is chairman of the charity Effective Intervention and a research associate at the Center for Economic Performance at the London School of Economics. He is also a principal in Salute Capital Management Ltd. Simon Johnson, the former chief economist at the International Monetary Fund, is the co-author of “13 Bankers.”
Some officials and former officials are taking the view that a large fund of financial support for troubled euro-zone nations could be decisive in stabilizing the situation. The headline numbers discussed are 2 trillion to 4 trillion euros — a large amount of money, given that the gross domestic product of Germany is 2.5 trillion euros and that of the entire euro zone around 9 trillion euros.
Perspectives from expert contributors.
Perspectives from expert contributors.
Never mind, say the optimists — we’ll get some “equity” from the stability fund and then leverage up by borrowing from the European Central Bank.
Such an approach, if it could get political approval, would buy time, in the sense that it would hold down interest rates on Italian government debt relative to their current trajectory. But leaving aside the question of whether the European Central Bank — and the Germans — would ever agree to provide this kind of leverage and ignoring legitimate concerns about the potential inflationary impact of such measures, could a 4 trillion-euro package, for example, stabilize the situation?
Think through the best-case scenario, in which the big package is put in place and, at least initially, believed to be credible. Proponents of this approach argue that the “market would be awed into submission”; business as usual would prevail, meaning that Italy and other potentially troubled sovereigns could resume borrowing at low interest rates; and the 4 trillion-euro fund would not actually need to be used.
This seems implausible. If the big government money shows up, and this pushes down yields on Italian government debt, what will the private-sector holders of that debt do? Some of them will sell, taking advantage of what they worry may be only a temporary respite and, for those who bought near the bottom, locking in a capital gain (as interest rates fall, bond prices rise).
So the European/International Monetary Fund bailout fund would acquire a significant amount of Italian, Portuguese, Spanish and other debt (including perhaps that of Greece and Ireland). If the credit used from this fund, with its central bank backing, reaches — let’s say — 1 trillion euros, how will the Germans feel about the situation?
Their worries will only be heightened by continuing budget deficits, made worse by recessions, throughout the periphery. Someone will need to finance those deficits, and the stabilization fund is likely to be the financier.
On current form, the Italians will have promised moderate austerity but delivered little. Stories about corruption in Italian public life — perhaps exaggerated but with more than a grain of truth — will become pervasive and continue to grate on northern European taxpayers.
In fall 1997, the International Monetary Fund — with the backing of the United States and Europe — provided what was then regarded as a substantial package of support to the Suharto government in Indonesia. But the government refused to close banks as agreed — and after one of President Suharto’s sons finally lost one failed bank, he immediately popped up with another banking license. Articles about Indonesian corruption and the ruling family were on front pages of major newspapers in the United States.
Donor fatigue set in. In January 1998, when the Indonesian government announced a budget that had slightly less austerity than planned, it was roundly castigated by the international community, setting off further sharp depreciation in Indonesia’s rupiah. This worsened the debt problems of Indonesia’s corporate sector, which had borrowed heavily and at short maturities in dollars.
Panic erupted, social unrest became increasingly manifest, and the real economy declined further.
Italy is not Indonesia, and Silvio Berlusconi is not President Suharto — who ended up leaving office. But the comparison still has value. Will the countries backing the enhanced and highly leveraged European Financial Stability Facility be willing to face substantial credit losses, i.e., actual and continuing transfers from their taxpayers to Italians and others?
Lech Walesa famously remarked that it was easier to make fish soup from fish than to do the reverse. So it is with fiscal crises — once fear prevails and markets start to think hard about the stress scenario, it is hard to solve the problem simply with reassuring words or financial support that never needs to be used.
Crisis veterans like to say, quoting former President Ernesto Zedillo of Mexico, that when markets overreact, policy needs to overreact in the stabilizing direction. But what really matters is not overreacting; it is making sure you do enough.
In Europe, the first thing peripheral governments need to do is stop accumulating debt, and quickly. Italian fiscal plans to balance the budget in 2012 look implausible, as they assume unrealistic growth. The planned Greek debt restructuring and increased taxes will not turn that economy around, nor prevent Greece from accumulating further debt. Despite all the reported austerity, the Irish government is still running a budget deficit near 12 percent of gross national product in 2011, while nominal G.N.P. actually declined in the first half of 2011.
Europe’s periphery also needs to recognize that it signed up to a currency union, and that requires a new approach to adjustment. Instead of having huge devaluations like those suffered in Mexico under Mr. Zedillo, in Indonesia under Mr. Suharto or in Poland under Mr. Walesa, Europe’s troubled nations need to raise competitiveness by reducing local costs.
That must primarily come through wage reductions and more competitive tax systems. In Ireland a pact with the major unions is preventing further wage reductions, while in Greece the government is strangling corporations with taxes in order to avoid deeper wage and spending cuts. The proposed Portuguese “fiscal devaluation” — meaning lower payroll taxes to reduce labor costs and an increase in the value-added tax to replace the revenue — looks like a weak attempt to avoid talking about the need to cut public spending and wages much more sharply in real, purchasing-power terms.
Putting in place a huge financial package is not enough. Policies have to adjust across the troubled euro-zone countries so that nations stop accumulating debt, and the periphery moves rapidly from being among the least competitive nations in the euro area to the most competitive — and this includes lower real wages, even if debts are restructured appropriately.
The European leadership is a long way from even recognizing this reality, let alone talking about it in public.
