A big eurozone bet

Eurozone policy-makers place a big bet

Simon Tilford
13 March 2012

Have eurozone policy-makers finally managed to lance the boil? They can certainly point to lower borrowing costs in Italy and Spain as evidence of stabilisation. Many of them argue that this demonstrates the success of the strategy of fiscal austerity and structural reforms. The more thoughtful among them acknowledge that borrowing costs in Spain and Italy have actually come down because of the ECB’s long-term refinancing operation (LTRO) – it has lent almost unlimited amounts of money in cash to the region's banks at 1 per cent, who in turn have bought Italian and Spanish debts. But they will then argue that this has carved out sufficient breathing space for structural reforms and fiscal austerity programmes to boost confidence and lift economic growth. There is no doubt the ECB has bought the eurozone time, but that time is not being used constructively. And the LTRO is storing up trouble for the future.

The ECB cannot support the banking system (and hence) the bond markets indefinitely. Its balance sheet has risen to close to 30 per cent of eurozone GDP. At some point the ECB will have to reverse its liquidity measures. To do this, the banking systems and bond markets of the struggling eurozone economies will need to have stabilised, and the banks will need to be in a position to start paying back the loans. This will require economic recovery. And here is the rub. Eurozone policy-makers base their confidence in the current strategy on the belief that the private sectors of the hard-hit economies are going to ride to the rescue. Indeed, they believe that austerity and structural reforms will make more households and firms confident to spend and invest. The problem with this analysis is that both households and business are hugely indebted and face a long period of deleveraging and/or face a very unfavourable economic environment. It is far from clear, for example, why already-indebted Spanish firms would suddenly start to invest in the teeth of falling demand. Nor is it clear why households – facing unprecedented unemployment – would increase spending. There is no reason to expect the private sector to pick up the baton.

The experience elsewhere in the eurozone's periphery demonstrates that tightening fiscal policy in the teeth of a recession is very dangerous. It can push highly indebted countries into a spiral that is tough to get out of. Nor are structural reforms any kind of panacea. Too many policy-makers and commentators attribute Greece's difficulties to the Greek authorities' failure to push through sufficient structural reforms over the last two years. This, they argue, has destroyed business confidence and investment in the country. There is no doubting the need for structural reforms in Greece, but the collapse in investment reflects the fact that firms cannot access capital and foreign businesses and banks are now loath to do business with their Greek counterparts because of the risk of default. Despite having pushed through a series of structural reforms over the last two years, Portugal is only a few months behind Greece. Business investment is collapsing and the country remains firmly shut out of the capital markets. Private sector forecasts expect the economy to contract by at least 5 per cent this year, with the economy sliding further into a debt trap.

There is scant reason to expect fiscal austerity to be any less destructive in Spain than in Greece or Portugal. Fiscal austerity of the order required by the EU will simply push the Spanish economy into a slump, which in turn will worsen the debt position of the private sector, amplifying the required amount of deleveraging, and ultimately how much private debt ends up on the state's books. Italy is in a stronger position than Spain, in that the country has much lower levels of private sector indebtedness. But if Spain slides into a depression, Italy will not escape contagion. The country's borrowing costs will remain very high, further weakening its public finances and pushing up borrowing costs for the private sector (public sector borrowing costs are the benchmark for the private sector).

In the circumstances, the Spanish government is absolutely right to spurn EU demands that it cut Spain’s budget deficit from last year's figure of 8.5 per cent of GDP to 4.4 per cent this year. But even the compromise target of 5.3 per cent (falling to 3 per cent in 2013) will undoubtedly prove impossible and result in an even deeper recession than the country already faces. Most forecasters already expect Spanish GDP to contract by 2 per cent this year, implying a big jump in the ratio of public debt to GDP. The current strategy is the worst of both worlds: it does little, if anything, to bring down public deficits but leads to a dramatic worsening of debt trajectories as the volume of debt relative to GDP rises rapidly. In short, it risks a repeat of Greece and Portugal.

Could exports come to the rescue? The solution propagated by 'austerians' is a so-called internal devaluation. Austerity and private sector wage cuts will lower inflation and costs and bring about improved trade competitiveness within the eurozone. This might just about be possible if German inflation were to surge, enabling these peripheral countries to improve their competitiveness without deflating nominal GDP. But this will not be allowed to happen. The ECB will raise rates to ward off the threat of higher inflation in Germany. In the run-up to the financial crisis, the ECB held rates too low for the needs of the eurozone as a whole in an attempt to boost the then ailing German economy, in the process helping to inflate the bubbles in the periphery. The perceived needs of the German economy will almost certainly take precedence again. And for obvious reasons. If the ECB allowed German inflation to surge, political support for euro membership in Germany could disintegrate.

The eurozone crisis is to a large extent an economic growth crisis and the ECB's LTRO does very little to address that. It will not slow the pace of bank deleveraging across the eurozone. It does little to deal with the aftermath of the asset price collapse or of massive misalignments in real exchange rates. Without a return to economic growth, the banks will not keep buying sovereign debt and will not be able to pay back the ECB. Indeed, the LTRO may ultimately make things worse, because it further concentrates risk in the struggling economies. Their banks have had to place decent collateral with the ECB in return for the money they have borrowed. In place of this capital they now have more of their own countries' sovereign debts. So the LTRO could actually worsen the rather poisonous nexus between sovereigns and banks.

The eurozone needs Monti, Rajoy and François Hollande (assuming he wins the upcoming French presidential election) to steer Europe away from the current dangerous course. The Italian and French governments have a strong vested interest in supporting the Spanish government, as a full-blown crisis in Spain would engulf Italy and ultimately France. However, the obstacles to such an alliance are formidable, not least the differences between Monti and Rajoy on the one side and Hollande on a range of economic and social issues. The Italian and Spanish leaders would have to persuade Hollande of the case for market-led reforms. Only then could they hope to overcome German opposition to debt mutualisation. However, much of the French policy elite fears that any open criticism of the German position would undermine the Franco-German alliance, in the process weakening French power and influence in Europe. The problem they face is that their current strategy of managing the eurozone crisis is bringing about the loss of influence they hope to prevent. 

Simon Tilford is chief economist at the Centre for European Reform.