Eurozone Problems

I’m giving a talk in Paris tomorrow. Here are some slides; they won’t come as a shock to regular readers, but it may be useful to see them all in one place.

First, I make the case that the overall economic crisis is driven by private debt in the US , not public debt:

Then I point to the huge swing of the private sector into financial surplus in the US, which necessitated large public deficits to avoid a much deeper slump:

I then turn to Europe, which has the additional problem of a capital flow bubble from north to south induced by the euro, which has to be reversed:

The counterpart of these current account imbalances was a large divergence in relative price levels:

Implicitly, Europe is relying on “internal devaluation” to reverse this divergence. But the reality is that this is very hard given nominal rigidity, even in Ireland, which is wrongly held up as an example of successful adjustment:

Also, Europe has bought into the notion that fiscal irresponsibility is at the heart of the crisis, which is true only of Greece and not true of the troubled countries as a group:

And even on the IMF’s reckoning, none of the austerity countries is plausibly on the road to a tolerable fiscal situation:

Authors: C. Randall Henning & Martin Kessler · January 31st, 2012 · Peterson Institute

The euro area crisis and debate over fiscal reform have led many observers to pray for salvation by a modern, European version of Alexander Hamilton. By this they generally mean someone capable of leading a movement for a robust fiscal union and implementing this vision (see for example McKinnon 2011). Europe has instead, they lament, a collection of leaders who are primarily responsive to divergent national electorates rather than engaged in building a pan-European political movement. Consequently, they despair, instead of transforming the fiscal architecture of the monetary union,¹ European officials are now dithering over the details of a fiscal compact,² which is little more than an uninspiring upgrade of the Stability and Growth Pact.

Balancing the Budget

The fiscal compact’s rules on balanced budgets are not necessarily wrong; their appropriateness depends on how they are ultimately designed and implemented. However, the emphasis on the fiscal compact distracts European policymakers from more immediate demands of the euro area crisis and is woefully incomplete and badly sequenced with other elements of fiscal and financial integration. In a new paper (Henning and Kessler 2012), we argue that the history of US fiscal federalism from the founding of the republic to the present holds important lessons for the architects of Europe’s fiscal union. Europeans do not want to replicate US experience but learn from it.³

As part of his plan to establish the credibility of the US government as a borrower and build a modern financial system, Hamilton famously assumed the debt of the states. This federal bailout, which was repeated after the War of 1812, is anathema to present concepts of the fiscal sovereignty of the states in the United States. But the powers of the federal government grew largely from that decision. After establishing its authority, the federal government shifted to a no-bailout stance in the 1840s, letting several states default. Simultaneously, and subsequently during the nineteenth century, states adopted balanced-budget rules of varying strength on their own accord. Today, all states except Vermont have such a rule inscribed in their law or constitution and, although these rules can leak, state debt accumulation has been relatively limited.

Debt Brakes

Balanced-budget rules among the states parallel the effort—adopted at the March 2011 European Council meeting and affirmed at the December 2011 summit⁴—to introduce constitutional rules or framework laws, otherwise known as debt brakes, in the member states of the euro area. The fiscal compact agreed at the December 2011 summit specified that members’ annual structural deficits should not exceed 0.5 percent of nominal GDP, among other things.

Before drawing too heavily on the US experience in concluding that constitutional debt brakes are a key solution to Europe’s debt problems, however, Europeans should consider three essential aspects of the context in which the balanced-budget rules of the American states operate.

• First, the US constitutional design is very different from what European leaders envisage for the euro area, i.e., debt brakes that are mandated by the union and enforced by the Commission and the European Court of Justice. The difference is likely to be consequential in two respects. We suspect that local ownership and enforcement make debt brakes more effective than they are under central mandates, particularly in the context of credible no-bailout norms; and we suspect that centrally mandated rules are likely to prove to be more brittle than those adopted in a decentralized fashion. When one state violates the rule, as the experience with the Stability and Growth Pact demonstrates, its applicability to other states is less credible. That is less likely to be the case with rules that have been adopted autonomously.

We acknowledge that some of the impetus for debt brakes comes from within euro area countries. The present crisis could be sufficiently traumatic and thus politically transformative to produce an autonomous reduction in debt tolerance within some of the most afflicted member states, just as the American states adopted balanced-budget rules autonomously from the federal government in the 19th century. Such an autonomous change in preferences would serve as an omen for the effectiveness of debt brakes. But the strength of the internal shift in debt tolerance is uncertain and is likely to vary significantly among member states.

• Second, stabilizing the banking system is primarily the responsibility of the federal government in the United States. As a consequence, this function did not come into conflict with balanced-budget rules at the state level. In the euro area, by contrast, harmonization of bank regulation is still young and the fiscal costs of bank rescues and recapitalization remain primarily a national responsibility. The introduction of debt brakes threatens to collide with the need for member states to mount large-scale rescues of their banking systems. As such provisions are put in place, therefore, it is all the more important that the euro area unifies banking regulation and creates a common pool of fiscal resources for rescuing and recapitalizing banks (Posen and Véron 2009, Véron 2011).
• Third, US federal debt has been supported by the full system of federal powers, including a sweeping power to tax, and the federal budget has helped to stabilize the national economy in a countercyclical fashion since the 1930s. State and local budgets have behaved procyclically during recessions in the United States. State-level restrictions would have been difficult or impossible to sustain in the absence of federal countercyclical policy. Although automatic stabilizers might play a greater role in some of the national economies in Europe than in the American states, creating stringent state-level debt brakes in Europe without a capacity for countercyclical stabilization would be a serious mistake.

The Route to Fiscal Union?

The rules of the fiscal union in the United States evolved in a distinct sequence. The federal government first developed a robust fiscal capacity, with the assumption of state debt, issuance of federal debt, and access to its own tax revenue. Once that was established, the states could adopt balanced-budget provisions. By introducing strict balanced-budget rules prior to a robust fiscal union—assuming that some of them harbor ambitions for such a union—European policymakers are attempting to reverse this sequencing. Adopting such rules might reassure the ECB and smooth the path for further expansion of its operations, both of which are desirable, but it leaves the euro area short in terms of countercyclical tools. The need for a fiscal instrument for macroeconomic stabilization is not a new observation, but we believe that it is an inescapable one, the implications of which have not yet been sufficiently incorporated in European deliberations over the fiscal architecture.

Advocates of the fiscal compact might note that the debt brakes are defined in structural terms, and therefore allow countercyclical action at the national level. While feasible in principle, this route to countercyclical capacity is strewn with problems of calculating the structural balance, external spillovers, and coordination with the fiscal stance of other members. Creating a common capacity for countercyclical action—through a more robust central budget, issuance of euro bonds, backed by tax authority—is more reliable. But this route of course requires strong political cohesion and robust institutions for the monetary union that would match those through which Hamilton worked.

Some worry that the modern equivalent of Alexander Hamilton cannot emerge in Europe for lack of a political union similar to that of the United States after 1789. But the absence of full political union in Europe is neither reason to despair nor an excuse for low expectations or half measures. Remember, as General Washington’s chief of staff, delegate to the Philadelphia Convention, and author of three fifths of the Federalist Papers, Hamilton himself helped to create the institutional prerequisites for the adoption of his plan, the Constitution, and the governing institutions of the young nation. He and the other founding fathers did so, moreover, under financial conditions considerably less favorable than European policymakers face today.

This piece is based on Working Paper 12-1: Fiscal Federalism: US History for Architects of Europe’s Fiscal Union [pdf] by C. Randall Henning, Peterson Institute for International Economics and Martin Kessler, Peterson Institute for International Economics and previously appeared at Voxeu.org.

There has been relative calm in the EZ crisis since December last year, when the ECB announced a three-year long term refinancing operation (LTRO) and a sharp widening of its collateral requirements. Government bond yields fell in the periphery and debt issuance in January went remarkably well, particularly for Spain and Italy. Has the LTRO fundamentally changed the likely path forward in the EZ crisis?

The EZ crisis is a debt crisis, a fiscal crisis, a financial crisis and a political crisis, but above all else it is a growth crisis. The only way the LTRO could help to end this crisis is if it were to mitigate the contraction in GDP the EZ is facing or stimulate growth. As Rebecca Wilder (@newsneconomics) has explained in a recent blog post, the three year LTRO is one in a series of steps the ECB has taken to plug holes as deposits have fled from EZ banks and private repo funding markets have dried up.

The three-year LTRO has helped to relieve some of the pressure on EZ banks and has avoided the failure of a major European bank (along with the cascade of bank defaults that would follow). However, EZ banks are in a process of significant deleveraging—which undermines growth—and the three-year LTRO is unlikely to really change this. Some banks may use the ECB facility to accumulate assets like domestic sovereign debt. Arguably Italian banks in particular are so exposed to their own sovereign debt they might as well double down and use the LTRO to sop up more of it. For the most part banks are likely to continue to reduce their cross-border exposure though and will horde ECB liquidity as they prepare for the worst.

THE battle over RBS CEO Stephen Hester’s pay has absorbed an awful lot of weekend press and media in Britain – one might call it a bout of Hesteria. Mr Hester has sensibly backed away from his bonus, since the position of „banking public enemy“ is not one to be relished – ask Sir Fred Goodwin.

There is a defence to be made of the bonus. Mr Hester did not create the mess at RBS; he is clearing it up. If he can remodel RBS and return it to the private sector, he will have delivered value to the taxpayer that could be in billions – in other words, more than a thousand times his bonus. If he walks away from the job, the public might lose a lot more than the £1m (in shares, not cash) that he was due to receive. By all accounts, he is a good manager and has made a decent fist of shrinking RBS’s giant balance sheet.

Politically, however, the problem is that Mr Hester is working for a (largely) state-owned company at a time when other public sector employees are suffering a wage freeze, benefits are being cut and so on. It is very difficult to argue that „we are all in the same boat“ if one state employee is being handed a luxury yacht. Doubtless, there are many teachers, doctors and nurses who are doing a fantastic job but they won’t get a bonus either.

Many of us might feel that, if Mr Hester struggles to make ends meet on his £1.2m basic salary (plus £420,000 pension contribution), that we would be willing to do the job for say £1.1 million. This is not quite as ridiculous an idea as it sounds; clearly, if the average person were employed as a brain surgeon, electrical engineer or a footballer, their inadequacy would be quickly exposed.

But a bank CEO’s worth is rather harder to judge. Clearly we can see examples of executives that have got it wrong, by overpaying for acquisitions or by recklessly leveraging the bank’s balance sheet. A previous post highlighted an excellent speech from Andrew Haldane at the Bank of England; he pointed out that bank CEO pay correlated very well with return on equity, but very poorly with return on capital. Gearing up the company proved very lucrative from them in the boom, but disastrous for everyone else in the bust.

Take another example; market share. We all appreciated Steve Jobs’ genius in creating new products and increasing Apple’s share of spend on electronic devices. But if a bank increases market share, that may simply be a sign it it taking too many risks; that was the case of New Century in the US subprime market and Northern Rock in UK mortgages.

Perhaps, then, the best bank CEO would be someone who says No to the expansion plans of his subordinates and who has a decent amount of respect for the economic cycle. That same person would not be motivated by getting rich quick. So it’s quite possible there might be a few people around who could do the job for £1.1m.

LONDON—Consumers and service providers in the euro zone head into February more upbeat about their prospects, a development that suggests the currency area’s economy may be stabilizing.

The European Commission Monday said the overall measure of business and consumer confidence in the 17 countries that share the euro—-known as the Economic Sentiment Indicator—rose to 93.4 in January from 92.8 in December. However, that outcome was weaker than the 93.6 forecast by economists and there was significant divergence between countries.

Although official figures will only be released on Feb. 15, many economists believe the euro-zone economy contracted in the fourth quarter of 2011.

But recent evidence suggests that the economy may have stabilized at the start of the year, and the confidence survey is consistent with that view.

Together with other surveys, it may help persuade the European Central Bank to leave its monetary policy unchanged when its governing council meets next month.

The survey came as new data indicated Germany’s consumer price inflation slowed in January on the year according to a preliminary reading, in line with expectations, leaving intact forecasts that the slowdown in euro-zone inflation will continue.  Germany’s federal inflation rate fell 0.4% on the month and increased 2% on the year in January, the German statistics office Destatis said Monday. In December, inflation was 0.7% on the month and 2.1% on the year. Inflation has been slowing since September’s three-year high of 2.6%.

Consumer confidence picked up for the first time since June, with the headline measure rising to minus 20.7 from minus 21.3. Consumers were less pessimistic about the outlook for the economy over the next 12 months, and less fearful of losing their jobs.

„The modest rise in euro-zone consumer confidence in January reinforces our belief that the ECB will hold off from cutting interest rates again in February as it looks to see if euro-zone economic activity is stabilizing,“ said Howard Archer, an economist at IHS Global Insight.

The headline measure of confidence among service providers rose to minus 0.6 from minus 2.6, driven by an anticipated pickup in demand over the coming three months. Construction companies also shared in the pickup, with the headline measure of confidence in that sector rising to minus 28.3 from minus 28.9.

The confidence measure for the manufacturing sector was unchanged at minus 7.2, while the measure for the retail sector fell to minus 15.5 from minus 12.2.

There were other signs of stabilization in the manufacturing sector. A quarterly survey found that capacity use increase to 79.9% in January from 79.6% in October, although it remained below its long-term average. And the survey also found that manufacturers expected export sales to pick up as a result of the euro’s recent depreciation.

A separate measure of the conditions for manufacturers—the Business Climate Index—rose to minus 0.21 from minus 0.32 in December, its first increase since February 2011.

„The improvement in the BCI was mainly driven by a more positive assessment of production trends observed in recent months and of export order books,“ the commission said.

Within the currency area there were significant divergences in January, with the ESI for Germany rising to 106.6 from 104.3, while the ESI for France fell to 91.4 from 93.5 and the ESI for Italy fell to 84.3 from 85.4.

The declines in France and Italy reflect the launch of new austerity programs designed to assure bond investors that the two governments can repay their debts.

Indeed, Italian business confidence index fell further in January, reaching its lowest level since November 2009 as expectations about future production worsened, Italy’s national statistics institute Istat said Monday.

Italy’s manufacturing business confidence index slipped to a seasonally-adjusted 92.1 in January from 92.5 in December. Confidence fell in the consumer and capital-goods sectors while improving slightly in the intermediate-goods sector, Istat said.

Italy’s economy faces strong headwinds from its tough fiscal austerity plans. Gross domestic product already began to contract in the third quarter of last year and the International Monetary Fund has warned it may shrink by more than 2% this year.