By Rob Parenteau, CFA, sole proprietor of MacroStrategy Edge, editor of The Richebacher Letter, and a research associate of The Levy Economics Institute
Reader note: please see yesterday’s post for a discussion of the fiscal balances map.
As evident from the financial balances map, there are a whole range of possible combinations of current account and domestic private sector financial balances which could be consistent with the 7% of GDP reduction in Spain’s fiscal deficit. But the simple yet still widely unrecognized reality is as follows: both the public sector and the domestic private sector cannot deleverage at the same time unless Spain produces a nearly unimaginable trade surplus – unimaginable especially since Spain will not be the only country in Europe trying to pull this transition off.
As an admittedly rough exercise, we can assume each of the peripheral nations will be constrained to achieving a fiscal deficit that does not exceed 3% of GDP in three years time. In addition, we will assume each nation finds some way to improve its current account imbalances by 2% of GDP over the same interval. What, then, are the upper limits implied for domestic private sector financial balances as a share of GDP for each nation?
Greece and Portugal appear most at risk of facing deeper private sector deficit spending under the above scenario, while Spain comes very close to joining them. But that obscures another point which is worth emphasizing. With the exception of Italy, this scenario implies declines in private sector balances as a share of GDP ranging from 3% in Portugal to nearly 9% in Ireland.
Private sectors agents only tend to voluntarily target lower financial balances in the midst of asset bubbles, when, for example home prices boom and gross personal saving rates fall. Alternatively, during profit booms, firms issue debt and reinvest well in excess of their retained earnings in order take advantage of an unusually large gap between the cost of capital and the expected return on capital. We have no compelling reasons to believe either of these conditions is immediately on the horizon.
The above conclusion regarding the need for a substantial trade balance swing flows in a straightforward fashion from the financial balance approach, and yet it is obviously being widely ignored, because the issue of fiscal retrenchment is being discussed as if it had no influence on the other sector financial balances. This is unmitigated nonsense. It is even more retrograde than primitive tales of “twin deficits” (fiscal deficits are nearly guaranteed to produce offsetting current account deficits) or Ricardian Equivalence stories (fiscal deficits are nearly guaranteed to produce offsetting domestic private sector surpluses) mainstream economists have been force feeing us for the past three decades. Both of these stories reveal an incomplete understanding of the financial balance framework – or at best, one requiring highly restrictive (and therefore highly unrealistic) assumptions.
The EMU Triangle
This observation is especially relevant in the Eurozone, as the combination of the policy constraints that were designed into the EMU, plus the weak trade positions many peripheral nations have managed to achieve, have literally backed these countries into a corner. To illustrate the nature of their conundrum, consider the following application of the financial balances map.
First, a constraint on fiscal deficits to 3% of GDP can be represented as a line running parallel to and below the horizontal axis. Under Stability and Growth Pact rules, we must define all combinations of sector financial balance in the region below this line as inadmissible. Second, since current account deficits as a share of GDP in the peripheral nations are running anywhere from near 2% in Ireland to over 10% in Portugal, and changes in nominal exchange rates are ruled out by virtue of the currency union, we can provisionally assume a return to current account surpluses in these nations is at best a bit of a stretch. This eliminates the financial balance combinations available in the right hand half of the map.
If peripheral European nations wish to avoid higher private sector deficit spending – and realistically, for most of the peripheral countries, the question is whether private sectors can be induced to take on more debt anytime soon, and whether banks and other creditors will be willing to lend more to the private sector following a rash of burst housing bubbles, and a severe recession that is not quite over – then there is a very small triangle that captures the range of feasible solutions for these nations on the financial balance map.
It is the height of folly to expect peripheral Eurozone nations to sail their way into the EMU triangle under even the most masterful of policy efforts or price signals. More likely, since reducing trade deficits is likely to prove very challenging (Asia is still reliant on export led growth, while US consumer spending growth is still tentative), the peripheral nations in the Eurozone will find themselves floating somewhere out to the northwest of the EMU triangle. The sharper their fiscal retrenchments, the faster their private sectors will run up their debt to income ratios.
Alternatively, if households and businesses in the peripheral nations stubbornly defend their current net saving positions, the attempt at fiscal retrenchment will be thwarted by a deflationary drop in nominal GDP. Demands to redouble the tax hikes and public expenditure cuts to achieve a 3% of GDP fiscal deficit target will then arise. Private debt distress will also escalate as tax hikes and government expenditure cuts the net flow of income to the private sector. Call it the paradox of public thrift.
As it turns out, pursuing fiscal sustainability as it is currently defined will in all likelihood just lead many nations to further private sector debt destabilization. European economic growth will prove extremely difficult to achieve if the current fiscal “sustainability” plans are carried out. Realistically, policy makers are courting a situation in the region that will beget higher private debt defaults in the quest to reduce the risk of public debt defaults through fiscal retrenchment. European banks, which remain some of the most leveraged banks, will experience higher loan losses, and rating downgrades for banks will substitute for (or more likely accompany) rating downgrades for government debt. A fairly myopic version of fiscal sustainability will be bought at the price of a larger financial instability.
Summary and Conclusions
These types of tradeoffs are opaque now because the fiscal balance is being treated in isolation. Implicit choices have to be forced out into the open and coolly considered by both investors and policy makers. It is not out of the question that fiscal rectitude at this juncture could place the private sectors of a number of nations on a debt deflation path – the very outcome policy makers were frantically attempting to prevent but a year ago.
There may be ways to thread the needle – Domingo Cavallo’s recent proposal to pursue a “fiscal devaluation” by switching the tax burden in Greece away from labor related costs like social security taxes to a higher VAT could be one way to effectively increase competitiveness without enforcing wage deflation. But these more comprehensive solutions, where financial stability, not just fiscal sustainability, is the primary objective, will not even be brought to light unless policy makers and investors begin to think coherently about how financial balances interact.
Or to put it more bluntly, if European countries try to return to 3% fiscal deficits by 2012, as many of them are now pledging, unless the euro devalues enough, then either a) the domestic private sector will have to adopt a deficit spending trajectory, or b) nominal private income will deflate, and Irving Fisher’s paradox will apply (as in the very attempt to pay down debt leads to more indebtedness), thwarting the ability of policy makers to achieve fiscal targets. In the case of Spain, with large private debt/income ratios, this is an especially critical issue.
The underlying principle flows from the financial balance approach: the domestic private sector and the government sector cannot both deleverage at the same time unless a trade surplus can be achieved and sustained. We remain hard pressed to identify which nations or regions of the remainder of the world are prepared to become consistently larger net importers of Europe’s tradable products. Pray there is life on Mars that consumes olives, red wine, and Guinness beer.