By Rob Parenteau, CFA, sole proprietor of MacroStrategy Edge, editor of The Richebacher Letter, and a research associate of The Levy Economics Institute
Last year we provided an analysis (on the Naked Capitalism blog and elsewhere, including the Levy Economics Institute Annual Minsky Conference, and CBC interviews), based on the financial balances approach that suggested a number of problems could arise with the eurozone’s pursuit of what are called “expansionary fiscal consolidations”. Without a large and sustained swing into a current account surplus, the financial balance approach revealed that the pursuit of fiscal consolidation would undermine the ability of the private sector to service the debt loads it had built up during the prior decade of currency union. Simply put, higher taxes and lower government spending drain cash flow from households and firms, and that increases the financial fragility of economies.
For a number of reasons, there appears to be a glaring blind spot with regard to private debt as investors and policy makers remain focused on reducing public debt growth. There is little or no recognition of how changes in fiscal policy may influence the sustainable paths available for the private sector to manage its financial obligations. For example, with regard to the case of Greece, the household debt to GDP ratio soared during the past decade, and is now on par with the rest of the eurozone. However, private sector nonfinancial debt stopped growing in 2008 as the Global Financial Crisis hit, and we have since witnessed the onset of a nominal income contraction since 2009, when fiscal policy became hamstrung by what amounts to a bond investor capital strike.
We currently have in hand an extreme case of this interaction of public and private financial conditions. Investor and policy maker attention is now focused squarely on the prospect of an imminent Greek public debt default. But the issue of a Greek government debt default immediately raises the issue of Greek bank solvency (since much of the Greek public debt is held on their books), and hence provokes the question of how the necessary bank recapitalization could proceed. I doubt the EFSF or ECB (or Qatari investors, for that matter, who must feel like Prince Alwaleed with his Citi holdings) will be in the mood for subsidizing a Greek bank recapitalization if Greece has defaulted on its public debt.
Oddly enough, the level of Greek bank write-offs has been falling since the turn of the year, and private loan growth is once again contracting on a year/year rate as of June. This makes no sense given that nominal GDP growth was contracting at more than a 5% year/year rate through mid year 2011. So what happens if Greek private debt outstanding starts shrinking because Greek banks not only have stopped making new loans, but they can no longer roll the old loans, and in fact, have to shrink their loan books through distress sales of existing assets because they are a) insolvent and b) unable to be recapitalized by the public sector? With regard to the latter, remember that in all likelihood, the Greek government will have to reduce expenditures to match the level of incoming tax revenues if it adopts the default option. Accordingly, there will be little room for them to bootstrap their own bank recapitalization. Possibly if they went completely AWOL, they could reconfigure the Greek central bank to somehow recapitalize the banks, but by then we are on to the new drachma.
I submit with Greece, the world is in all likelihood about to witness yet another case study in Irving Fisher’s debt deflation dynamics, which he described a lifetime ago after losing his shirt in the Great Depression – an experience that led him to rethink his conviction that markets are generally self-stabilizing in a general equilibrium fashion. The attempt to move toward zero public debt growth can have very destabilizing results on economies in which the private sector has spent the prior decade leveraging up. This follows from the simple application of double entry book keeping to macroeconomics. As policy authorities who work with the financial balance approach must know, it is a conclusion that depends on no high macroeconomic theory, Keynesian or otherwise. Whether German PM Schauble will be able to recognize that, even as the Greek debt deflation plays out in front of his own eyes, is debatable. Whether the Reinhart and Rogoff Bible will be re-examined for errors or omissions is also debatable. Whether we are about to see “failed nation states” emerge in the eurozone as a result of blithely ignoring these simple principles of double entry book keeping remains to be seen.
Faith based economics is a funny thing that way – although at the moment, it does not look like Zorba is about to get the last laugh, at least not until the debt deflation sewage from the periphery backs up all the way to German banks and German exporters. A Greek public debt default will place the question of the necessary eurozone wide bank recapitalization at the head of the line, which is where the IMF’s Lagarde was trying to place it a week ago before EU officials reeled her back in this week. Even if governments are able to swiftly execute publicly assisted bank recapitalizations in the wake of Greek default, it is high time to recognize that attempting a multi-year, multi-country fiscal consolidation against the backdrop of high private debt to income ratios is bound to produce rising private debt distress, with all that means for the ability of the private sector to generate the income growth necessary to service existing private debt load and higher taxes, and with all that means for the ability of financial institutions to remain solvent. Perhaps this is a lesson best relearned sooner, rather than later. It cost Irving Fisher his fortune, and then his house, before he was prepared to learn that lesson. We need not be so stubborn this time around.