Wednesday, November 09, 2011

Death of the euro, Wednesday edition: algebra's revenge

Paul Krugman thinks it may be getting close to a climax. In This Is The Way The Euro Ends 11/09/2011, he writes:

Seriously, with Italian 10-years now well above 7 percent, we’re now in territory where all the vicious circles get into gear — and European leaders seem like deer caught in the headlights. ...

Every even halfway plausible route to euro salvation now depends on a radical change in policy by the European Central Bank. Yet as John Quiggin says in today’s Times, the ECB has instead been part of the problem. ...

I still find it hard to believe that the euro will fail; but it seems equally hard to believe that Europe will do what’s needed to avoid that failure. Irresistible force, meet immovable object — and watch the explosion.
As Eric Lyman reports in As Italy's debt cost dangerously soars, what's next after Berlusconi? Global Post 11/09/2011:

On Tuesday, the 75-year-old leader best known for verbal gaffes, "bunga bunga" sex parties, and a steady stream of legal troubles, lost a key parliamentary vote. After several hours of reflection and meeting with his children and close advisors, [Silvio] Berlusconi told Italian President Giorgio Napolitano he would relinquish his power after the latest Italian emergency austerity package is approved by parliament.
Lyman seems to accept Herbert Hoover economics as based in reality, however: "More than anything, Italy is in dire need of fiscal austerity: the country’s public debt has reached $2.6 trillion, the equivalent to 120 percent of the country's gross domestic product."

Debt problems combined with fiscal austerity during a depression invite the furious revenge of algebra.

The International Monetary Fund (IMF) provided a very helpful guide to sovereign debt (bonds) as a percentage of GDP earlier this year, as of April 2011. The 2011 percentages are estimates, but they provide a useful comparison. As a general rule, 120% is generally considered the upper limit of what most countries can reasonably carry as debt relative to GDP. Japan shows 229% as the debt/GDP percentage, and I'm not sure on the particulars of why they can carry such a large load without a Greek-style debt crisis.

The US ratio is 100% but it wouldn't be a debt crisis if it were far large than that. Since the dollar is the world's reserve currency, the US capacity to carry debt is far greater than any EU country's. The fact that the US debt ratio isn't a problem in the credit markets is reflected by the negative real interest on much of the US paper; investors are literally willing to pay the US government to hold their money securely in government bonds.

Here are some of the 2011 ratios for EU countries. The ones current under major pressure by the bond markets are Greece, Ireland, Italy, Portugal and Spain.

EU countries, eurozone members (debt-crisis countries in bold):

Austria: 70%
Belgium: 97%
France: 88%
Germany: 80%
Greece: 152%
Ireland: 114%
Italy: 120%
Netherlands: 66%
Portugal: 91%
Spain: 64%

EU countries, non-eurozone members:

Britain (UK): 83%
Czech Republic: 42%
Denmark: 46%
Sweden: 37%

Notice that with Spain in particular, their debt ratio is lower than non-debt-crisis countries Austria, Belgium, Britain, France, Germany, and the Netherlands. Greece is the only eurozone country that actually had built up what would be unpayable levels of debt under stable conditions. The others became vulnerable to bond speculators because they don't control their own national currencies because they are part of the eurozone.

Where algebra works its wrath is when austerity economics is applied to the crisis countries in the midst of the current economic depression. The debt ratio has a numerator (the debt) and a denominator (GDP). If GDP shrinks without a parallel reduction in the debt, the debt ratio gets higher and therefore the country's debt looks riskier. And what we've seen dramatically in Greece but also in other crisis countries is that the EU is demanding austerity economics as they are now doing with Italy. In Greece's case, that has caused the denominator to shrink and therefore makes their debt situation look even worse.

The destructive spiral can also be seen in Italy. Alexander Lee writes in Is Italy’s Opposition out of Options? Dissent 11/09/2011

Berlusconi’s Achilles’ heel was his economic policy. In the face of the European debt crisis, his government came apart at the seams. Although the 2010 budget report required for the implementation of austerity measures was finally passed on Tuesday afternoon, his strategy for dealing with Italy’s mounting economic woes—spending cuts, job cuts, and tax increases—has come under attack from all sides in recent weeks. Confindustria (an Italian business group), the European Central Bank, and CGIL and CSIL (Italy’s major labor unions) have all criticized Berlusconi’s proposals as a recipe for higher unemployment, limiting economic growth, and punishing the lower-middle class. Then, on October 3, Moody’s downgraded Italy’s debt rating, and a week later a first draft of the budget report was rejected by parliamentarians. On Tuesday morning traders began demanding record yields for Italian bonds in a clear indication of falling market confidence in his leadership.

Already weakened by incessant scandals, the economic downturn pushed the prime minister’s popularity to a low of 24 percent. According to some polls published in the week before his resignation announcement, some 62 percent of Italians wanted the prime minister to step down. On October 15, 150,000 demonstrators furious at worsening conditions and Berlusconi’s proposed austerity measures took to the streets, with some hundreds attacking shops, government buildings, and riot police seemingly indiscriminately.
Lee goes on to discuss the "deer caught in the headlights" mentality that has gripped European leaders both conservative and social-democratic and has them locked onto Herbert Hoover economics in this depression, the economic equivalent of putting out fire with gasoline:

The failure of the Italian center left to elaborate clear policy alternatives also fits within a broader trend in European politics. It is not just the PD but rather European opposition parties on both the left and the right that have been unable to propose any alternative to sweeping cuts as a solution to the mounting debt crisis.

Perhaps the most striking example is provided by Greece. Although former Prime Minister George Papandreou leads the center-left Panhellenic Socialist Movement, he has found himself in a position similar to the right-wing Berlusconi’s in recent days. Hastening to meet targets to guarantee the next €8 billion tranche of emergency loans from the EU–European Central Bank–IMF troika, George Papandreou’s now defunct government has faced massive opposition. ...

Yet despite its opposition to Papandreou’s austerity measures, the center-right opposition has not propounded an alternative. While the refusal of Antonis Samaris, leader of the center-right New Democracy, to join a coalition government headed by the former prime minister was ultimately responsible for Papandreou’s downfall, Papandreou was only able to withdraw his proposal for a referendum because New Democracy agreed to support his austerity measures in parliament. New Democracy is on the verge of joining a new national unity government and will exert a decisive influence on policy formation within days. There is, however, no clear sense of what—if anything—its participation in government will change.
The failure of leadership in Spain is just as bad:

Outgoing Prime Minister José Luis Rodríguez Zapatero’s strategy of imposing a constitutional cap on the state budget, making sweeping cuts to the public sector, eliminating corruption, and rationalizing the banking sector has been widely questioned. Throughout the summer the "Indignados" occupying public squares in Spain grew in strength and scope. Their huge demonstrations of early August were repeated on October 15, with more than 50,000 protestors massed in Madrid and upward of 250,000 in Barcelona.

Yet while Mariano Rajoy Brey—leader of the People’s Party—commands a solid lead in opinion polls, his popularity is based mostly on the unpopularity of Zapatero’s government. Committing to EU-agreed targets, Rajoy has announced that he will follow Zapatero’s plan of cutting the budget deficit to 4.4 percent of GDP this year. At the regional level, PP-led governments have already been pursuing an aggressive policy of cutting public-sector jobs, and there is no indication that this will cease should Rajoy be elected. The few novel ideas which Rajoy has suggested—including modest tax cuts for small business and subsidies for new employers—are conditional on economic recovery and thus unlikely ever to be implemented. [my emphasis]
Writing a cap on government expenses into the Spanish constitution was a particularly brainless idea in a situation with no shortage of bad ideas being believed by policymakers in blind faith.

Lee goes on to explain that Keynesian economics is badly needed in the current European situation. But, similar to the situation in the US, the left-leaning parties that should have been its major advocates - though there's nothing inherently "left" about Keynesian economics as a an analysis of the economy - have instead been preaching austerity economics instead of building up a constituency and public awareness of the need for stimulative measures.

IMF chief Christine Lagarde, in china to ask for money to help bail out European countries in the current debt crisis, warned of the possibility of a Lost Decade in Europe, a name taken from Japan's depression which has gone on for more than a decade now. Lagarde sees the likelihood of a "downward spiral of insecurity and financial instability." (Schuldenkrise: IWF-Chefin befürchtet "verlorenes Jahrzehnt" Spiegel Online 09.11.2011)

See also Michael Goldfarb on What would happen if Greece leaves the euro zone? Global Post 11/09/2011 for some speculation on what could happen if Greece exits the euro - though it's entirely possible that Italy will go before Greece. As he notes, people are starting to plan ahead: "TUI, Germany's largest package-tour operator, sent a letter to Greek hotels requesting that they accept payment in drachmas in the event that Greece is forced to return to its old currency." Goldfarb also discusses Argentina in 2001-2 as a key comparison situation.

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