Except for lower debt refinancing costs, the fundamentals of peripheral eurozone economies have not improved in the last six months. At best they are unchanged, but they are probably worse. The region’s crisis continues to be just a liquidity crisis as far as policymakers are concerned – and not caused by problems in the “real” economy. But is peripheral Europe really suffering primarily from a liquidity crisis? When do we call it a solvency crisis?
In February I got back from a two-day trip to London, where I spoke at an interesting event organised by the Carnegie Endowment. The attendees were for the most part senior bankers and investors, and I got the impression that several, though maybe not all, shared with me a certain amount of surprise that European bond markets were up this year. We were even a little shocked that the buoyant markets were being interpreted as suggesting that the worst of the European crisis was behind us. The euro, the market seems to be telling us, has been saved, and peripheral Europe is widely seen as being out of the woods.
I cannot name any of the attendees at the Carnegie event because it was off the record, but one of them who seemed most strongly to share my scepticism is a very senior and experienced banker whose name is likely to be recognised by anyone in the industry. After I finished explaining why I thought the euro crisis was far from over, and that I still expected that absent a serious effort from Germany to boost domestic spending – an effort likely to leave the country with rapidly rising debt – at least one or more countries would eventually be forced off the currency, he told the group that he hadn’t made as gloomy a presentation only because he considered it impolitic to sound as pessimistic as I did.
Neither of us, in other words, (and few in the meeting) felt that the recent market enthusiasm was justified. Never mind that the Spanish economy, to return to the country I know best, contracted again in the fourth quarter of last year, that it is expected to contract again this year, that unemployment is still rising, and that the ruling party is involved in yet another scandal that has driven its popularity down to 20 percent. Never mind that young Spaniards are emigrating (20,000 a month net), that the real estate market continues to drop, that businesses are still disinvesting and popular anger is extraordinarily high. The ECB, it seems, is willing to pump as much liquidity into the markets as it needs, so rising debt levels, greater political fragmentation, and a worsening economy somehow don’t really matter. This crisis continues to be just a liquidity crisis as far as policymakers are concerned – and not caused by problems in the “real” economy – and the solution of course to a liquidity crisis is more liquidity.
But is peripheral Europe really suffering primarily from a liquidity crisis? It would help me feel a lot better if I could find even one case in history of a sovereign solvency crisis in which the authorities didn’t assure us for years that we were facing not a solvency crisis, but merely a short-term problem with liquidity. A sovereign solvency crisis always begins with many years of assurances from policymakers in both the creditor and the debtor nations that the problem can be resolved with time, confidence, and a just few more debt rollovers.
To take one possibly illuminating example, I started my trading career during the Latin American debt crisis, which officially began in August 1982. I joined the market in 1987, when bankers and policymakers were still assuring everyone that the problem Latin America was facing was a liquidity problem. As long as we could keep rolling loans over, they earnestly explained, the problem would eventually resolve itself at little to no relative cost (well, Latin America was struggling with unemployment, capital flight, hyperinflation and political turmoil, but I guess that doesn’t really count).
It wasn’t until 1990 that the first formal debt forgiveness took place – known as the Mexican Brady Bond restructuring – and before the end of the decade nearly every country except Chile and Colombia had their own Brady bonds. Even those two countries, and all the others, had managed to obtain for themselves a significant amount of informal debt forgiveness through debt-equity swaps and debt repurchases at huge discounts from face value (some legal and some not quite legal).
Why did it take so long for bankers and policymakers to recognise the truth – that this was not just a liquidity problem? Actually it didn’t. Most bankers knew by 1985-86 that the region was actually suffering from a generalised solvency problem, and among the big banks JP Morgan had been taking substantial provisions all along. No one could formally acknowledge the possibility of insolvency, however, because to have done so would have required that all of banks take much greater provisions than they already had. This would have created a problem. Of the top ten banks in America, only JP Morgan would not have been technically insolvent had the banks been forced to mark their LDC loan portfolios to market.
In May 1987 Citibank, after many years of replenishing its capital, was able to announce suddenly and to the great surprise of the entire market that it had decided to take a huge amount of provisions against dodgy sovereign loans. By 1989-90 the rest of the big American banks were also able to accept the write-offs without becoming technically insolvent. That is when everybody formally “discovered” that in fact the LDC debt crisis was a lot more than just a liquidity crisis.
This is the key point. The American bankers weren’t stupid. They just could not formally acknowledge reality until they had built up sufficient capital through many years of high earnings – thanks in no small part to the help provided by the Fed in the form of distorted yield curves – to recognise the losses without becoming insolvent.
And this matters to Europe. There is simply no way European banks, especially in Germany, can acknowledge the possibility of sovereign insolvency until they, too, have built up enough capital to absorb the losses. They have, unfortunately, been painfully slow to do so, even with yield-curve help from the ECB, and so I suspect that this is going to remain a “liquidity” problem for many more years. While it does, the debt-burdened countries of peripheral Europe are going to suffer a decade of weak growth, high unemployment, and contentious politics, all the while the debt growing faster than the economy.
The New Gold Bloc
Or the peripheral countries can regain competitiveness quickly by leaving the euro, in which case after a year or so of confusion growth would return almost immediately, especially in countries like Spain that have managed to put into place a number of very important labour market reforms. The historical precedent is clear. Crisis-stricken countries that have forced through robust reforms to address their comparative lack of competitiveness will continue to struggle under the burden of high debt and an overvalued currency, but once they directly address both, growth usually returns quite quickly.
And there have been real reforms in Spain for all the grumbling. Several euro-optimists have pointed out that unit labour costs in Spain have dropped substantially relative to Germany, by as much as 6 or 7 percentage points. So this whole reform process is working, they claim, and if we can just wait it out another year or two Spain will be fully competitive again.
I am not so sure. Although I agree that there have been real economic reforms, I am a lot less sanguine about the ability of these reforms to stave off the crisis. First, the reforms have come at a huge social cost, and it isn’t obvious that people can suffer much longer as they already have. After all we know how to force down unit labour costs. It is really quite easy. High unemployment usually does the trick.
The problem is that Spain, after four years of punishingly high unemployment, has only clawed back in labour competitiveness about one-third of what it needs to claw back in total, and Madrid has already picked most of the low hanging fruit. As brutally difficult as this has been, this was the easy part. For Spain to claw back other 10 – 15 percentage points in unit labour costs, and it may need more, may well be beyond the capacity of the population to endure.
Second, labour is only one factor in international competitiveness. Capital is the other, and everyone is in a hurry to forget this. It is hard to calculate the appropriate trade-off, but while relative labour costs in Spain have certainly declined, the relative cost of capital has just as certainly risen, and probably by a lot more (to the extent that businesses can even get capital). On February the Financial Times had this article:
Businesses in the core of the eurozone are cashing in on easy monetary policy to borrow at record low rates, while those based in the periphery are still struggling to find market funding, according to new data. Barclays analysis of European Central Bank data suggests that companies based in the “core” of the bloc have been the main beneficiaries of the central bank’s promise last June to do “whatever it takes” to save the eurozone.
Companies based in France, Germany, Belgium and Holland were able to borrow a net €37bn of ultra-cheap debt from the markets in the second half of last year, following the announcement. But companies based in Italy, Spain, Portugal and Greece added only about €12bn of market borrowing, with only the biggest companies such as Telecom Italia and Telefonica able to access the capital markets.
At the same time these peripheral eurozone countries faced a €65bn reduction in net bank lending, as the region’s crisis-hit banks reduced lending in a bid to strengthen balance sheets.
At best we can say of the combination of lower labour costs and higher capital costs that there has been a transfer of resources from the capital-intensive parts of the economy to the labour-intensive parts. Aside from the fact that this probably doesn’t bode well for future productivity growth, it suggests that for all the pain of reform Spanish businesses still cannot compete.
Some people might argue – and do – that the sharp contraction in Spain’s current account deficit, from 5 percent of GDP in 2008 to around 1 percent today, shows that Spain has indeed become more competitive, but this of course isn’t at all obvious. Much of the “improvement” seems to have occurred because of a drop in imports, which suggests greater export competitiveness hasn’t played much of a role here – which it shouldn’t have done if I am right about the impact of higher costs of capital in eroding the benefits of lower labour costs.
Unemployment levels well above 15 – 20 percent (and I assume official unemployment of 26 percent is probably overstated by the failure to account for the “black” economy) are an incredibly effective way of forcing a trade deficit to contract, because when people can’t buy anything, they also can’t buy tradable goods. As they stop purchasing those tradable goods however these goods would necessarily have been diverted to exports, even without any improvement in the country’s overall competitiveness.
This might imply that whatever increase in exports we have seen may be no more than the export of goods that Spaniards used to buy but no longer can. This kind of export performance is not a consequence of improved competitiveness. It is simply a consequence of rising unemployment.
What’s more, if Spain is ever going to repay its very rapidly rising debt, it needs a lot more than a lower trade deficit. It needs a very high trade surplus to fund net capital outflows (unless we are expecting an unlikely surge in net private capital inflows). Actually to be technically correct I should say that in order to repay its debt Spain needs a very high current account surplus, and given Spain’s huge interest burden, this actually means it needs a whopping trade surplus since the trade surplus has to exceed the interest outflows before it can be used to pay down debt. If unemployment is the best tool to get us there, I am not sure the Spanish population can bear the burden needed to get us the necessary high trade surplus.
So in spite of the good news in the Spanish bond markets, I still don’t think we can pop the champagne corks. Except for the debt refinancing costs, the underlying fundamentals have not gotten better in the last six months. At best they are unchanged, and probably they are worse.
How long must Spain hold on to prove how serious it is about staying the course? A lot longer, I think. After all it wasn’t until around 1931-32 that France began suffering from its membership in the gold bloc, but they doggedly held on until 1936 when they finally threw in the towel and devalued. The Spaniards are proving tougher than the French were, possibly because among the older generation (although not so much the younger) there is a tremendous residual worry (and shame) that Spain might not truly be European, and this is creating much of the loyalty to Europe, of which the euro is the great symbol.
But the Spanish still have a lot of pain to absorb. By the way if we were to see an intensification of the debate in France about the euro, I suspect that this will give a green light to Spanish public intellectuals, for whom France is the North Star, to discuss the prospect themselves. Until then, in Spain you are not really supposed to talk about abandoning the euro if you want to be taken seriously. It is a little like England in the 1920s, when for much of the policymaking elite abandoning the country’s free trade principles and leaving gold were unmentionable – until many years of unemployment suddenly made both policies very “mentionable” in the first years of the 1930s.
In my opinion the happy bond markets are, as they have so often been under similar circumstances in history, a little premature. I think the phrase “there is light at the end of the tunnel” was popularised by Herbert Hoover around 1931, when the US stock markets staged a strong rally, convincing him and others that the crisis was over. Of course it wasn’t, and the buoyant markets gave back everything and more over the next three years.
By Michael Pettis
Michael Pettis is a senior associate at the Carnegie Asia Programme and professor of finance with Peking University’s Guanghua School of Management. Pettis previously taught at Tsinghua University and Columbia University, and worked on Wall Street in trading, capital markets and corporate finance.
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