Let's assume – and I know it is a dangerous assumption – that they manage to do a credible deal this weekend that carries the three elements needed to stitch together the eurozone for a while yet. These are: a default for Greece, support for European banks, and expansion of the European Financial Stability Facility. Where do we go from there?
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Well, a huge amount will depend on the detail and there will inevitably be a high degree of scepticism towards whatever has been agreed, given the ineffectiveness of previous rescue packages. But let's assume that this will be a good enough patch to carry confidence through the winter and thereby buy the eurozone authorities some time. If that is right then the focus will switch from bailout to adjustment: from the financial consequences of past errors to the need to correct present ones.
There are several elements to this. One is the need to have a budgetary position that is sustainable, which in practice means a budgetary position than can be financed from the markets without recourse to any external guarantee. In other words it may be acceptable for the time being for Germany to guarantee some element of Spanish or Italian borrowings but that cannot be a long-term sustainable situation, if only because the German balance sheet is not strong enough to carry such obligations.
Getting budgets back to balance or actually surplus is just the start. There is another and in some ways more difficult adjustment, which is to reduce the trade and payments imbalances both within Europe and in the rest of the world. As far as Europe is concerned one of the huge problems is that the common currency has led to economic divergence rather than convergence. Costs have shot up in the weaker countries and been held down in the strongest one, Germany. So Germany, which arguably joined the eurozone at too high a rate, has become super-competitive, while much of southern Europe has become progressively less so.
There is a response. Countries can do what in effect Germany did, which is to crunch down costs, boost productivity, improve quality so that goods can be sold at a premium and get out of lower-value-added lines. But among the fringe European countries only Ireland is so far succeeding in making this transition, with sharp cuts to wage rates as well as other austerity measures, and even so I understand that Irish costs are still higher than those of the UK, particularly at present exchange rates.
It is the practical difficulties of making such huge adjustments to pay and benefits that have usually led to countries devaluing their currencies. That is by no means a painless way of cutting costs and it does have the effect of reducing living standards through higher inflation, but in practice it is easier, partly because it shifts some of the burden to savers. But of course this option is not open to countries while they remain within the eurozone. So the for time being direct austerity is the only way of making the adjustment.
Another way of looking at the need for adjustment is to look at countries' external asset position: the value of a country's overseas assets minus the value of assets within the country owned by foreigners. Countries that run large current account surpluses eventually pile up external assets, either in the form of foreign securities (eg China buying US treasury bonds) or other assets abroad (eg Germany owning US car plants). Similarly, countries that run current account deficits will eventually build up external liabilities.
In the case of the US and UK, our persistent current account deficits have led to both countries moving to a net deficit on the stock of external assets. However, the deficits in both cases are not huge relative to GDP, as the first graph shows. That is partly because we have both devalued our currencies, which automatically cuts the value of assets at home and increases those abroad, and partly because both countries earn a higher return on external assets than we pay out on liabilities. You could say we borrow cheap and invest well.
Within the eurozone, however, the position is less stable. Taken as a whole the eurozone remains in modest deficit but, as you can see, within the eurozone there has been a sharp divergence between Germany and Spain.
The second graph shows the present position for selected European countries and for the US and UK. Portugal, Ireland and Greece join Spain at the head of the league table of debtors. Germany is the only significant net creditor.
Does this matter? Well it may come to matter a very great deal. Goldman Sachs, which drew attention to this divergence in the asset position of eurozone countries, feels this balance sheet effect may become even more important than the trade effect of a currency union.
You have to ask: to what extent is it tolerable for one country to "own" another? What do the owners want in exchange? Remember that the "owned" country has to pay an annual tariff to the owner. So there is a reverse Robin Hood effect. Those poorer countries have to pay money, either in interest rent or dividends, to the richest one.
This is bound to cause tension and is certainly not what the eurozone was supposed to do. But the alternative, not paying the money, is in effect to declare a default and not just for Greece.
There is a wider problem of imbalances here, one that goes far beyond Europe. We live in a world where some creditor countries have regarded building up a large stock of external assets as some kind of statement of economic might. Japan did so in the 1970s and 1980s and retains that position as a creditor nation now. China is emulating Japan, though the authorities there would put a rather different spin on their actions. But at least currencies can adjust. China's stock of external assets has been depreciated by the decline of the dollar. It is not quite fair to say that the US is stealing from China because this is a willing trade between two adult partners but the US is certainly borrowing on highly favourable terms.
To say that, though, is no solution. As the Bank of England's Governor Sir Mervyn King noted in a speech this week, global imbalances – with, in shorthand, the US and parts of Europe consuming too much and much of Asia consuming too little – is extremely serious.
This highlights a central problem of the world economy but one that is more apparent in a fixed exchange rate system than a floating rate one. It is that there is an inbuilt asymmetry in the world economy, for there is more pressure on deficit countries to adjust than there is on surplus countries.
We live in a world of too many savers and not enough borrowers. It may be that the only way of making these adjustments is to devalue the assets of the savers, but that is at best an imperfect way of doing so and at worst one that undermines the entire world trading system.Reuse content