Satyajit Das: Europe’s debt disease is in remission – it’s not cured

Economic Outlook: Growth will not be strong enough to reduce unemployment  or improve solvency

European leaders are interpreting stabilisation of economic activity and stable borrowing costs as evidence that the debt crisis is over. Austerity programmes, debt write-downs, the European Central Bank’s commitment to “do whatever it takes” to preserve the euro, the proposed banking union and the finalisation of the primary bailout fund (European Stability Mechanism) have all helped restore relative financial stability. There were falls in the interest rates of peripheral countries and a rally in stock markets, although no meaningful recovery in the real economy.

The cost of Spanish 10-year debt fell from more than 7.5 per cent to around 4 per cent; Italy from 6.7 per cent to under 4 per cent; Greece from 30 per cent to about 10 per cent; Portugal from 12 per cent to around 6 per cent. The Spanish and Italian stock markets recorded a one year gain of 31 per cent and 24 per cent respectively. The French and German stock markets rose by over 24 per cent. In contrast, eurozone gross domestic product fell 0.1 per cent during the third quarter of 2012, 0.6 per cent during the fourth and 0.3 per cent during the first quarter of this year, with sharper falls in the weaker economies. Modest growth was registered in the second quarter.

But austerity has failed to bring public finances and debt under control. Increases in taxes and cuts in government spending have led to contractions in economic activity, reducing government revenues as unemployment rates increase. Budget deficits, while smaller, persist and debt levels continue to rise.

Eurozone GDP is now 3 per cent below the 2007/2008 level. It is also some 13 per cent below trend levels. Individual economies have fared even worse: the Greek economy has decreased by 23 per cent; Italy by 9 per cent; and Ireland, Spain and Portugal by 8 per cent. Eurozone unemployment is 12 per cent. Some weaker nations have higher figures: Greece 28 per cent;  Spain 26 per cent; Portugal 17 per cent; and Italy and Ireland 14 per cent. Youth unemployment is significantly higher in some countries, at 25 to 50 per cent.

The eurozone used large current account surpluses, which have increased to a surplus of 2.3 per cent of GDP, to reduce the need for internal adjustment. Falling Greek wages and improvement in Italian and Spanish exports are cited as evidence that imbalances are correcting and peripheral countries are regaining competitiveness.

Unfortunately, this improvement may be dependent on the value of the euro. If the euro continues to rise, due to the US continuing its quantitative easing programme for longer than expected, then improvements in economic activity may slow. Fundamentally, all countries cannot achieve an increase in net exports. 

The IMF recently concluded that eurozone internal adjustments were cyclical, due to slower growth and weaker currency rather than sustainable structural policy changes. Internal cost adjustments within the euro-  zone have been slow, driven in part by the reluctance of stronger countries, led by Germany, to reflate and switch from their export-driven models. The prospects of such changes occurring in the short term are poor.

Reduced dependence on foreign capital has also stabilised borrowing costs. Leading into the crisis, Greece, Ireland, Portugal, Spain and Italy were running current account deficits which were financed by imported capital. Most countries are now funding their needs domestically. Around 70 per cent and 60 per cent of all Spanish and Italian government bonds respectively are now held domestically. Almost 100 per cent of net issuance of Spanish and Italian government is now purchased by domestic investors, reducing vulnerability.

The ECB provided low-cost funding to domestic banks to buy government bonds which are lodged as collateral for the loan. Withdrawing from foreign markets and reducing exposure to riskier investments, the banks have been “encouraged” to purchase government bonds, which generate attractive profits.

The policy does not address the problems of debt levels. It concentrates exposure to government bonds and creates problems if the debt has to be restructured and it increases the vulnerability of the banking system.

Stabilisation has meant that governments are reluctant to continue austerity programmes in the face of weak economic activity and high levels of unemployment. Pleading exceptional circumstances, many nations have sought and received exemptions. Deficit and debt reduction targets have been deferred, although even these are unlikely to be met.

Overall, economic improvement will, at best, be slow. Growth will not be strong enough to reduce unemployment or improve solvency of banks, corporations or households.

In reality, the European financial crisis has been in remission since mid-2012, with the symptoms of the underlying disease temporarily suppressed. There is a high probability of a relapse.

Satyajit Das is a former banker and  author of “Extreme Money” and  “Traders Guns & Money”

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