Euro zone strategy of austerity and internal devaluation set to fail
SERIOUS MONEY: THE EURO ZONE continues to lurch from one crisis to the next. Spain is the latest nation state to require assistance, with €100 billion being provided to keep its ailing financial system afloat.
Though the package is being labelled as a banking sector bailout, an official sovereign rescue seems only a matter of time. Cyprus is virtually certain to cry for help in the not-too-distant future, and it’s anybody’s guess how long it will take before Italy becomes unstuck.
Meanwhile, Europe’s policymakers are suffering from “deficit attention disorder”, and continue to pursue a two-pronged strategy of fiscal austerity and internal devaluation in the currency union’s troubled periphery. The policies are almost certain to fail, and are likely to push the euro-project ever closer to complete collapse.
To appreciate why this strategy is unlikely to succeed, investors need to understand the accounting identity that links the financial positions of an economy’s three primary sectors – the public, private and external elements. It is important to recognise the financial position or savings-investment balance of these three sectors must sum to zero. In other words, the surplus/ (deficit) of the public and private sectors combined must be equal to the deficit/ (surplus) of the external sector. This is not a theory, but economic fact.
In the context of fiscal austerity, the desired reduction in the budget deficit at a given level of output must be accompanied by an equal and opposite adjustment in the financial position of the private sector and/or the external sector. It is simply not possible for all three sectors to increase their savings relative to investment at the same time.
If the public sector wishes to reduce its budget deficit, the private sector must increase its indebtedness and/or the country must borrow less or lend more to the rest of the world. The latter means the country must reduce its current account deficit or increase its surplus, which effectively translates to an increase in exports relative to imports.
Successful fiscal consolidations in the past have typically been accompanied by the leveraging of private sector balance sheets and currency devaluation. The former is unlikely to occur for a variety of reasons, while the latter cannot happen in a currency union, and a weaker euro per se will not help to eliminate the periphery’s current account deficits since the external imbalances are primarily intra-regional.
A desired leveraging of private sector balance sheets is simply not rational behaviour in the current climate. Non-financial private sector indebtedness ranges from 145 per cent of gross domestic product (GDP) in Greece to a mind-numbing 365 per cent in Ireland, and the relatively high numbers means the capacity to add new borrowings is limited.