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.
Further, the wage cuts and high unemployment rates associated with internal devaluation mean household consumption is fragile, which is hardly an environment conducive to robust business investment. Finally, the banking sectors across the periphery are stressed and short of capital, which means they are not in a position to lend to anyone but the best credits.
In the absence of a private sector credit expansion, a successful fiscal consolidation rests on a state’s ability to effect an offsetting improvement in its external position. However, it is not possible for all countries to export their way back to prosperity, and with sluggish demand now apparent across the entire monetary union, the required adjustment appears most unlikely to take place through robust export growth.
If the private sector does not plan to reduce its savings relative to investment to the extent required by the planned fiscal consolidation, and/or the magnitude of the current account adjustment falls short of that required, then fiscal austerity will cause output to fall. Lower incomes will see the private sector save less than desired, weak demand will see the current account adjust through lower imports, and lower tax revenues will see fiscal austerity fall short of plan.
All told, the current two-pronged strategy is likely to perpetuate the economic and employment crisis, and the social consequences may ultimately lead to the abandonment of austerity programmes. In this regard, Hans-Joachim Voth has studied the “austerity trap” and finds that, “from the end of Germany’s first democracy in the 1930s to the anti-government demonstrations in Europe after 2009, austerity has tended to go hand in hand with politically motivated violence and social instability”.
Voth’s work shows social instability increases rapidly once expenditure cuts exceed 2 per cent of GDP, and reaches its highest level with cuts of 5 per cent or more. He finds social instability is positively related to the length of time during which austerity is pursued. Not surprisingly, the study shows governments yield to the demands of the people in the face of substantial unrest and do not persevere with painful cuts.
Europe’s policymakers continue to pursue a two-pronged strategy of fiscal austerity and internal devaluation in an effort to bring an end to the crisis in a beleaguered euro-zone. The policies are destined to fail and the increased social tension is likely to push the single currency ever closer to the abyss.