[Andrew Sheng] European debt depression ― the state vs. the market

In the 1930s, the American economist Irving Fisher first outlined the dangers of debt deflation dynamics. The first stage involves distress selling of assets by the borrowers to reduce their debt. Stage two affects bank balance sheets that contract when customers are paying off their debt. A general fall in asset prices, signaling the reversal of the asset bubble, creates a further fall in business net worth. 

The consequent decline in the profit level cuts back trade volume when households feel less confident to spend and investors worry about the future. At the macro level, trade and output fall while unemployment grows, causing more market pessimism. As the public begins to hoard cash, the velocity of circulation slows down further. This causes a fall in nominal rates, but since inflation may be falling faster, the rise in real rates worsens the debt burden of the borrowers.

The eurozone is in the grip of this depressing state of affairs.

During a recent visit to Paris, London and Dublin, I heard only gloom and doom, with a normally unflappable euro-technocrat even accusing the media of trying to kill the euro by fanning more fear. The options for saving the euro appear to be more and more limited by the day. There is no doubt in my mind that the German proposal of fiscal union is the sensible solution for the euro, because it addresses the structural defect of not having a fiscal mechanism to deal with the side-effects of a single currency union.

The markets had a temporary rally, even as the new Italian prime minister announced austerity measures to restore confidence in Italian bonds. The interest rate on 10 year Italian bonds duly fell from 7.3 percent per annum to 6 percent, but even at that level, the real interest rate (after deducting inflation of 3.3 percent) is 2.7 percent. With the economy growing at near zero and the debt/GDP ratio surpassing 100 percent, it is not surprising that the markets feel that the Italian debt situation is unsustainable.

Thus, though the package agreed on by German Chancellor Merkel and French President Sarkozy may have staved off the barbarians at the gate for the moment, the financial markets still consider that they cannot fix a plane in mid-flight.

The arithmetic of debt deflation is relentless. High real interest rates deflate asset prices, but bank liabilities in the form of deposits are fixed nominally. So the pressure is on European bank balance sheets. The banks are in a bind, because they hold a lot of European sovereign debt paper, which is deflating in value as real interest rates rise. So the European problem is a twin bank-fiscal bind, in which the governments have to bail out the banks, but their own fiscal debt overhang is now the root of further deflation.

The financial consensus seems to insist that the European Central Bank must print money and go for zero interest rates like the U.S. Fed. The ECB has resisted this because of Germany’s fear of inflation. New ECB Chairman Mario Draghi is already preparing the ground for this action by cutting interest rates slightly, but the European banking system is going through a liquidity crunch because banks are scared of lending to each other, and there are signs that there is an internal flight to quality, as depositors shift their savings to higher quality bonds within the eurozone. So the surplus countries like Germany are flush with inflows, whereas illiquidity plagues the deficit countries like Italy.

During my first visit to Dublin, it was noticeable that there were many commercial properties for sale. My host remarked that his property which was worth 1.3 million euros before the crisis is now worth less than 500,000 euros. Ireland has certainly undertaken a Hong Kong-style deflation in the wake of the eurozone crisis. Hong Kong’s experience with the link to the U.S. dollar meant the economy must be flexible to maintain the fixed exchange rate. Ireland had to do the same. The Irish authorities understand that restoring growth and confidence is the only viable way out of a debt deflation.

The World Bank ranks Ireland as the 10th easiest place in the world to do business. Unit labor costs have fallen by 12 percent and exports grew more than 24 percent in the last 12 months, bringing the current account into balance. The economy is now back to 1 percent growth in 2011, after suffering negative growth since 2007. Thus, Ireland is best poised for growth in the event the ECB goes for quantitative easing and if the euro depreciates.

The eurozone crisis must be seen in its proper context. The eurozone is not a poor economic bloc. A survey of household debt showed that the Italians have the lowest household debt relative to the other eurozone households. This means that the Italian people are rich, while the government may be in hock. Hence, it is well within the means of the under-taxed Italian people to solve their government’s fiscal problems. This is not a question of using the savings of poorer Asians to rescue richer Europeans.

Before the crisis, the financial markets underpriced European sovereign debt risks. Now, they demand usurious real interest rates that can only mean eventual default, which would also destroy the value of their investments.

Companies can go bankrupt, but countries do not disappear. The political reality is that the state cannot afford to satisfy its relatively few creditors by destroying the jobs and security of its many citizens. The real issue is whether ultimately the power of the market wins over the will of the state.

In August 1998, the Hong Kong government had to intervene in the markets to restore stability. This battle is being fought in Europe today. Whichever side wins, the outcome is likely to be ugly. 

By Andrew Sheng

Andrew Sheng, the author of “From Asian to Global Financial Crisis,” president of the Fung Global Institute. ― Ed.

(Asia News Network)