A look at the dynamics of debt explains why draconian budget cuts won't fix what ails Europe's most indebted economies. Growth is an essential part of any rescue plan for countries such as Greece and Cyprus. Even as those countries struggle, the likely impact of the end of the Federal Reserve's quantitative easing program on bond markets threatens further difficulty for them if they don't begin growing. But European policymakers have fewer tools than their U.S. counterparts to stimulate growth. That means the European Central Bank must lead the way in exploring strange new worlds in search of solutions to the sovereign debt crisis.
The eurozone. The final frontier. These are the adventures of the european central bank. Its continuing mission: to explore new frontiers of monetary policy, to seek out new tools and send new communications, to boldly go where no central banker has gone before.
ECB log, crisis year six, Captain Mario Draghi: "we are considering both standard and non-standard measures. [...] We are thinking 360 degrees."
For European economists and investors, 2013 feels like science fiction, complete with space and time travel. After considering the unconventional measures and messages coming from the ECB, one is tempted to say, "beam me up, Mario." For countries on the eurozone's periphery, though, being bailed out might yet be more likely than being beamed up.
Earlier this year, we've seen Cyprus bailed out with depositor bail-in and have hoped that Portugal and Ireland might exit their European Stability Mechanism (ESM) programs. We've also experienced quarterly anxiety over whether the troika of the European Union, the International Monetary Fund and the European Central Bank will approve the next credit tranche for Greece and we continue to wonder which member of the European Monetary Union (EMU) could be the next to require an EU-orchestrated bailout.
Austerity, Growth, or Both?
While this drama has played out, the main actors' roles have changed and their priorities have shifted. Few European leaders now call for further austerity. Instead, many have begun lobbying for an end to budget constraints to avoid further economic contraction and loss of wealth and jobs. The ongoing recession in many highly indebted eurozone countries is causing increasing social unrest and thwarting budget consolidation and structural reforms.
A growing crowd of commentators and discontented voters argues that fiscal targets set by creditors for countries that receive international financial support are too ambitious. They reject those lenders' demands for what they call unacceptably deep cuts to social benefits and subsidies at a time when economies are collapsing and jobs disappearing.
These impacts would hurt less if budget cuts and structural reforms were accompanied with some growth stimulus. The trouble is that the countries most in need of such stimulus have few means to provide it. Instead, they depend both on their EU partners' willingness to accept their delays in reaching budget goals and on the ongoing support of the only EU institution with room to maneuver — the ECB.
An increasing number of EU citizens and governments, along with the International Monetary Fund, oppose uncompromising austerity and unpopular social and budget reforms. They also demand the EU provide more fiscal leeway and financial assistance. Meanwhile, Germany leads a shrinking group of countries that insist the debtor countries restrain their budgets and stick to agreed upon plans to cut public debt.
But not even Germany opposed the recent postponement of budget goals by France, Italy and Portugal. Unfortunately, such small tweaks along the path to budget consolidation are insufficient to boost growth in any of the ailing EMU countries. Fiscal policy options are constrained both by the excessive debt levels of some countries, and by the lack of a fiscal union in the eurozone which could enable transfer payments from healthier countries to weaker ones in order to spur growth.
This inefficient fiscal framework leaves only the ECB to help ameliorate the impact of austerity on the eurozone's peripheral economies. While the central bank has ballooned out its balance sheet and cut interest rates to their lowest level ever, these relatively conventional weapons have neither ended the peripherals' recessions, nor convinced the market that countries such as Spain and Italy are safe for investors.
Since July 2012, when these countries' bond yields rose beyond sustainable levels, the ECB has explored new and unconventional means to keep the crisis from escalating to a point where larger countries risk losing access to market financing.
Figure 1 // Outstanding Government Debt
Sources: Ecowin, Meriten Investment Management, forecasts for 2013/2014: EU Commission
The ECB's first truly unconventional move came in July 2012 with the so-called Draghi put, when the president remarked that the ECB would do "whatever it takes to preserve the euro." This now-famous statement calmed markets and brought down Spanish and Italian bond yields. But Draghi's vow to support the single currency was not as unqualified as it may have sounded. He prefaced his pledge by using the phrase "within our mandate," and therein lay restraint. When the ECB launched the Outright Monetary Transactions (OMT) program in September 2012, it institutionalized the Draghi Put and showed the limits of the bank's willingness to do "whatever it takes" by requiring countries applying for ESM support to also undertake reform programs.
Early in July 2013, the ECB again responded to an unwelcome development with an unconventional communication. When the Federal Reserve announced it would wind down its bond purchase program, yields on US Treasurys and European government bonds surged. In light of the fragile state of the eurozone economies and, more importantly, the unsustainable state of many member states' public finances, the ECB saw a risk of financial market destabilization. Up to this point, it had refused to "pre-commit" to future interest rate changes. But in order to counter the unwarranted rise in euro area yields, it dropped this rule at the July council meeting, saying, "The Governing Council expects the key ECB interest rates to remain at present or lower levels for an extended period of time."
Beyond their immediate effects on financial markets, the ECB's strategy shifts suggest that the central bank accepts that it needs to buy countries more time than originally anticipated to reform themselves and tackle their debt problems. However, the ECB's means are limited by its mandate and statutes prohibiting action that could be seen as financing a member country's current budget. Hence, today's institutional framework, which is being challenged in Germany's constitutional court, does not give the ECB tools as powerful as the Fed's. The ECB cannot buy bonds in the market unconditionally or pre-emptively. Nor can it provide the targeted and meaningful economic stimulus some of the peripheral countries require.
That inability of fiscal and monetary policy to effectively stimulate member economies in recession is one reason the eurozone is growing more slowly than the U.S. The eurozone economies and their public finances also face higher risks if the Fed's plan to slow and ultimately end quantitative easing results in higher bond yields in Europe without increased growth.
An Analytical Approach To The "Austerity Versus Growth" Debate1
The importance of both financing costs and growth to the financial health of indebted countries becomes immediately clear when one considers the debt ratio, which is the proportion of outstanding debt to nominal gross domestic product (GDP):
Debt ratio (% of GDP) = 100 x outstanding debt / nominal GDP
The debt ratio rises whenever the level of outstanding debt grows faster than nominal GDP. It can also rise if GDP contracts by more than the amount by which the absolute debt level declines. This principle shows why growth is an important factor to consider when assessing a country's debt situation (nominal growth, ie, combined volume and price growth).
Changes in the debt ratio will predominantly be influenced by a country's budget balance. To see the influence of financing costs on those changes, we can look at the balance of the current budget this way
budget balance = primary balance – net interest expenditure
The primary balance is the difference between revenues and spending, excluding interest payments. The interest payment amount equals the product of the debt level and the average interest rate payable on outstanding liabilities. Therefore, changes in the debt ratio are determined by
- the nominal GDP growth rate w
- the primary balance (in % of nominal GDP) Pt
- the debt level of the previous period (in % of GDP of previous period) Dt-1
- the average effective interest rate i
The exact relation is given by the so-called debt dynamics equation:2
The second term describes the "snowball effect," in which the mountain of debt that has already accrued grows all the more rapidly than the amount by which the interest payable exceeds nominal GDP growth. Hence, a country's debt ratio increases whenever a primary deficit is not compensated by a negative snowball effect (i < w) or when a primary surplus is counteracted by a positive snowball effect (i > w).
The fact that the debt ratio can rise even if there is a primary surplus (for example, if the effective interest rate exceeds the nominal GDP growth rate by a sufficient amount) shows why austerity measures alone are not enough to reduce the debt and why a parallel growth-oriented reform policy is indispensable.
The austerity measures imposed on countries receiving bailout loans from the European Financial Stability Facility or the ESM should lower primary deficits. In cases of severe over-indebtedness, they may even produce primary surpluses over the medium term.
Figure 2 shows that the primary balances of all of the countries reviewed (with the exception of Cyprus) have improved since 2009. Italy has even run a primary surplus in the past two years, which is not that unusual in light of its high debt level prior to the crisis. The chart also shows that all of these countries had run primary surpluses before the launch of the euro.
Figure 2 // Primary Balances
Note: Line markings represent the year the euro was introduced
Sources: Ecowin, Meriten Investment Management
We can assume that the opportunity to join the monetary union in the 1990s (2008 for Cyprus) motivated many countries that had traditionally run deficits to strengthen their budgetary discipline. That motivation in some cases evaporated all too quickly after joining the eurozone. Still, it's worth remembering that those countries were able to run primary surpluses. Unlike today, however, they could rely on strong global growth which helped consolidate their fiscal positions.
All these countries have been in recession practically since the crisis began and it is far more difficult for them to achieve primary surpluses today than before the start of the monetary union. Unlike then, they cannot devalue their currencies and they have also made long-term financial commitments such as social security benefits that cannot be trimmed without serious opposition.
Figure 3 // Nominal GDP Growth (annual average in %)
Sources: Ecowin, Meriten Investment Management
As we've seen, even running a primary surplus is no guarantee that the debt level will decline – particularly when a country is mired in a deep recession. The worst case scenario is a downward spiral of economic contraction and ever increasing debt that necessitates ever-bigger bailout loans or even results in a sovereign default. A number of EMU crisis countries risk sliding into precisely such a situation and those risks are increasing with each bit of bad news about growth and every increase in financing costs.
Figure 4 // GDP Growth (Nominal) and Implicit Interest on Government Debt
Sources: Ecowin, Meriten Investment Management, forecasts for 2013/2014: EU Commission
Figure 4 shows that according to the European Commission's forecast, no crisis country can expect nominal growth to exceed the interest payable on outstanding public debt, either this year or next. That suggests the snowball effect will likely increase their debt levels. In order to stabilize or ultimately reduce their debt, all six countries would have to run primary surpluses and/or sell assets, which would reduce debt defined by the SF term in the equation above.
Figure 5: Primary balances required to stabilize public debt ratios in 2013 and 2014
GDP % y/y
1 In percent of nominal GDP
Sources: EU Commission, AMECO database, Meriten Investment Management
We believe that among these countries, only Ireland might be able to achieve a large enough primary surplus to stabilize or perhaps slightly reduce its debt in 2013-2014. The debt levels of Spain, Portugal and Italy are likely to rise again as they pay interest above their likely GDP growth rate and they are unlikely to generate primary surpluses large enough to compensate. Greece and Cyprus undoubtedly face the most challenging situation, and we expect to see debt ratios rise significantly in both countries. The European Commission forecasts that Greece's debt will surge to 175 percent of GDP while Cyprus's is expected to rise to 124 percent.
Analyzing the eurozone's debt dynamics shows that both Greece and Cyprus may not be able to sustain their debts or to finance themselves in the markets without external aid. That makes the EU's bailout policy essential for avoiding sovereign defaults within the eurozone.
We believe that bailout loans coupled with austerity measures will not be enough to diminish the debt burden, at least in the most deeply indebted countries. What is needed instead is a mix of fiscal consolidation, structural reforms that improve medium- to longer-term growth potential, and short-term stimulus that helps bridge the gap until reforms bear fruit.
We remain cautiously optimistic that our view is shared by policymakers in Brussels as well as among leaders in crisis countries, even if some publicly distance themselves from austerity for domestic political reasons.
Risks to Debt Sustainability
Even so, we are concerned that the limitations of EMU fiscal and monetary policy leave some countries very exposed to a global increase in bond yields that could be triggered by the end of quantitative easing by the Fed, or by disappointing growth. In our debt dynamics equation, a 100 basis point increase in the effective interest rate on outstanding debt would raise the primary surplus required to stabilize debt by 1.3 percentage points in Italy and by 0.8 percentage points in Spain. For each 0.5 percent growth disappointment, an extra 0.5 percent surplus would be required to offset the effect on the debt ratio.
We believe that the ECB will continue to lend maximum constructive support to the consolidation process and will do all it can to keep higher U.S. Treasury yields from spilling into the eurozone periphery and creating instability. The ECB's OMT program may not prevent such a spill-over as it cannot go live without a prior request for a bail-out by a problem country. In a perceived emergency, the ECB might thus have to turn to outright, unregulated bond purchases again, or at least acknowledge this might be an option. This path would be a last resort, a final bout of unconventional policy that would risk conflicts with the German constitutional court, but the ECB might consider it the lesser of two evils compared with the alternative of allowing a larger EMU country to slide more deeply into trouble.
Even if we trust that the ECB will ultimately be prepared to take such action, the precursor of a potential emergency situation would create great discomfort for investors in EMU periphery assets. With this in mind, we will closely watch the news regarding Fed tapering, economic data in the crisis countries, and signs that higher yields are spilling over into them.
1 See for example Martner / Tromben (2004)
2 SF denotes the stock/flow adjustment, which reflects transactions that are not included in the primary balance but influence the level of debt, e.g. asset acquisitions or sales.
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