The big danger is Europe
Europe may no longer be able to save itself. Too many countries have too much debt. Its economic growth — which helps countries service their debts — is too feeble. And nervous financial markets seem increasingly prone to dump the bonds of vulnerable countries. This is the real risk to the global and U.S. economic recoveries, far overshadowing Standard & Poor’s downgrade of U.S. Treasury debt and Monday’s sharp stock market decline.
Europe represents about one-fifth of the world economy and buys about a quarter of American exports. While Europe’s debt crisis was confined to a few small countries, they could be rescued; other European countries supplied loans to substitute for the credit denied by private lending markets. In 2010, Greek, Irish and Portuguese government debt totaled about 640 billion euros (about $910 billion), less than 7 percent of the 9.8 trillion euros of debt of all members of the European Union.
With Spain, Italy and possibly France now under financial assault, the situation changes dramatically. There are more debtor nations and more debt at risk. In 2010, Italy’s debt was 1.8 trillion euros; Spain’s 639 billion euros; and France’s 1.6 trillion euros. But there are fewer countries that can support a rescue; and some of them have heavy debts. Even Germany’s ratio of debt to gross domestic product (GDP), a measure of debt in relation to its economy, was a hefty 83 percent last year, similar to France’s. (The big difference between France and Germany is that Germany’s economy is growing faster.)
Until now, Europe’s leaders have tried to muddle through: Rescue Greece, et al.; hope that modest economic recovery and limited austerity by debtor countries cure the crisis. But this formula is reaching its limits.
Austerity — spending cuts, tax increases — is standard economic medicine for overborrowed countries. It may work for individual countries or even a few countries at a time. But if most of Europe embraces austerity, the logic backfires. Economic growth slows; recession may reemerge. Lower tax revenue makes it harder for countries to service their debts. As this becomes obvious, the financial crisis feeds on itself. Investors sell the bonds of weak countries, sending up their interest rates and making the debt burden heavier.
This is the monster now stalking Europe. Last week, rates on 10-year Italian and Spanish bonds exceeded 6 percent, roughly four percentage points above rates on 10-year German bonds. Meanwhile, the outlook for economic growth is deteriorating without offsetting gains in the rest of the world that might boost Europe’s exports.
So Europe now faces a crisis that is at once financial, economic, diplomatic, political and social. The vaunted “European model” of generous welfare benefits is steadily reneging on its promises. Naturally, this is highly unpopular. Strains among countries are worsening as all seek to shift blame and costs to others.
Can Europe save itself? If not, will anyone? One suggestion is a common bond that would allow weak countries to share Germany’s credit rating; but this would have Germany guarantee other countries’ debts — a role Germans are likely to reject. There seem to be three other possibilities.
First, the European Central Bank — Europe’s Federal Reserve — tries to stabilize financial markets by buying the bonds of besieged debtor nations. It’s already bought Greek, Irish and Portuguese bonds; now it’s buying Italian and Spanish bonds. But where does this stop? The ECB is acting reluctantly, because it fears that excessive bond purchases (“monetizing” government debt) would unleash an inflationary flood of money. This approach is Muddling Through 2.0.
Second, the International Monetary Fund organizes a global rescue package worth trillions of euros. Europe’s debtor nations could borrow at low rates with long maturities. Once debt pressures were relieved, Europe could follow more pro-growth economic policies. But any package would have to be heavily financed by countries with huge foreign exchange reserves, meaning oil producers and — most importantly — China, with reserves of $3.2 trillion.
Third, some European nations could negotiate write-downs on their debts or default on them. Superficially, this seems a solution. But it would create other problems. Defaults would inflict huge losses on banks, insurance companies and pensions. Many European banks might collapse unless rescued. Who would rescue them? Confidence would plunge. A recession would seem unavoidable. Defaulting countries would also have trouble borrowing in the future.
All these possibilities involve momentous political, economic and technical uncertainties. What if the crisis spreads from Italy to Belgium or France? Would China contemplate bailing out Europe? If it did, there would be a stunning transfer of geopolitical power and prestige to China. Can the ECB (or the Fed) buy endless quantities of government bonds without someday fueling inflationary expectations? The questions swirling around Europe are terrible to contemplate. But they will not soon go away.
By Robert J. Samuelson,
http://www.washingtonpost.com/opinions/the-big-danger-is-europe/2011/08/08/gIQABzq02I_story.htmlStagnant and paralyzed
Editor's Note: Michael Spence, a Nobel laureate in economics, is Professor of Economics at New York University’s Stern School of Business, Distinguished Visiting Fellow at the Council on Foreign Relations, and Senior Fellow at the Hoover Institution, Stanford University. His latest book is The Next Convergence – The Future of Economic Growth in a Multispeed World. Visit Project Syndicate for more and follow it on Facebook and Twitter.
By Michael Spence, Project Syndicate
The recent dramatic declines in equity markets worldwide are a response to the interaction of two factors: economic fundamentals and policy responses – or, rather, the lack of policy responses.
First, the fundamentals. Economic growth rates in the United States and Europe are low – and well below even recent expectations. Slow growth has hit equity valuations hard, and both economies are at risk of a major downturn.
A slowdown in one is bound to produce a slowdown in the other – and in the major emerging economies, which, until now, could sustain high growth in the face of sluggish performance in the advanced economies. Emerging countries’ resilience will not extend to double-dip recessions in America and Europe: they cannot offset sharp falls in advanced-country demand by themselves, notwithstanding their healthy public-sector balance sheets.
America’s domestic-demand shortfall reflects rising savings, balance-sheet damage in the household sector, unemployment, and fiscal distress. As a result, the large non-tradable sector and the domestic-demand portion of the tradable sector cannot serve as engines of growth and employment. That leaves exports – goods and services sold to the global economy’s growth regions (mostly the emerging economies) – to carry the load. And strengthening the U.S. export sector requires overcoming some significant structural and competitive barriers.
What the world is witnessing is a correlated growth slowdown across the advanced countries (with a few exceptions), and across all of the systemically important parts of the global economy, possibly including the emerging economies. And equity values’ decline toward a more realistic reflection of economic fundamentals will further weaken aggregate demand and growth. Hence the rising risk of a major downturn – and additional fiscal distress. Combined, these factors should produce a correction in asset prices that brings them into line with revised expectations of the global economy’s medium-term prospects.
But the situation is more foreboding than a major correction. Even as expectations adjust, there is a growing loss of confidence among investors in the adequacy of official policy responses in Europe and the U.S. (and to a lesser extent in emerging economies). It now seems clear that the structural and balance-sheet impediments to growth have been persistently underestimated, but it is far less clear whether officials have the capacity to identify the critical issues and the political will to address them.
In Europe, risks spreads are rising on Italian and Spanish sovereign debt. Yields are in the 6-7% range (generally viewed as a danger zone) for both countries. Combined with their low and declining GDP growth prospects, their debt burdens are becoming sufficiently onerous to raise questions about whether they can stabilize the situation and restore growth on their own.
Italy and Spain expose the full extent of Europe’s vulnerability. Like Greece, Ireland, and Portugal, membership in the euro denies Italy and Spain devaluation and inflation as policy tools. But the declining value of their sovereign debt – and the size of that debt relative to that of Europe’s smaller distressed countries – implies much greater erosion of banks’ capital base, raising the additional risk of liquidity problems and further economic damage.
The domestic policy focus in Europe has been to cut deficits, with scant attention to reforms or investments aimed at boosting medium-term growth. At the EU level, there is not yet a complementary policy response designed to halt the vicious cycle of rising yields and growth impairment now faced by Italy and Spain.
Credible domestic and EU-wide policies are needed to stabilize the situation. Neither is forthcoming. Recent market volatility has been partly a response to the apparent rise in the downside risk of policy paralysis or denial.
In the U.S. side, the integrity of sovereign debt was kept in question for too long. During those months of political dithering, U.S. treasuries became a riskier asset. Then, with the immediate default risk removed, money stormed out of risky assets into Treasuries to wait out the economic bad news – mainly feeble and declining growth, employment stagnation, and falling equity prices.
Little in America’s domestic policy debates hints at a viable growth and employment-oriented strategy. In fairness, some believe that cutting the budget is a sufficient growth strategy. But that is neither the majority view, nor the view reflected by the markets.
Structural and competitive impediments to growth have been largely ignored. There is little recognition that domestic aggregate demand cannot be restored to its pre-crisis levels except through growth. In fact, the household savings rate continues to rise.
The details may elude voters and some investors, but the focus of policy is not on restoring medium- and long-term growth and employment. Indeed, there is profound uncertainty about whether and when these imperatives will move to the center of the agenda.
In the emerging economies, by contrast, inflation is a challenge, but the main risk to growth stems from the advanced countries’ problems. In addition, reforms and major structural changes are needed to sustain growth, and these could be postponed, or run into delays, in a decelerating global economy.
The resetting of asset values in line with realistic growth prospects is probably not a bad outcome, though it will add to the demand shortfall in the short run. But uncertainty, lack of confidence, and policy paralysis or gridlock could easily cause value destruction to overshoot, inflicting extensive damage on all parts of the global economy.
This somewhat bleak picture could change, though probably not in the short run. Stability can return, but not until domestic policy in the advanced countries, together with international policy coordination, credibly shifts to restoring a pattern of inclusive growth, with fiscal stabilization carried out in a way that supports growth and employment.
In short, we confront two interacting problems: a global economy losing the struggle to restore growth and the absence of any credible policy response. Too many countries seem to be focused more on political outcomes than on economic performance. Markets are simply holding up a mirror to these flaws and risks.
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