I got back last
week from a two-day trip to London, where I spoke at an interesting event
organized by the Carnegie Endowment. The attendees were for the most part
senior bankers and investors, and I got the impression that several, though
maybe not all, shared with me a certain amount of surprise that
European bond markets were up this year. We were even a little shocked that
the buoyant markets were being interpreted as suggesting that the worst of the
European crisis was behind us. The euro, the market seems to be telling
us, has been saved, and peripheral Europe is widely seen as being out of
the woods.
I cannot name any
of the attendees at the Carnegie event because it was off the record, but one
of them who seemed most strongly to share my skepticism is a very senior and
experienced banker whose name is likely to be recognized by anyone in the
industry. After I finished explaining why I thought the euro crisis was far
from over, and that I still expected that absent a serious effort from Germany
to boost domestic spending – an effort likely to leave the country with rapidly
rising debt – at least one or more countries would eventually be forced off the
currency, he told the group that he hadn’t made as gloomy a
presentation only because he considered it impolitic to sound as pessimistic as
I did.
Neither of us, in
other words, (and few in the meeting) felt that the recent market enthusiasm
was justified. Never mind that the Spanish economy, to return to the
country I know best, contracted again in the fourth quarter of last year, that
it is expected to contract again this year, that unemployment is still rising,
and that the ruling party is involved in yet another scandal that has driven
its popularity down to 20%. Never mind that young Spaniards are emigrating
(20,000 a month net), that the real estate market continues to drop, that
businesses are still disinvesting and popular anger is extraordinarily high. The
ECB, it seems, is willing to pump as much liquidity into the markets as it
needs, so rising debt levels, greater political fragmentation, and a worsening
economy somehow don’t really matter. This crisis continues to be just a
liquidity crisis as far as policymakers are concerned – and not caused by
problems in the “real” economy – and the solution of course to a liquidity
crisis is more liquidity.
But is peripheral
Europe really suffering primarily from a liquidity crisis? It would
help me feel a lot better if I could find even one case in history of a
sovereign solvency crisis in which the authorities didn’t assure us for years
that we were facing not a solvency crisis, but merely a short-term problem with
liquidity. A sovereign solvency crisis always begins with many years of
assurances from policymakers in both the creditor and the debtor nations that
the problem can be resolved with time, confidence, and a just few more debt
rollovers.
To take one
possibly illuminating example, I started my trading career during the Latin
American debt crisis, which officially began in August 1982. I joined the market in
1987, when bankers and policymakers were still assuring everyone that the
problem Latin America was facing was a liquidity problem. As long as
we could keep rolling loans over, they earnestly explained, the problem would
eventually resolve itself at little to no relative cost (well, Latin America
was struggling with unemployment, capital flight, hyperinflation and political
turmoil, but I guess that doesn’t really count).
It wasn’t until
1990 that the first formal debt forgiveness took place – known as
the Mexican Brady Bond restructuring – and before the end of the decade nearly
every country except Chile and Colombia had their own Brady bonds. Even those
two countries, and all the others, had managed to obtain for themselves a
significant amount of informal debt forgiveness through debt-equity swaps and
debt repurchases at huge discounts from face value (some legal and some not
quite legal).
Why did it take so
long for bankers and policymakers to recognize the truth – that this was not
just a liquidity problem? Actually it didn’t. Most bankers knew by 1985-86
that the region was actually suffering from a generalized solvency problem, and
among the big banks JP Morgan had been taking substantial provisions all along. No
one could formally acknowledge the possibility of insolvency, however, because
to have done so would have required that all of banks take much greater
provisions than they already had. This would have created a problem.
Of the top ten banks in America, only JP Morgan would not have been technically
insolvent had the banks been forced to mark their LDC loan portfolios to
market.
In May 1987
Citibank, after many years of replenishing its capital, was able to announce
suddenly and to the great surprise of the entire market that it had decided to
take a huge amount of provisions against dodgy sovereign loans. By 1989-90
the rest of the big American banks were also able to accept the write-offs
without becoming technically insolvent. That is when everybody formally
“discovered” that in fact the LDC debt crisis was a lot more than just a
liquidity crisis.
This is the key
point. The American bankers weren’t stupid. They just could
not formally acknowledge reality until they had built up sufficient capital through
many years of high earnings – thanks in no small part to the help provided by
the Fed in the form of distorted yield curves – to recognize the losses without
becoming insolvent.
And this matters
to Europe. There is simply no way European banks, especially in
Germany, can acknowledge the possibility of sovereign insolvency until they,
too, have built up enough capital to absorb the losses. They have,
unfortunately, been painfully slow to do so, even with yield-curve help from
the ECB, and so I suspect that this is going to remain a “liquidity” problem
for many more years. While it does, the debt-burdened countries of peripheral
Europe are going to suffer a decade of weak growth, high unemployment, and
contentious politics, all the while the debt growing faster than the economy.
The new gold bloc
Or the peripheral
countries can regain competitiveness quickly by leaving the euro, in which case
after a year or so of confusion growth would return almost immediately,
especially in countries like Spain that have managed to put into place a number
of very important labor market reforms. The historical precedent is clear.
Crisis-stricken countries that have forced through robust reforms to address
their comparative lack of competitiveness will continue to struggle under the
burden of high debt and an overvalued currency, but once they directly address
both, growth usually returns quite quickly.
And there have
been real reforms in Spain for all the grumbling. Several euro-optimists have
pointed out that unit labor costs in Spain have dropped substantially relative
to Germany, by as much as 6 or 7 percentage points. So this whole
reform process is working, they claim, and if we can just wait it out another
year or two Spain will be fully competitive again.
I am not so sure. Although I
agree that there have been real economic reforms, I am a lot less sanguine
about the ability of these reforms to stave off the crisis. First, the reforms
have come at a huge social cost, and it isn’t obvious that people can suffer
much longer as they already have. After all we know how to force down unit
labor costs. It is really quite easy. High unemployment usually does the trick.
The problem is
that Spain, after four years of punishingly high unemployment, has only clawed
back in labor competitiveness about one-third of what it needs to claw back in
total, and Madrid has already picked most of the low
hanging fruit. As brutally difficult as this has been, this was the easy part.
For Spain to claw back other 10-15 percentage points in unit labor costs, and
it may need more, may well be beyond the capacity of the population to endure.
Second, labor
is only one factor in international competitiveness. Capital is the other,
and everyone is in a hurry to forget this. It is hard to calculate the
appropriate trade-off, but while relative labor costs in Spain have certainly
declined, the relative cost of capital has just as certainly risen, and
probably by a lot more (to the extent that businesses can even get capital). On
Monday the Financial Times had this article:
Businesses in the
core of the eurozone are cashing in on easy monetary policy to borrow at record
low rates, while those based in the periphery are still struggling to find
market funding, according to new data. Barclays analysis of European
Central Bank data suggests that companies based in the “core” of the bloc have
been the main beneficiaries of the central bank’s promise last June to do
“whatever it takes” to save the eurozone.
Companies based in
France, Germany, Belgium and Holland were able to borrow a net €37bn of
ultra-cheap debt from the markets in the second half of last year, following the
announcement. But companies based in Italy, Spain, Portugal and Greece added
only about €12bn of market borrowing, with only the biggest companies such as
Telecom Italia and Telefonica able to access the capital markets.
At the same time
these peripheral eurozone countries faced a €65bn reduction in net bank lending, as the region’s
crisis-hit banks reduced lending in a bid to strengthen balance sheets.
At best we can say
of the combination of lower labor costs and higher capital costs that there
has been a transfer of resources from the capital-intensive parts of the
economy to the labor-intensive parts. Aside from the fact that this
probably doesn’t bode well for future productivity growth, it suggests that for
all the pain of reform Spanish businesses still cannot compete.
Some people might
argue – and do – that the sharp contraction in Spain’s current account deficit,
from 5% of GDP in 2008 to around 1% today, shows that Spain has indeed become
more competitive, but this of course isn’t at all obvious. Much of the
“improvement” seems to have occurred because of a drop in imports, which
suggests greater export competitiveness hasn’t played much of a role here –
which it shouldn’t have done if I am right about the impact of higher costs of
capital in eroding the benefits of lower labor costs.
Unemployment
levels well above 15-20% (and I assume official unemployment of 26% is probably
overstated by the failure to account for the “black” economy) are an incredibly
effective way of forcing a trade deficit to contract, because when
people can’t buy anything, they also can’t buy tradable goods. As they stop
purchasing those tradable goods however these goods would necessarily have been
diverted to exports, even without any improvement in the country’s overall
competitiveness.
This might imply
that whatever increase in exports we have seen may be no more than the
export of goods that Spaniards used to buy but no longer can. This kind of
export performance is not a consequence of improved competitiveness. It is
simply a consequence of rising unemployment.
What’s more, if
Spain is ever going to repay its very rapidly rising debt, it needs a lot more
than a lower trade deficit. It needs a very high trade surplus to fund net
capital outflows (unless we are expecting an unlikely surge in net private
capital inflows). Actually to be technically correct I should say that in order
to repay its debt Spain needs a very high current account surplus, and given
Spain’s huge interest burden, this actually means it needs a whopping trade
surplus since the trade surplus has to exceed the interest outflows before it
can be used to pay down debt. If unemployment is the best tool to get us there,
I am not sure the Spanish population can bear the burden needed to get us the
necessary high trade surplus.
So in spite of the
good news in the Spanish bond markets, I still don’t think we can pop the
champagne corks. Except for the debt refinancing costs, the underlying
fundamentals have not gotten better in the last six months. At best they are
unchanged, and probably they are worse.
How long must
Spain hold on to prove how serious it is about staying the course? A lot
longer, I think. After all it wasn’t until around 1931-32 that
France began suffering from its membership in the gold bloc, but they doggedly
held on until 1936 when they finally threw in the towel and devalued. The
Spaniards are proving tougher than the French were, possibly because among the
older generation (although not so much the younger) there is a tremendous
residual worry (and shame) that Spain might not truly be European, and this is
creating much of the loyalty to Europe, of which the euro is the great symbol.
But the Spanish
still have a lot of pain to absorb. By the way
if we were to see an intensification of the debate in France about the euro, I
suspect that this will give a green light to Spanish public intellectuals, for
whom France is the North Star, to discuss the prospect themselves. Until then,
in Spain you are not really supposed to talk about abandoning the euro if you
want to be taken seriously. It is a little like England in the 1920s, when for
much of the policymaking elite abandoning the country’s free trade principles
and leaving gold were unmentionable – until many years of unemployment suddenly
made both policies very “mentionable” in the first years of the 1930s.
In my opinion the
happy bond markets are, as they have so often been under similar circumstances
in history, a little premature. I think the phrase
“there is light at the end of the tunnel” was popularized by Herbert Hoover
around 1931, when the US stock markets staged a strong rally, convincing him
and others that the crisis was over. Of course it wasn’t, and the buoyant
markets gave back everything and more over the next three years.
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