The great lending reversal

Historical stereotypes show that the rich owed a great share of their incomes to leverage. They invested borrowed money in remunerative enterprises and leveraged it to raise their incomes. In contrast, the middle-class and poor were seen as debt-averse and relying on debt only when forced into it. However, as this IMF study indicates, the roles, atleast in terms of the debt-aversion of the non-rich, appear to have changed. Sample this evidence from the US,

In 1983, the top 5 percent had 80 cents of debt for every dollar of income, while the remaining 95 percent had 60 cents for every dollar. By 2007, after decades in which an increasing share of income flowed to the top, the situation had reversed. The top 5 percent had 65 cents of debt for every dollar of income, while the remaining 95 percent had $1.40 in debt for every dollar.

The authors use cross-country data and develop models that try to simulate changes in income distribution and household debt to GDP ratios and its impact on the economy. Their DGSE model, where workers income shares decline at the expense of investors, show,

Loans to workers from domestic and foreign investors support aggregate demand and result in current account deficits. Financial liberalization helps workers smooth consumption, but at the cost of higher household debt and larger current account deficits. In emerging markets, workers cannot borrow from investors, who instead deploy their surplus funds abroad, leading to current account surpluses instead of deficits.  

In other words, the only way to sustain high levels of consumption and national aggregate demand growth in the face of stagnant incomes was for poor and middle-class households to borrow. And its result is widening inequality and eventual debt-default which brings down the whole economic edifice. 

They therefore argue that the only sustainable way to reduce this is to address the critical issue of stagnant incomes. It is now well-established that markets do not generate efficient outcomes with income distribution. The prevailing balance of power in the economic structure and its hand-maiden political establishment, are too skewed to generate the desired level of income distribution.

To address the immediate challenge of debt-reduction among households, an "orderly debt reduction" wherein the process takes a few years may be the most appropriate method. In the medium to long-run, given the skewed distribution of incomes between labour and capital, this market failure will have to be addressed through an institutionalized mechanism that restores some element of collective bargaining. 

What ails Eurozone?

This from Ezra Klein is instructive, 

After it joined the euro area in 2001, Greece went from paying about 7 percent interest on a 10-year bond to a bit more than 3 percent because investors assumed that its debt was backed by Germany and the European Central Bank. This encouraged profligacy in Athens.

When the European economic and monetary union (EMU) became operational from 1 January 1999, all the peripheral eurozone economies experienced windfall gains from the sharp reduction in bond yields and resultant cost of borrowing. Over a four year-period, beginning 1995, the bond yields more than halved and converged around 4% across most of the eurozone economies (see graphics on France, Spain, Portugal, Greece, Italy, Ireland, Belgium).

Governments and, especially, corporates piled up debt, especially by way of borrowings from banks in the core area economies, as they splurged on this sudden access to cheaper capital, triggering off resource mis-allocation and asset bubbles. The boom also led to rise in wages and input prices, with the resultant decline in relative economic competitiveness. Therefore, deleveraging and restoration of external competitiveness is critical to a sustainable resolution of Eurozone's problems.

Update 1 (7/5/2012)

Paul  Krugman has this excellent analysis of how Germany managed its successful reforms last decade. As he writes, Germany benefited hugely from an export boom, driven by a combination of inflation in its periphery and rise in trade competitiveness vis-a-vis its Eruozone partners. 

Update 2 (10/5/2012)

Spain is a classic example of a country brought to its knees by reckless private external borrowing.

Even today, the government debt as a percentage of the total economic output for Spain is a relatively low ratio of 70 percent, compared with 165 percent for Greece and 120 percent for Italy. But, according to a recent report by McKinsey on global debt, Spain’s nonfinancial private sector debt is 134 percent of gross domestic product, higher than any major economy in the world with the exception of Ireland, where the figures are skewed by the outsize presence of foreign multinationals. Factoring in bank, household and government obligations, the total figure rises to 363 percent of GDP, trailing only Japan at 512 percent and Britain at 507 percent. 

Corporates borrowed heavily to invest and to diversify by buying large equity stakes in companies in Spain and elsewhere. Massive public investments in infrastructure helped boost the demand for private supply. The Times writes about a "relentless private sector downsizing in Spain — by individuals weighed down by mortgages and corporations tethered to their boom-time loans — that threatens to make the Spanish economic collapse semipermanent as opposed to cyclical".

What's common between the PIIGS and India's electricity utilities?

For a start, both are deeply in the red and require debt restructuring programs that need to go beyond mere rescheduling or re-packaging. Further, both need fundamental reforms that the respective policymakers and governments appear unwilling to embrace! And finally, in both cases, so far governments have been interested in merely kicking the can down the road.

Both governments appear to be treating the symptoms instead of the underlying problems. The Eurozone needs to face up to the reality that its peripheral economies' debt problems can recede only if their economies grow fast enough to bring down the debt-to-GDP ratios. This would require abandoning the current austerity programs and embracing policies that address fundamental issues like competitiveness problems (Ken Rogoff says wages should be halved), banking solvency, and fiscal transfers from the core economies.

In Eurozone, everyone realizes that the immediate problem is the resolution of the massive debt overhang faced by governments and financial institutions in many peripheral economies. After having exhausted all the conventional interest rate monetary policy tools and faced with ballooning debt finance costs by countries like Greece, the European Central Bank (ECB) first introduced a bond-purchase program in May 2010. After it failed to unfreeze the credit markets and lower yields and when fears of defaults mounted, threatening even Italy and Spain, in August 2011 the ECB announced a three-year concessional long-term capital provision program for Eurozone banks.

Some of those banks in turn used the money to buy higher-yielding government bonds, facilitating governments’ access to affordable credit without violating a legal ban that prevents the central bank from financing governments. The first infusion involved provision of of €489 billion (or $642.5 billion at the current exchange rate) in low cost three-year loans to 523 banks. The second round is slated for February 29, 2012.

In case of India's mostly state-owned distribution utilities, faced with an estimated losses (or non-performing loans) worth nearly Rs 70000 Cr over the last five years (since 2006) and a possible cumulative losses of over Rs 1.75 lakh Cr, the Government of India (GoI) is training its energies on a way out of this massive debt gridlock. A Planning Commission report has suggested that these loans be ring-fenced into special purpose vehicles guaranteed by the state government.

However, any sustainable solution would need both GoI and the state governments to implement policies that dramatically lower the shamefully high distribution losses, increase tariffs periodically to bring it in line with cost of service, and reduce the haemorrhage due to the free power for agriculture. A report released by credit rating agency Crisil estimated the gap between the average cost of supply per unit of power and the realization per unit was as high as 86 paise.

All stakeholders would do well to remember that such debt restructuring is not new to the electricity sector. Early last decade, before the current wave of deregulation and liberalization in the sector started, the accummulated losses of the State Electricity Boards (SEBs) were hived off their balance sheets and the SEBs were unbundled. Ten years down the line, nothing much appears to have changed as the next round of debt restructuring looms large.

In conclusion, both Eurozone countries and distribution utilities need to not only shake-away their debts but also undertake fundamental structural reforms. In the former, it will have to involve policies that sets the stage for recovery and economic growth, which in turn will reduce the debt-to-GDP ratios. The latter will have to follow a two-pronged approach of atleast partially off-loading their debts and simultaneously embracing all the earlier mentioned reforms.

Eurozone crisis in graphics

A series of excellent graphics from Paul Krugman that points to the underlying causes behind Europe's current crisis.

Contrary to conventional wisdom, surging public debt and fiscal irresponsibility was not the cause for the current problems, even among the peripheral economies. Greece was the only exception. The graphic shows how public debt to GDP ratios continued to decline across the PIIGS throughout last decade till the crisis struck.



However, in the aftermath of the Eurozone integration, there was a sharp surge in capital inflows from the core to the peripheral economies. Both demand and supply side forces drove these flows. On the demand side, the single currency and the resultant sharing of sovereign risk lowered the cost of capital for all these economies, thereby making debt available at cheap rates for the domestic industry.

On the supply side, this capital flow bubble was induced by the sudden decline in the sovereign risk of the peripheral economies (given their integration into a single currency union), the bright economic prospects and the potential for higher returns. Investors assumed that the biggest supporters of European integration, Germany and France, would never let a weaker eurozone country default on its obligations, for fear of derailing the political union of Europe. This belief enabled precisely such countries and their private financial institutions to borrow heavily at cheap rates. Predictably, these flows led the emergence of large current account imbalances.



The sudden influx of easy money led to a sharp increase in price levels and wages across the PIIGS economies. The economic competitiveness of these economies took a hit, especially in relation to the core area economies.



Despite the austerity programs under implementation in these economies, the debt-to-GDP ratios are not expected to come down anytime soon. The shrinking economies have contributed to the declines in interest rates.



Update 1 (28/2/2012)

Paul Krugman on what caused the Eurozone crisis,

At root, their problems are primarily caused by balance-of-payments rather than sovereign debt issues; they had huge capital inflows between 1999 and 2007, which led to inflation, and now they need somehow to regain competitiveness. But overlaid on this is a sovereign-debt crisis, which has forced them to seek aid — and the lenders are demanding harsh austerity in return, which is further depressing economies already suffering from severe overvaluation.

See also this set of graphics from Krugman. This shows the impact of austerity on Greece.

Eurozone debt sustainability

The most important question surrounding the Eurozone crisis is about the sustainability of the current debt levels, especially given each country's economic prospects.

The simple reality, stripped off all economic theory, is that the debt-to-GDP ratios can come down only if the GDP growth rate (the denominator) is faster than that of the growth in debt stock (the numerator). In other words, so long as the economy declines, even if the debt stock remains the same, the debt-to-GDP ratio will increase.

In this context, even as European economies implement severe austerity policies of wage freezes, government spending cuts, and tax increses, the biggest casualty appears to be growth itself. But for Germany, Eurozone would have been already deep in the red. Eurostat has reported that for the last quarter of 2011 GDP in the 17-nation euro area fell 0.3% from the prior three months, the first drop since the second quarter of 2009. Greece’s GDP slumped 7% in the fourth quarter from a year earlier.




The British economy shrank 0.2% in the last quarter of 2011 and unemployment rate is now at 8.4%, the highest since endd-1995 and is forecast to rise through 2012. In fact, the British National Institute of Economic and Social Research (NIESR) has warned about the country slipping into recession in 2012 and has forecast that the UK economy will contract by 0.1% this year. It has urged the government to loosen its fiscal stance and shore up faltering demand.

The debt-to-GDP ratios of all the peripheral economies have risen sharply since the onset of the Great Recession. They have continued to rise through all of 2011 and are expected to sustian the trend through 2012.



The best indicator of the prospects of a country emerging out of a sovereign debt hole is its primary fiscal balance, which is a measure of the fiscal balance excluding debt service. The Kiel Institute barometer of public debt calculates how much debt countries can bear in the long term by examining the primary surpluses of countries. It is based on the assumption that the ratio of the primary surplus to GDP (the primary surplus ratio, PSR) must be equal to or greater than the debt ratio (S) times the difference between the nominal interest rate (i) and the nominal growth rate (g) if the debt ratio is to remain stable.

PSR ≥ S(i – g)

It maps the primary supluses required by the Eurozone economies to sustain their current debt levels based on the aforementioned assumption. The growth rates, optimistic and pessimistic rates, are long-term rates and the interest rates are the 10 year long-term bond yields. Greece and Portugal face extraordinary challenges even with very optimistic long-term growth scanarios.



In the circumstances, the only way appears to be an early debt restructuring. However, even with this, the extent of haircuts required on Greek debt would almost wipe out its creditors. Portugal, and to a lesser extent Ireland, too would require some form of debt restructuring deals. Fortunately, the bigger economies of Italy and Spain look relatively safe.



See also these stories that chronicle the austerity miseries of Britain, Portugal, and Greece.

Greece in two graphs

From the excellent Floating Path comes two graphics that capture the true magnitude of Greece's problems. Over the past three years, its public debt has ballooned even as the economy has contracted.



The graphic below captures the distrubution of its 355 bn Euro debt.

The global debt develeraging cycle

Excellent report from the McKinsey Global Institute on the global debt deleveraging cycle in the aftermath of the bursting of the sub-prime bubble in 2008.

The report points to the experience of Sweden and Finland with their respective debt deleveraging crises of 1990s, both of which involved two stages. In the first, households, corporations and financial institutions reduce their debt significantly over several years, while economic growth is negative or minimal and government debt rises. In the second phase, growth rebounds and government debt is reduced gradually over many years.



But for the US, South Korea, and Australia, all the ten major developed economies are in the initial stages of the debt deleveraging cycle.



The composition of debt among households, non-financial corporations, financial institutions, and the government varies widely across these ten countries. The total debt of the Japan, driven by government borrowings, and United Kingdom, driven by loans taken by financial institutions, are of great concern.



Ironically, apart from Ireland, the debt positions of the other PIIGS economies does not look as frightening as those of UK and Japan. Only the Irish debt bears striking similarity with that of UK.



The report contrasts the successful recoveries of Sweden and Finland with the relative stagnation of Japan and identifies six critical markers of progress before the economic recovery takes off - the financial sector is stabilized and lending volumes are rising; structural reforms have been implemented; credible medium-term public deficit reduction plans are in place; exports are growing; private investment has resumed; and the housing market is stabilized, with residential construction reviving.

The fiscal and monetary "wiggle-space" - where does India stand?

Free Exchange points to the contrasting macroeconomic positions of developed and emerging economies. While the former has limited fiscal and monetary space to stimulate their economies any more, the later have adequate cushion on both fronts, if the need arises.

The average budget deficit of emerging economies last year was only 2% of GDP, against 8% in the G7 economies. And their public debt ratios were on average only 36% of GDP, compared with 119% of GDP in the rich world.

The Economist article uses a mix of fiscal and monetary policy paramters to arrive at the respective nations flexibility to manoeuvre with expansionary policies. It points to five parameters that determine the monetary policy space - inflation, credit growth, real interest rate, exchange rate movements, and current account balance. It added up the scores on these five parameters to produce an overall measure of monetary manoeuvrability. On the fiscal policy side, it constructs a fiscal-flexibility index, combining government debt and the structural (ie, cyclically adjusted) budget deficit as a percentage of GDP.



It ranked 27 emerging economies according to their monetary manoeuvrability and fiscal flexibility using a "wiggle-room index" constructed using the aforementioned parameters. This index is a reflection of the ability of countries to withstand a global downturn by stimulating their economies. The verdict,

The index suggests that China, Indonesia and Saudi Arabia have the greatest room to support growth. At the other extreme, Egypt, India and Poland have the least room for a stimulus, thanks to excessive government borrowing, large current-account deficits, and uncomfortably high inflation. Brazil is also in the red zone.

At first glance, on most parameters, India stands out as being among the most constrained of emerging economies. On the fiscal side, its combined government fiscal deficit of around 9% of the GDP, means that there is limited space available for any stimulus spending.

However on the monetary side, given the recent declining trend in inflation, the 13 consecutive repo rate increases by the RBI in response to rising inflation gives the central bank adequate monetary space to stimulate the economy. Further, since credit growth has been below par and exchange rate appears to have weathered its brief period of volatility, the monetary side space may not be as constrained as it appears now.

Further, while its total public debt, at about 68% of GDP, may look high by the standards of emerging economies, closer analysis reveals that it may not be as dismal as is being projected. Here are three reasons

1. The overwhelming share of this public debt is owed to domestic creditors. In fact, the total external debt (public and private) is estimated to decline to 17.4 of GDP for 2011, with government share being a mere 4.4% of GDP. As of end-September 2011, of the total external debt of $326.6 bn, with government and non-government shares in the total external debt being 24.3% and 75.7% respectively. Short-term debt accounted for 21.9% of the country's total external debt, while 78.1% was long-term. Adjusted for this, the real effective debt burden, in relation to a sovereign debt default risk, shrinks considerably. The only area of slight concern should be the 27.4% CAGR in external commercial borrowings between end-March 2006 and end-March 2011.



2. At 122% of GDP, its overall debt is the second lowest among all the major economies. Only Russia has a lower overall debt-to-GDP ratio.

3. Though its government may be profligate, the other major engines of economic growth - households, non-financial corporates, and financial institutions - have the healthiest balance sheets among all major economies, including China.





This means that all the non-government drivers of economic growth stand on very strong platforms and have enough "wiggle-room" to manoeuvre. All that is now required is for the government to get governance and policies right. Will that happen?

What drives hedge funds which buy Greek debt?

As Greece prepares a legislation to force all private bondholders to take losses on its debts as part of an ECB-EU-IMF rescue package, the hedge funds appear to be playing a game of brinkmanship with Greece.

Hedge funds have been known to use hardball tactics to make money. Now they have come up with a new one: suing Greece in a human rights court to make good on its bond payments. The novel approach would have the funds arguing in the European Court of Human Rights that Greece had violated bondholder rights, though that could be a multiyear project with no guarantee of a payoff.

One of the terms of the 130 billion euro ($165.5 billion) rescue package for Greece, is to cut its debt by 100 billion euros through 2014 by forcing its bankers to accept a 50% loss on new bonds that they receive in a debt exchange. In addition, the Greek government is unwilling to offer the 4% interest rate on new bonds received in exchange for the old bonds. Hedge funds argue that this will effectively increase the relative haircut to between 60-70%.

Though Greece has been negotiating with its bond holders on voluntary haircuts, in the range of 50% of the debt value, these talks have made little headway. The EU-ECB-IMF had made such haircuts and consequent debt restructuring a mandatory requirement for releasing the next instalment of rescue package funds for Greece.

Many of the bondholders - hedge funds, pension funds, banks, etc - have already insured their positions through credit default swaps and find the deal offered by Greece less attractive than a forced default. But a forced haircut would unnerve the markets and potentially destabilize the global financial markets.

Interestingly, over the past year, despite there being ample evidence of Greece being close to default, several hedge funds have continued to buy into Greek debt. All of them were ttracted by the massive potential returns despite the potential for default and a perceived belief that EU and ECB would let Greece default. A Times report nicely captured the incentives,

"Greece may never be able to pay off its huge debts, but its bonds, long scorned by investors, are suddenly being gobbled up by hedge funds... many have turned their attention to the hot yet risky euro zone trade of the moment: buying Greek government bonds that traders say are changing hands for as little as 36 cents for each euro of face value. The investors hope to book a fat profit on the expectation that the European Union and the International Monetary Fund will once again bail out Greece, fearing a global financial disaster if they do not...

Those speculating in Greek bonds are taking on well-documented risks, not the least of which is the possibility that the country will fail to reach a final agreement with the I.M.F. and the European Union and will not get the next portion of money needed to avoid default."

In fact, a major portion of the current bond holders are not the original ones - large European banks - and are speculative investors who have purchased their bonds in recent months. The Times report estimated that as on September 2011, about 30% of the investors bought their bonds after July 21. This share would surely have climbed in the subsequent months.

I have two observations from these events.

1. The hedge fund managers are obviously playing chicken with Greece and Eurozone. Who will be the first to blink? If they are able to scare Greece, EU, ECB, and the IMF away from forced default and/or to get the IMF and EFSF/EU to accept losses, by amplifying fears of a global financial market contagion (driven by bond market vigilantes), then the hedge funds stand to make fantastic gains. Conversely, the governments could call the bond market bluff and proceed with the haircuts and debt restructuring, thereby imposing serious costs on the hedge funds.

2. The action of the hedge funds in buying into Greek debt despite clear knowledge of all the associated risks bears remarkable similarity to the role of real estate agents in India who scout for lands emrboiled in litigation or whose titles are not clear.

Such lands, embrolied in litigation or uncertainty for many years, even decades, cannot be developed without settling the encumberances by clearing the title. Real estate agents with close political connections see them as opportunities. They buy into these lands, including the litigation, at cheaper than the market rates. Then they use their official connections to either weaken government claim (for example, by making the government advocates soft-peddle on court litigation) and eventually get it transferred to private interests or use political muscle power to arm-twist the other private parties into signing away their interests at a bargain rate.

Such agents, who are present in all Indian cities, and have connections with influential people in the establishment - politicians, officials, and judges - are classic risk managers. They spot the opportunity, weigh pros and cons - risks associated with getting the title cleared off encumberances - and make their investments.

The modus operandi is eerily similar to that of the hedge fund managers who have invested in Greek debt despite enough evidence that Greece would default on its sovereign obligations. Like the real estate agents, all these hedge fund managers wield considerable influence in the corridors of power - governments, central banks, financial market regulators, and big financial institutions. Again, like them, the real estate agents try to leverage this influence to benefit them. In fact, they become confident that with an appropriate mixture of brinkmanship and nudging of the powers-that-be who decide on the terms of the Greek default, they would be able succeed with a favorable debt restructuring deal.

These real estate agents operate purely outside the legal boundaries. However, the trades executed by hedge funds, in the face of very obvious and extreme risks, are perfectly legal. Is there a case for atleast some regulation on such trades?

In the instant case, it was plain obvious, as early as early last year, that haircuts on Greek debt was inevitable. In the circumstances, the only logical reason for hedge funds to pile into Greek bond was a belief that they could influence the debt restructuring process. Given the moral hazard and other incentive distortions created by these actions, is there a case to restrict such trades, especially under such conditions?

Supporters of these trades will obviously point to their positive role in risk diversification by helping banks off-load risks to those best able to bear them. But then this diversification becomes a double-edged sword when the buyers do so on the aforementioned assumptions. Systemic risk then gets amplified instead of being diversified.

Post script - As for Greece itself, even with the deal, its debt would be no less than 120% of GDP in 2020 (down from 140% of GDP at $450 bn today) — which seems to be slight progress given the austerity and pain its citizens must endure during this period.

Graphic linkfest from 2011

Excellent graphics from the Wonkblog, BBC, and the Atlantic. All graphics below highlight important economic and social trends in a most striking manner.

It is no secret that any meaningful attempt to rein in America's debts has to involve addressing the burgeoning public health care expenditure. The graphic below makes this clear. Relentlessly rising health care costs coupled with demographic changes are driving the growth of these programs, while the open-ended structure of these programs is responsible for much of the increase in health care costs.



This graphic captures the extent of political polarization in the US. In the late 1960s, the most conservative Democrats in the House and the most liberal Republicans voted together frequently enough (as shown by the overlap between the two distributions) to make centrist legislating successful. By the late 1980s, that overlap was dwindling and today, it is largely gone.



Inequality is already one of the most important concerns for the US economy. As the graphic shows, corporate profits have not only recovered their post-recession highs, they’ve surpassed it and are growing, even as workers compensation as a share of the economy is declining continuously.



Thomas Gallagher of Scowcroft Group points out from the graphic below that the steep bull market since the early 1980s and the fact that previous such bull markets were preceded by pretty severe bear markets, is reason enough to be minimize expectations for overall stock market gains over the next several years.



Given the extent of job losses during the Great Recession, this Hamilton Project graphic shows that it may be years before the US economy regains the pre-recession level of jobs. If the economy adds about 208,000 jobs per month, which was the average monthly rate for the best year of job creation in the 2000s, then it will take until February 2024 — over 12 years — to close the jobs gap.



The chart below shows the real GDP in the US and the level of total civilian employment from 2002-2011. Its trends are an indicator of the gravity of labour market problem facing the US economy. While the total output has regained the pre-crisis level, the labour market is stuck way below. In other words, the US economy is producing the same output as in Q4 2007 with 6.6 million fewer workers. This jobless recovery points to a combination of increased productivity and labour market shifts (towards jobs which employ fewer jobs).



The graphic below captures the true magnitude of the global macroeconomic imbalance. It highlights the explosion of current account surpluses and official investments of delveloping economies in foreign financial assets, especially US Treasury Bonds. The mirro image of this is the rise in current account deficits in the developed economies.



Tyler Cowen's book, The Great Stagnation, has drawn attention to the stagnation in the Total Factor Productivity (TFP) of the US economy since the early 1970s. TFP is a measure of how much the economy is receiving a boost from innovation and new ideas, as opposed to, say, people working longer hours or taking a second job.



The graphic below highlights the power of the Fed's monetary policy announcements. On August 9, 2011, the FOMC meeting minutes announced that the economic conditions were 'likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013'. The market reaction was impressive.



One of the most powerful measures of the depth of the Great Recession is the output gaps that have emerged in both sides of the Atlantic. Bridging them could take years.




The two illuminating graphics ought to clarify the source of America's current debt crisis. It clearly points to the Bush legacy - tax cuts and Iraq-Afghan wars - as the main drivers of the ballooning deficit. Further, the much maligned stimulus spending and bailout policies have contributed only marginally to the debt stock and deficit. However, the loss of revenues due to the economic downturn has had a very significant effect.

The Global Debt "Minsky Moment"

FT Alphaville points to an excellent speech by Canada’s central bank governor Mark Carney where he points to the inevitability of a prolonged period of deleveraging among the developed economies to shake off the mountains of accumulated debt. He feels that the global "Minsky moment" has arrived, and a combination of debt restructuring, inflation and growth need to be deployed.

The speech contains several superb graphics that beautifully captures the debt trap in which US and Europe have entrapped themselves. The balance sheets of households and governments on both sides of the Atlantic have worsened dramatically over the past decade or so.




Following the bursting of the sub-prime mortgage bubble, net household wealth of Americans dropped spectacularly. This wealth can be regained only through a combination of increased savings and recovery in asset values.



Europe experienced a hugely imbalanced and unsustainable economic growth after the monetary union. Cross-border lending exploded, capital was cheaply available, public spending grew, and booms ensued. This eroded competitiveness, especially among the peripheral economies with respect to Germany. Euro-wide price stability masked large differences in national inflation rates. Unit labour costs in peripheral countries shot up relative to the core economies, particularly Germany.



Financial globalisation, driven by savings glut in emerging Asia and consumption demand in the developed economies, led to the build up of external imbalances. The magnitude of these savings glut, best exepmlified by China's monstrous foreign exchange surpluses, allowed larger debt burdens to persist for longer than historically was the case.



All this was obviously not sustainable. When the bubble burst and Great Recession took hold, the consequences were severe. The World Bank estimates the world GDP output gap to be more than $7 trillion by 2017.



As these graphics reveal, all these economies built-up several critical structural imbalances over the past two decades. In all of them, compared to the previous two decades, public debts rose sharply, household wealth rose spectacularly, cross-border capital flows increased dramatically, and unit labour costs climbed. A fortunate confluence of favorable factors were inflating these bubbles and boosting economic growth.

Now that the bubbles have been deflated and the business cycle has changed direction, all these aforementioned macroeconomic indicators are naturally on the way down to their pre-bubble (not pre-crisis) norms. In many respects, this is a natural correction and there may be little that governments can do to avoid them.

The sources of European sovereign debt crisis

The graphic below which highlights the sources of public debt in Europe since 2007 for Germany, Italy, France, and the UK offers several insights.



1. Stagnant or declining economy is understandably a large source of growth in the debt-to-GDP burden. As I have blogged earlier, this is true of America's current deficit. The graphic shows the same of France, and in particular UK. UK, which has had the largest austerity drive, has also had the largest increase in debt-to-GDP ratio. Conversely Germany's robust growth has kept its deficit from being higher than it would have been without.

2. As the debt burden crosses the unsustainable mark, two effects are likely to kick in. One, the absolute value of debt repayment increases. Two, the cost (interest rate) of debt service (rescheduling and raising new debt) rises and this feeds into the first. Italy, with its 120% of GDP debt stock and bond yields which touched 7%, is clearly the example of this.

3. As Matt Yglesias writes, the graphic also shows that Italy's major problem is a liquidity crisis which threatens to drive the country insolvent. It even has a primary surplus and its debt problems are a direct result of exploding debt service costs. The graphic also highlights how all the other standard factors driving up debt are absent. With the ECB refusing to act as a lender of last resort, Italy is facing a "national-level bank run"!

4. As Brad Plumer writes, Germany has had the largest fiscal stimulus and spend the most bailing out banks. The result has been financial stability and growth, though both are now threatened by a pan-European contagion from the PIIGS.

How Germany benefited from Eurozone

As the Eurozone tethers on the brink of collapse, questions are being raised about Germany's reluctance to play a more aggressive role in stabilizing the situation. More specifically, about its opposition to a lender of last resort role by the ECB and even some form of fiscal transfers to the peripheral economies.

Critics find this German attitude surprising since the German economy is one of the biggest beneficiaries of the monetary union. The far reaching labour market reforms and wage restraint exercised in Germany over the last decade enhanced its labour market competitiveness over the other Eurozone economies.

The tight embrace of a single currency meant that Germany's competitors did not have access to the most conventional instrument used to address trade competitiveness - exchange rate devaluation. In fact, far from exercising similar reforms and wage restraints to match Germany, the peripheral economies experienced a decade of asset bubble and/or debt driven economic boom, which drove up labour wages. The graph below shows how wages remained more or less stagnant in Germany, even as it rose elsewhere.



Labour market was not the only source of distortions. The monetary union and the attendant boost to their sovereign risk ratings meant that the peripheral economies suddenly had access to very cheap capital, a major share of which came from German and French banks. This too went towards fuelling asset bubbles (Spain and Ireland), wage price spirals (Portugal), government spending (Greece and Italy), and a consumption boom. Thanks to its increasing competitiveness, Germany provided the natural supplier for consumption booms in these countries. German exports ballooned.



So, as I have blogged earlier, among other things, the recovery path for the peripheral economies will certainly have to involve efforts to restore labour market competitiveness. This can be achieved either through internal devaluation or wage moderation in the peripheral economies or inflation in the core economies. Given the magnitude of re-balancing required, it may be necessary to have both.

But even with all this and without some form of radical debt restructuring and extendend period of monetary accommodation by the ECB, the survival of the Euro project looks increasingly in doubt.

Postscript

Paul Krugman points to the importance of export growth in Germany's economic growth of the last decade. A large share of these exports are to fellow Eurozone members, including the PIIGS. As the consumption elsewhere tanks, German exports will take a hit. It is impossible to expect consumption in these economies to regain its strength any time soon. In the circumstances, the only option left is for a massive German fiscal stimulus. This would not only keep aggregate demand in Germany up, but also provide an anchor for imports from the weak peripheral economies. In other words, German pump priming could boost growth both domestically and in the rest of Eurozone.

There are obviously two issues of concern. One, what magnitude of stimulus would be required to have any meaningful impact? Two, does Germany have the fiscal fire-power to sustain a big bazooka?

Update 1 (10/12/2011)

Nowhere has the benefits of euro integration more apparent than in the labour market as the graphic below shows. The German unemployment rate has steadily fallen since 2006, while that elsewhere has risen. German unemployment rate fell from 9.6% (4 million out of work) at the end of 2006 to 5.5% (just 2.3 million people out of work) today, both the figures being the lowest since the 1991 reunification.



As Floyd Norris writes, "It held down its labor costs during the boom, strengthening its competitive position relative to other members of the euro zone. The fact that those countries were in the euro zone helped to depress the currency’s value relative to other currencies, which made German exporters even more competitive."

This is a stunning statistic about the contrasting fortunes of the two parts of Europe,

"Put another way, at the end of 2006, 32 percent of the unemployed workers in the euro zone were Germans. Now the figure for Germans is 14 percent. The peripheral countries’ share went to 61 percent from 39 percent."

Europe's debt squeeze

Satyajit Das has an excellent illustration of the magnitude of problems facing the Eurozone economies,

"Assuming borrowing costs of 4 per cent and a debt-to-GDP ratio of 120 per cent, Italy needs to grow at 4.8 per cent just to avoid increasing its debt burden where its budget is balanced. At current market borrowing costs of 7 per cent, Italy has to grow at an unlikely 8.4 per cent just to avoid increases in its debt levels.

Given low projected growth rates and elevated borrowing costs, Italy must reduce its debt levels significantly to avoid the risk of insolvency. Assuming interest costs of 4 per cent and growth of 2 per cent, Italy would have to run a budget surplus of 5 per cent per annum for 10 years to reduce its debt to 90 per cent of GDP. Alternatively, it must sell state assets to reduce its debt...

Assuming borrowing costs of 3 per cent and a debt-to-GDP ratio of 81 per cent, Germany needs to grow at about 2.4 per cent to avoid increasing debt levels. France needs to grow at even higher levels."

He writes about the implication of this state of affairs,

"The toxic cocktail of high levels of existing debt, large and seemingly irreversible structural budget deficits, low growth rates and high borrowing costs makes the position of many European countries unsustainable. Beleaguered economies have to run budget surpluses (through spending cuts and tax increases), grow at very high rates, decrease their borrowing costs or achieve a combination of these merely to stabilise their debt."

He points to the futility of fiscal austerity to reduce deficits and argues that debt write-downs are inevitable,

"Events show that the combination of a large stock of debt, intractable, corrosive budget deficits, low growth rates and increasing borrowing costs can result in a rapid slide into a sovereign debt crisis. As interest rates increase as a result of rising investor concern about creditworthiness, attempts to cut the budget deficit merely reduce growth, exacerbating the problem. Without a significant reduction in the amount owed to creditors, the country is locked into a self-defeating cycle of austerity, continuing budget deficits and increasing public debt."

Bond markets are freezing up as evidenced by the rapidly rising bond yields in the last few weeks.



With the cost of Italian long term debt rising well past the 7% mark and public debt at 120% of GDP, Nouriel Roubini feels that any mixture of austerity, higher taxes and structural reforms will not be enough to backstop Italy's slide. He advocates partial debt restructuring involving lengthening the tenor of Italian debt and reducing the coupon rate on existing debts, including that on foreign investors.

In this context, James Surowiecki argues that unlike Greece, the other peripheral economies like Italy and Spain have strong fundamentals and their problem "isn’t the debt itself but, rather, the soaring interest rates", which in turn threatens to turn a liquidity crisis into a solvency crisis. The bond markets reaction has created a vicious cycle: fear of default raises interest rates, and higher interest rates make default more likely. But as Satyajit Das illustrates, even if the ECB agrees to become the lender of last resort, the Italian debt situation has become too bad to be salvaged by merely buying time.

Update 1 (11/12/2011)

The European governments finally agreed on measures for closer economic and fiscal integration with strict rules and semi-automatic sanctions to enforce budget discipline. Since Britain opposed it, instead of changing the Treaty itself, the 17 Eurozone members agreed to for an intergovernmental deal that will have to be negotiated outside the EU legal framework. Of the remaining 9 non-EMU EU countries, six will join the deal immediately while three others are considering it.

Under the deal, each government will adopt a "golden rule" to ensure balanced budget (a structural deficit of no more than 0.5%); the European Court of Justice will ensure that national fiscal rules comply; automatic fines will be imposed for governments that breach 3% deficit limit, unless qualified majority decides otherwise
Firewall. The leaders also agreed to lend €200bn to the International Monetary Fund via their central banks and establish a European Stability Mechanism, the new €500bn fund, to come into effect from July 2012 (this would be in addition to the €440bn European Financial Stability Facility).

In the meantime, the ECB too took important decisions to expand its monetary support. It lowered interest rates by 25 basis points to 1%; agreed to provide unlimited amounts of cheap liquidity to financial institutions for three years (from the earlier one year) should help them buy more bonds; diluted collateral standards and expanded the types of securities it was willing to accept for its credit window operations. The ECB's decision to emerge as a lender of last resort to all financial institutions was intended to overcome technical objections to it lending directly to sovereigns.

How European sovereign debt became the new "sub-prime"?

Sovereign debt has been at the center of the Eurozone crisis. In the aftermath of the US sub-prime mortgage meltdown, European banks fled to what they saw as safety - bonds issued by countries in Europe’s seemingly ironclad monetary union. As Europe tethers on the brink, even triple-A rated sovereign bonds of the peripheral economies have been exposed for their true colors.

The Times has this nice summary of how European sovereign debt became the new sub-prime,

"How European sovereign debt became the new subprime is a story with many culprits, including governments that borrowed beyond their means, regulators who permitted banks to treat the bonds as risk-free and investors who for too long did not make much of a distinction between the bonds of troubled economies like Greece and Italy and those issued by the rock-solid Germany.

Banks had further incentive to overlook the perils of individual euro zone countries because of the fees they earned for underwriting sovereign debt sold to other investors... As the subprime crisis peaked on Wall Street, banks sharply increased their underwriting of European sovereign debt. In 2007, the world’s big banks made $113.9 million in underwriting fees; by 2009, that number had more than doubled to $273 million...

Their special relationship with governments sometimes also presented a unique dilemma: it gave banks little incentive to publicize red flags even if they were suspicious about sovereign debt...

For most of the last decade, bond yields among Germany, Greece, Portugal, Ireland, Italy and Spain traveled in a tight pack. That meant investors buying and selling those bonds acted as if the countries were almost equally safe simply because they were members of the euro zone, despite shaky finances in Greece, real estate bubbles in Ireland and Spain and high debt in Italy...

Regulators bear much of the responsibility. Before 1999, when Europe forged its monetary union, regulators permitted banks to treat as risk-free the debt of any country that belonged to the Organization for Economic Cooperation and Development, a club of developed nations that includes the United States and most of Europe."

The graphic below illustrates the foreign debt exposures to various Eurozone countries and the contagion dangers of European sovereign debts.



And the graphic below has the summary of the latest Eurozone sovereign debt exposures.

The dismal European landscape

One of the most contentious debates surrounding the sovereign debt crisis in Europe is that about the institutional mechanism to provide the necessary liquidity support to the embattled economies.

The European Central Bank (ECB) is not empowered to provide the unconventional monetary policy actions that the Fed did in the US and thereby backstop losses and unfreeze credit markets as a lender of last resort. Further, there is strong ideological and political opposition to printing money to buy the debts of individual members for fear of stoking inflation.

Therefore, as a compromise, the Eurozone leaders had established the European Financial Stability Fund (EFSF) to provide financial assistance to these governments. The IMF joined hands with the EFSF in structuring a first round of Eurozone financial stabilization fund of 440 m Euros.

Its mandate and firepower was designed with the objective of rescuing Greece, Ireland and Portugal. However, now with the turmoil spreading to Italy, Italian bond yields crossing the seven percent mark, and the country facing the danger of losing market access, the stabilization fund clearly looks under capitalized. A "big bazooka" appears necessary.



There is also a growing realization, given the magnitude of market uncertainty surrounding the Eurozone, that the current liquidity crunch being faced by otherwise sound economies like Italy (and maybe France later) could turn into a solvency crisis. And if this happens to the country with the fourth largest public debt, it will be the final nail in the Euro project and have devastating consequences for the world economy itself. The frantic search for possible solutions to provide adequate liquidity cover for Italy is understandable. Nouriel Roubini writes,

"Once a country that is illiquid loses its market credibility, it takes time – usually a year or so – to restore such credibility with appropriate policy actions. Therefore unless there is a lender of last resort that can buy the sovereign debt while credibility is not yet restored, an illiquid but solvent sovereign may turn out insolvent. In this scenario sceptical investors will push the sovereign spreads to a level where it either loses access to the markets or where the debt dynamic becomes unsustainable. So Italy and other illiquid, but solvent, sovereigns need a 'big bazooka' to prevent the self-fulfilling bad equilibrium of a run on the public debt. The trouble is, however, that there is no credible lender of last resort in the eurozone."

One option which has found favor with a number of opinion makers but has been rejected by Germany and the ECB is to issue Eurobonds. It is argued that such bonds, issued initially through the EFSF, could simultaneously solve two problems. One, it would help raise the cash required to refinance the debts of countries finding it difficult to access the debt market. Second, it could complement the German bund and provide an alternative risk-free investment avenue. Such assets can help stabilize the financial markets by providing investment avenues for institutional investors to rebalance their portfolios as they exit the struggling peripheral economy bonds.

In an FT article, Wolfgang Münchau has rejected the notion of leveraging the EFSF to purchase Italian and other PIIGS debt. He describes his Eurobond proposal,

"The EFSF could announce that it would make unlimited purchases of national sovereign bonds to keep their spreads under an agreed cap – say 2 per cent for 10-year bonds. The European Central Bank would refinance the EFSF for as long as it takes. Once the Eurobonds are in place, EFSF liabilities would simply be transformed into Eurobonds. This would not constitute an illegal monetisation of debt, as long as the endgame for the EFSF is credible."

But there are strong reasons to cast doubts on success with the Eurobond plan. For a start, the issuance of Eurobonds would require changes to the Treaty itself. Before that could happen, it would have to overcome entrenched opposition in Germany. Further, it will consume valuable time. After this even if it arrives, it may be too late to save the monetary union.

In any case, monetary policy support is only one side of the policy requirement spectrum. Another formidable challenge facing the new Italian government involves the fundamental restructuring of the economy, especially its labor market. The country has lost labor cost competitiveness against Germany by more than 50% since the mid-nineties. The reforms required include dismantling the two-tier jobs market, which protects the jobs of older workers in dying industries but traps youngsters in temporary work; and the industry-wide wage bargains that mean businesses cannot match wages to productivity. The closed-shop professions and trades, and the mircro-sized family businesses, are a barrier to innovation and efficiency. The business landscape which is dominated by small firms should accommodate more bigger sized firms. The pension system should be further reformed and a clampdown on tax evasion enforced.

However, as Nouriel Roubini writes, structural reforms like raising taxes, cutting spending and getting rid of inefficient labour and capital during structural reforms have a negative effect on disposable income, jobs, aggregate demand and supply. The recessionary deflation that Germany and the ECB are imposing on Italy and the other periphery countries will make the debt more unsustainable. He feels that there can be only one denouement,

"Even a restructuring of the debt – that will cause significant damage and losses to creditors in Italy and abroad – will not restore growth and competitiveness. That requires a real depreciation that cannot occur via a weaker euro given German and ECB policies. It cannot occur either through depressionary deflation or structural reforms that take too long to reduce labour costs.

So if you cannot devalue, or grow, or deflate to a real depreciation, the only option left will end up being to give up on the euro and to go back to the lira and other national currencies. Of course that will trigger a forced conversion of euro debts into new national currency debts...

Only if the ECB became an unlimited lender of last resort and cut policy rates to zero, combined with a fall in the value of the euro to parity with the dollar, plus a fiscal stimulus in Germany and the eurozone core while the periphery implements austerity, could we perhaps stop the upcoming disaster."

Even without going into any of these, the details of sustainably financing and paring down its massive public debt of €1,900bn (120% of GDP) is frightening. This problem, difficult in normal times, is amplifed by a weak economy (it is the only major economy where per-capita GDP declined annually in the 2001-10 period) and severe austerity measures. Though much of its debt is short-term, as much as €350 bn of debt comes due next year. An FT article argues that any increase in bond yields (and therefore cost of capital) will weaken the economy and deepen the debt crisis,

"The impact of crisis interest rates is likely to increase the annual debt burden by less than 1 per cent of GDP next year, compared to what would happen with 'normal' interest rates... With medium term nominal GDP growth likely to be in the doldrums at 2 per cent per annum, interest rates at 6.5 per cent would mean that Italy needs to run a primary surplus of 5.5 per cent of GDP indefinitely in order to stabilise its debt/GDP ratio at 120 per cent."

In simple terms, if Italy is to make a significant dent on its public debt problem, it will have to pull off reforms that ease the economy into a growth path that can create a primary budget surplus of over 5% of GDP for several successive years. And all this with a depressed economy, weakness among major trading partners, and a severe bout of austerity. As the FT writes, "If such a large fiscal consolidation can be achieved in the teeth of a recession, it will be very impressive, to say the least".

Update 1 (28/11/2011)

Wolfgang Munchau offers a three pronged approach to resolving the Eurozone crisis. First, aggressive intervention by ECB to provide massive temporary short-term liquidity and unlimited guarantee of a maximum bond spread or a backstop to the EFSF. Second, end the current process of cross-broder national guarantees and float joint-and-several liability eurozone bonds of credible size. Third, a fiscal union.