Source: Foreign Policy
Compounding the MeltdownIn early November, a European academic, speaking at my central bank seminar, assured a very skeptical group of Peking University undergraduates that no country in Europe would need to leave the euro or restructure its debt (except Greece, which had already restructured). The main problem facing the crisis countries, he said, was a short-term financing gap, and this had become urgent only because of a wave of irrational fear in the financial markets (encouraged, he hinted darkly, by interested foreigners). As this fear subsides, he argued, Europe, with the right set of domestic reforms, could work its way successfully out of the crisis.
My students were right to be skeptical. Peripheral Europe faces more than a financing gap, and irrational fear is not the main problem. Unfortunately, too many policymakers make the same mistake as the European academic, which only shows how little they understand the balance sheet dynamics that lead to crisis. The recent request by newly elected Spanish Prime Minister Mariano Rajoy -- that financial markets give him a little time, "more than half an hour," to resolve the crisis -- indicates just how confused they are.
This is also the same mistake made a week later by the Hungarian Ministry for National Economy when Moody's downgraded that government's debt to junk status. "Obviously, the forint's weakening is not justified by either the performance of the Hungarian economy, or the shape of the budget," the ministry said. "Therefore, it can be driven only by a speculative attack against Hungary."
Like Rajoy, the Hungarian ministry has missed the point. Hungary's economy will certainly weaken, and the government's budget will deteriorate -- but not because of speculators. What is in fact happening is that many actors, from bondholders to labor unions to entrepreneurs to politicians, will protect themselves from the crisis by responding in ways that unfortunately worsen the crisis, and this worsening of the crisis will put all the more pressure on them to respond further.
There is nothing mysterious about the process. It is widely understood in economic theory that financial-distress costs for overly indebted businesses are actually incurred not at bankruptcy but long before, when weakening credit forces stakeholders to behave in ways that undermine growth and reinforce credit deterioration. This explains why crises tend to move slowly at first and then suddenly spin out of control.
The same thing happens to overly indebted sovereign borrowers. When do they have too much debt? The short answer: They have too much debt when the market believes they have too much. This may seem a trite and even meaningless answer, and the European academic who spoke to my class certainly thought so; but, in fact, understanding this is key to understanding the process of financial collapse.
It works in a straightforward way. As the government's fiscal credibility declines, the behavior of major sectors in the economy must automatically change, and this change forces further decline in fiscal credibility. The decline is slow at first, but because it is self-reinforcing it can suddenly accelerate.
The most obvious behavioral changes are in the actions of creditors, who of course raise lending rates, shorten maturities, and push more risk onto the borrower. This raises default probabilities by increasing the cost of servicing the debt and, more importantly, by making the balance sheet ever more fragile.
Unfortunately, it doesn't stop there. Households know that fiscal crises are often resolved by eroding the value of savings through inflation or depreciation, and they react accordingly. The threat that the government will freeze bank deposits and devalue the currency causes them to cash in their deposits and take the money out of the country, as they are already doing in several peripheral European countries, where bank deposits are declining at an alarming rate. In Greece, bank deposits have dropped by one-fifth since the beginning of 2010. This constrains lending sharply and slows growth, while eliminating what is normally a very stable funding base.
What's more, because governments have taxing authority and businesses are easy political targets in a crisis, declining government credibility automatically changes private business behavior. Instead of funding the investment that will generate future economic activity -- especially given weaker growth prospects and higher interest rates -- businesses disinvest and entrepreneurs leave. As they do, workers lose jobs, growth is reduced further, and so debt-servicing capacity drops. By November, investment in the eurozone had contracted for four consecutive months. "The fastest rates of contraction," the Financial Times reported, "were in Greece, Spain and Italy." This is exactly what we would expect, and of course it will continue.
Workers, too, must respond to the crisis. Unions get stronger, workers are radicalized, and labor agitation increases. This further weakens growth by raising both business and political uncertainty.
Finally -- and the historical precedents are very clear here -- policymakers themselves respond in ways that reinforce the crisis. As politically instability rises, extremist parties become more powerful, and political time horizons contract sharply. In response, politicians promote self-serving policies aimed at staying in power by addressing short-term problems, even if these hurt longer-term growth prospects.
A case in point was the desperate requests over the past three months by eurozone politicians that Asian central banks, led by China, provide financing to peripheral Europe. The purpose of Asian help was to forestall the short-term financing crisis, but of course any increase in Asian capital flows to Europe must automatically be accompanied by larger European trade deficits as the euro strengthens on the back of these inflows. Simply put, Europe wanted a short-term bailout even though it would worsen medium-term growth prospects.
These predictable adverse changes in behavior are already happening in much of Europe. A rising probability of default, in other words, has forced most of the major sectors of the economy into behavior that is causing balance sheets systematically to weaken and economic growth prospects systematically to decline. Riskier debt and slower growth, of course, increase the probability of default further, so these sectors are forced even more urgently into accelerating their behavior.
The options facing much of Europe now are either a slow and then suddenly rapid spiral into collapse, or a resolution of the crisis. The prescient English economist Walter Bagehot explained 140 years ago one way in which the latter could occur: Only a massive and fully credible loan guarantee will reverse the self-reinforcing process of balance sheet deterioration. Germany, worried perhaps a bit quixotically about its own debt credibility (which is anyway threatened by a European collapse), is adamant that it will not assume the risk.
The second way is to acknowledge the problem immediately before the economy is further damaged, in which case the afflicted counties must freeze deposits, devalue the currency, and quickly restructure the debt. The third way is immediate fiscal union, though the longer it takes to engineer so radical a solution in such a poisoned atmosphere, the harder it will be to pull it off.
Without a resolution, national balance sheets will simply deteriorate quickly, and economic weakness will increase, along with the ultimate cost of the crisis. Pretending that Europe suffers only from a financing gap and irrational fear, and that with the right set of polices it will eventually work its way through the crisis -- the same option mistakenly chosen in nearly every previous sovereign debt crisis -- is the worst possible policy option.
History and economic theory suggest that it is not fear we have to fear. It is the failure of policymakers to understand how a crisis evolves.