By mid-2012 it is clear that the global recovery is at risk. By increasing uncertainty, while depressing demand in an important part of the world economy, the Eurozone crisis is dangerously slowing growth in the US and emerging economies. This is particularly worrying since the US economy could easily be pushed close to the recession zone. This would be worrisome since if the US engine were to stall, it will be very difficult to restart – given the constraints weighing on both fiscal and monetary policy.
If the Eurozone slowdown is not rapidly curbed, the world’s economies could soon, one by one, end up adopting precisely those ‘beggar thy neighbour’ policies that the G20 tried to forestall at the end of the last decade. It is still possible for the Great Recession to morph into a second Great Depression (Eichengreen and O’Rourke 2012). To avoid this, understanding and correcting the errors in Eurozone government policy is essential.
To do so, we have to go back to the global policy action that took place at the end of last decade: the G20 response to the deflationary shock that hit the world economy after the fall of Lehman Brothers.
- The sharp drop in private spending propensities associated with the collapse of globalised finance had put the world economy on the brink.
- Without a quick increase in public spending and borrowing, the fall of world activity would have been dramatic, especially in those economies – most of the Anglo-Saxon world, Spain, etc – where, in the preceding years, the increase in private borrowing and spending had been the fastest.
In a just-published study (Brender et al. 2012) we show that, left on its own, the fall in private spending propensities that took place in those economies would have lowered their nominal income by roughly 20%, while at the same time sharply deteriorating budget balances all over the world. This last, often neglected, point is not surprising.
The post-Lehman confidence shock led to a fall in private spending propensities in the economies where they were elevated without increasing those propensities in the rest of the world. This implied that global activity would have had to fall until the deterioration in public balances absorbed the surplus savings generated by the world private sector. Thanks to the coordinated stabilisation effort launched by the G20, nominal activity hardly fell, on average, in the directly hit economies while it (only) decelerated in the rest of the world.
To be honest the effort was far from truly coordinated but at least it was synchronised. The sharp increase in public deficits however put the public debt of most developed economies on an unsustainable trajectory. The need for a coordinated strategy to exit this situation was immediately mentioned, but as soon as things started to look rosier it was forgotten.
Policy divergence emerges
By 2010, governments on both sides of the Atlantic had clearly adopted diverging strategies.
- For the US restoring self-sustained growth was the priority,
- For Europe the priority was to bring budgets back into balance.
The problem is that reducing budget deficits without harming growth had become trickier (Wolf 2010). In the post-Lehman period, the chances that the behaviour of the private sector will be ‘non-Ricardian’ have tremendously increased.
Accounting identity at work
Monetary policy has lost most of its traction in recent years due to past financial excesses. Borrowers who are burdened with excessive debt and lenders with bad loans do not react quickly to lower policy interest rates, so private demand is not stimulated.
In this ‘non-Ricardian’ world, accounting identities make the implication of a quick rebalancing of the budget clear.
- If the public sector borrows less, while
- The private sector does not borrow more (or does not save less), then
- The country as a whole will borrow less, thus
- Its current-account has to improve.
Net exports will, one way or another, increase.
Of course the adjustment path makes a difference.
- If exports can grow fast because the country’s competitiveness has increased or because the demand for its product is dynamic, imports – and hence domestic demand – may not have to contract in order to grow less than exports.
- If this is not the case, things will be more painful.
The implied improvement in the current account may have to be achieved through a contraction of imports and hence domestic demand.
The contribution of net trade to (nominal) domestic income growth will of course be the same in both cases but the pace of income and domestic demand growth will be very different. Having overlooked this point, some European governments have tried – or have been asked – to reach ambitious fiscal targets at a too fast pace, with the predictable consequence of pushing their economies if not yet into a tailspin as has been the case for Greece, at least towards a vicious contraction of activity.
Figure 1. Spain net financial saving rate by sector (% of GDP)
Source: Bank of Spain
The Spanish case gives – unfortunately – a perfect illustration of the dangers associated with fiscal tightening in an economy where the spending propensity of the private sector is petrified. From 2007 on, this propensity fell sharply and its mirror image, the private sector’s net financial saving ratio, jumped: expressed in terms of GDP points, it moved from -11% of GDP to +6%. As in the rest of the world, the government tried to stabilise the economy and its deficit widened from +1% of GDP to -11% of GDP. Correspondingly the current account improved by close to five GDP points (Figure 1).
Fiscal tightening then started. Over the 2010-2011 period, the public deficit shrunk by close to three GDP points but the private sector financial saving ratio diminished by less than half this amount and as a consequence the current account further improved. The way this happened is telling however.
Contrary to what is often said about Spanish competitiveness, exports did their fair share. During those two years, they grew exactly as fast as in Germany (Figure 2). For a few quarters at least the improvement in the current account remained compatible with some increase in imports and domestic demand. But since the second half of 2011, the European slowdown has led to slower export growth while at the same time fiscal policy was further tightened and Spanish domestic demand had to contract to allow for a downward adjustment in imports. If, as announced, the Spanish government tries at any cost to reach its overly ambitious fiscal targets, with no miraculous improvement in foreign demand in sight, domestic demand will keep on crumbling. This will then put Spain on a trajectory that could soon resemble the one Greece has just followed.
Figure 2. Nominal exports and imports of goods and services (2007 = 100)
Sources: Thomson datastream, National Statistical Service of Greece
The conclusion is easy to draw. Eurozone governments have to acknowledge that their response to the sovereign crises has been wrong. In present circumstances, bringing budgets back to balance as quickly as possible and at any cost for growth is a recipe for disaster. The pace of fiscal tightening has to be adapted, on a country-by-country basis, to both the pace at which the healing of private sector balance sheets takes place and the pace at which foreign demand for domestic goods and services expands.
Can this be sold to the markets? Yes, especially if it is included in a strategy aimed at regaining control of the euro crisis and part of a coordinated effort to support the weakening global recovery. Remember that markets are more pragmatic than politicians: the only thing they price is the chances to get their money back in due time. What they know for sure is that where activity now falters badly those chances are diminishing.
This column title paraphrases the title of a Paul Krugman blog post “Death by accounting identity” (Krugman 2011).
Brender A, F Pisani, and E Gagna (2012), The sovereign debt crisis: placing a curb on growth, CEPS, Brussels.
Eichengreen, Barry and Kevin H O’Rourke (2012), “A tale of two depressions redux”, VoxEU.org, 6 March.
Guajardo, J, D Leigh, and A Pescatori (2011), “Expansionary austerity: new international evidence”, Working Paper, International Monetary Fund, Washington DC.
Krugman, P (2011), “Death By Accounting Identity”, The New York Times, 25 November.
Portes, J (2012), “Is austerity self-defeating? Of course it is”, VoxEU.org, Comment in the VoxEU debate "Has austerity gone too far?", 10 April.
Wolf M (2010), “Why plans for early fiscal tightening carry global risks”, Financial Times, 17 June.