Three facts and a national accounting identity

I want to begin by stepping back from all the details and acronyms of the euro crisis –  LTROs, NCBs, ELA, SMP, EFSF and all the rest of it – and looking at some high-level macro facts.

This isn’t to suggest the details are unimportant. Far from it: I’m currently making a living out of understanding market and institutional details and how they influence events, so it’s in my interest to talk up their importance. But I think we should start out by understanding the big picture. So here are three macro facts that influence my overall view of the crisis.

Fact (1) – The euro area’s governments on average are less indebted than those of the US, UK or Japan.

The chart below shows general government net debt (historic and latest IMF forecasts) in the euro area, compared to the US, UK and Japan. You can see that debt levels in the euro area are the lowest of the four economies, which is in fact an improvement from pre-crisis relative to the US and UK.

Fact (2) – The euro area’s external balances are slightly positive, compared to current account deficits in the US and UK.

The chart shows that, overall, the euro area does not have a big current account adjustment to make relative to the rest of the world. In fact, the euro area exports to the rest of the world slightly more than it imports, in contrast to the US or UK.

The combination of (1) and (2) is the starting point for saying that the euro crisis is the result of a political coordination problem, not inexorable economic logic. If it were legitimate to analyse the euro area’s economy on a ‘consolidated’ basis – in the (implausible) extreme, if the euro area were to make the same decision as England/Wales/Scotland or New York/Texas/Florida, to become one big country – then the fiscal aspect of the euro crisis would disappear overnight (and with it, much – though not all – of the banking and growth crises that accompany it).

But such ‘consolidated’ analysis doesn’t make sense until the political coordination problem is solved. It doesn’t matter that the euro area’s net debt is a (relatively) healthy 68% of GDP when, for instance, three of its member states (Greece, Italy and Portugal) are individually liable for net debts of or above 100% of their individual GDPs. Which leads on to the third fact, concerning the scale of the imbalances that need to be addressed in the near future through further coordination.

Fact (3) – Within the euro area, Greece, Cyprus and Spain have  large fiscal and external imbalances still to address. Ireland also has a large fiscal (but not external) imbalance and Portugal has a large external (and medium fiscal) imbalance.

Let’s reflect on this for a moment. The current account matters because it tells us an economy’s reliance on foreign capital – since the flip side of a current account deficit is the capital account surplus to finance it (from the balance of payments identities).

The euro peripherals got into trouble in 2009-2010 because they’d been running large fiscal deficits (to some extent a consequence of the 2008 banking crisis) that they funded by issuing debt to foreign investors. When those foreign investors started to worry about the solvency of those governments, these foreign capital inflows would have ground to a halt and current accounts would have had to adjust immediately. Under a floating exchange rate, this would have meant a currency crisis and probable default on foreign-currency debts. Under a pegged exchange rate, this instead requires an adjustment in domestic imbalances – governments would have immediately had to cut spending and hike taxes to balance their budgets and remove the need to borrow from foreign investors, with wrenching effects on domestic demand (as in the euro-pegged Baltic states during 2008-2009).

But within the euro area, other mechanisms came into play (to briefly go into some of the institutional detail of the euro area). Specifically, EFSF-IMF lending to peripheral governments and Target 2 ‘lending’ by the Bundesbank to the peripheral national central banks (NCBs) took the place of some of the previous capital inflows. Bruegel recently published an excellent paper explaining how these official sources replaced foreign private investors after the ‘sudden stops’ in capital inflows to these countries.

Why does all this matter? Well, to wean themselves off official (EFSF-IMF and Target 2) support, Greece, Cyprus, Ireland, Portugal and Spain still have adjustments to make. But the first four of those countries only account for 6% of euro-area GDP. Frankly, the degree of political coordination needed for the other 94% to support them as they adjust really isn’t that great. And if some of those four countries were to decide to call it quits, the rest of the euro area should be able to continue pretty much okay without them. (Rather, it would be the exiting countries that are likely to suffer the most.)

Italy isn’t mentioned here for a reason: looking at the data, its fiscal deficit (3.9% of GDP – 70th largest in the world last year) and current account deficit (3.2% of GDP – 94th largest in the world last year) really aren’t that big.  Italy has a large stock of debt, which is concerning given low trend GDP growth (i.e. low growth in the ability to service those debts). But it can both address the slow-growth problem and correct the current account deficit through ‘low-hanging fruit’ reforms to labour and product markets, such as those being introduced by Mario Monti’s technocratic government (though Italy may need to rededicate itself to the Monti programme given recent signs of slippage).

This leaves Spain. Spain is where I think the real euro-area problem sits – the fiscal deficit is huge already and the government may face further costs to support the moribund banking sector. Meanwhile, unemployment is already at 24.4% and the economy is formally back in recession, yet the government somehow needs to reduce spending / increase taxes by a further 3.2% of GDP in this year alone to meet its 2012 deficit target of 5.3% of GDP. An EFSF package may be needed to recapitalise the banks or set up a bad bank to segregate their bad loans. Spain is certainly the big challenge to the future of the euro area.

And a national accounting identity

Even in the case of Spain though, there are reasons to think things aren’t quite as bad as they might appear. Look at how far to the left of the chart Spain is from the red dashed line that shows where the fiscal deficit equals the current account deficit. From the national accounting identities, we know that the current account deficit (X-M) is equal to the sum of private savings (S-I) and public savings (T-G) – in other words, for one sector (private, public or rest-of-world) to run a deficit, another sector must run a corresponding surplus. The fact that Spain’s 2011 fiscal balance (-8.5% of GDP) was so much worse than its current account balance (-3.7% of GDP) shows that the private sector is running a large financial surplus (+4.8% of GDP). This is the private sector deleveraging after its pre-crisis borrowing splurge, which contributes to the weak growth environment.

But as long as the private sector wants to run these surpluses, doesn’t it mean there is some sort of natural domestic buyer base for Spanish government debt? At the very least, Spain’s nowhere near Greece, where the ultimate source of funding for the 9.2% of GDP fiscal deficit last year was the rest of the world (the current account deficit was 9.7% of GDP) and so the government is entirely reliant on the generosity of the other euro members.

I’d be interested in other people’s thoughts. Spain clearly has a fiscal imbalance problem. But it seems to be under fewer pressures than other countries to rapidly eradicate its budget deficit, because it’s not actually as reliant as they are on foreign capital. And in fact, as long as the Banco de Espana is able to keep building up Target 2 liabilities versus other euro-area NCBs, isn’t Spain able to continue running modest current account deficits (albeit hopefully at a reducing rate), even in the face of a sudden stop in private capital inflows? And doesn’t this mean that in Spain’s case there is more scope for a ‘Plan B’ of, not a fiscal splurge, but at least a slower fiscal adjustment that need not further undermine an economy that’s already in recession? This is partly why I’m not quite as pessimistic as some people about the ability of Europe to sort its (i.e. Spain’s) mess out.

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