Buy the rescue rumor, sell the announcement. Following this simple strategy throughout Europe’s debt crisis has been popular with the fleet-footed. First risk assets sell off. Then they rally on expectations of a comprehensive solution, the announcement comes, markets conclude it is insufficient and within weeks they sell off again, engulfing more victims in their wake. This piecemeal strategy by the eurozone’s leaders, one reactive policy slice at a time, is backfiring.
Instead of crowding in the private sector, capital flight is accelerating from periphery countries, banks exposed to them are shut out of funding markets and Europe’s problems have infected risk premia globally. Greece’s economy is shrinking under the burden of fiscal tightening, causing it to miss fiscal targets and highlighting the impossibility of both saving and growing out of a debt overhang without exchange rate flexibility. As contagion spreads, markets care less about the size of Greece’s haircut and more about whether Spain, Italy and the French banking system are solvent. Italy and Spain’s governments need to raise some €325 billion next year and Europe’s banks need two-thirds as much again to reach a 9% core tier 1 capital ratio, sums that will quickly exhaust the European Financial Stability Facility’s (EFSF) lending capacity. The rally in risk assets in October reflects expectations for yet another comprehensive solution, triggered by José Manuel Barroso’s “road map to stability and growth” announced on October 12th. So far, it appears that the measures will fail to address the root causes of the eurozone’s sovereign debt problems.
Design Flaws
The crisis is revealing the eurozone’s original design flaws. Spain’s problems are not that much different from the United Kingdom’s (UK), yet Spanish sovereign debt yields double that of UK debt. We believe Spain’s problems would not be as bad as they are if the eurozone were a sovereign state. The eurozone was equipped with a single monetary policy and centralized payment system as if it was one country, but it is not. Irrevocably fixed exchange rates eliminated currency volatility and facilitated cross-border trade and capital flows. Aided by low interest rates, huge savings-investment imbalances developed. In Spain and Ireland they manifested themselves in real estate bubbles, in Greece and Portugal in excess consumption and in Germany in over reliance on exports. Markets, as well as the Stability and Growth Pact, failed to discipline excess borrowing. While economic integration proceeded at a rapid pace, political and social integration stagnated. Cross-border labor mobility remained low and the primacy of politics remained at the national level. The eurozone is thus ill-equipped to deal with the reversal of cross-border savings flows now taking place.
A country’s savings balance is equal to the difference between domestic savings and domestic spending on investment. Expressed as an accounting identity, a country’s savings balance equals its current account balance, which measures the difference between what a country earns from the rest of the world and what the world earns from it:
savings balance = current account balance = domestic savings – domestic investment spending
Disparate current account balances among eurozone member states underlie the market’s anxiety about its incomplete design features. Europeans like to point out that, taken as a region, the eurozone current account is broadly in balance. We believe this comparison is misleading, so long as the eurozone lacks a market or a fiscal mechanism to reallocate resources from one region to another when faced by a shock. A deeper look at the eurozone’s current account balance and the adjustment mechanisms for correcting savings imbalances shows why.
We divide eurozone member states into three groups: one that has generated large and persistent current account surpluses, one whose external accounts are broadly balanced and one that has generated large and persistent current account deficits (Figure 1).
A country running a current account surplus saves more than it invests and produces more than it consumes. Conversely, a country running a current account deficit is able to maintain higher levels of investment than would otherwise be possible without foreign financing. Through cross-border lending and borrowing, surplus countries accumulate financial claims on, and deficit countries obligations to, those with whom they trade. These financial claims and obligations are captured in a country’s net international investment position (Figure 2), which is analogous to the cumulative current account balance. The eurozone’s current account surplus countries have accumulated claims on the rest of the world worth ~40% of their gross domestic product (GDP) while the deficit countries owe obligations to the rest of the world worth ~80% of their GDP.
Large and persistent current account surpluses and deficits are ultimately unsustainable in a fixed exchange rate system. Germany’s current account surplus is as equally problematic as Spain’s current account deficit so long as their exchange rate is fixed, labor mobility limited or they do not engage in fiscal transfers. In a floating exchange rate system the currency acts as the adjustment mechanism. In a fixed exchange rate system without labor mobility or fiscal transfers, output and non-tradable goods and service prices adjust. This adjustment process can be destabilizing when accompanied by capital flight.
Capital Flight
Faced with a large and sudden withdrawal of capital, current account deficit countries in a fixed exchange rate system have to raise domestic savings the hard way: by stopping spending. Capital flight from regions of a monetary union tends to cause their bond and equity prices to collapse without a large currency depreciation because part of the currency is redistributed inside the zone. Fiscal tightening, without a coherent growth strategy or exchange rate flexibility can further depress economic growth, render a country incapable of servicing its debt and perhaps lock it in to a downward spiral.
Membership in the eurozone has its advantages though: banks have recourse to the European Central Bank (ECB). As investors withdrew capital from the eurozone’s current account deficit countries, the ECB filled the gap. Via its refinancing operations, emergency lending assistance and outright purchases of government and covered bonds, we estimate the ECB is now lending periphery countries about €600 billion liquidity, up from less than €100 billion in 2007. In contrast, lending to core countries is about €100 billion, down from €400 billion in 2007 (Figure 3).
Thanks to the ECB, banks and sovereigns experiencing capital flight have avoided default. But the ECB is also slowing down the savings adjustment process. Periphery countries ran a current account deficit of €227 billion in 2008. By the end of 2010 that deficit had declined to €145 billion. Between 2008 and 2010, however, the ECB supplied these same countries with €320 billion additional liquidity, a sum far exceeding the €82 billion decline in their current account deficit and reflecting the extent of portfolio outflows. In going about its duty of delivering a common monetary policy and avoiding another Lehman-like default, the ECB has inadvertently assisted periphery countries to live beyond their means. Had the ECB not provided this liquidity, the recession would have been worse. One cost has been to lessen the pressure on periphery country governments, particularly those in Rome and Madrid, to implement structural reforms that are still needed restore the market’s trust in their ability to service their debt. And it highlights the impossibility of the ECB’s dilemma: allowing markets to discipline governments into taking action yet intervening in markets to prevent a collapse of the eurozone.
Corner Solutions
Markets are imperfect disciplining machines prone to irrational under- and overshooting, but sometimes they send blatantly clear signals. Italian credit default swaps intermittently above 500 basis points and a near 50% decline in European bank stock prices this year are signals markets will likely not return to supporting the eurozone as it is. What before was unthinkable has now become possible. To reach equilibrium, we believe markets are signaling the Economic and Monetary Union’s (EMU) leaders to choose one of two corner solutions: downsize to a smaller, stronger, homogenous group of countries or adopt a federation with political and fiscal union. Both choices are fraught with enormous financial and political challenges.
First, surplus countries cannot afford to let Spain and Italy default, which their exiting the eurozone would likely entail. Germany’s explicit and contingent claims on periphery countries alone amount to 35% of its GDP through its share of the ECB’s capital, commitments to the EFSF and via its banks’ holdings. If the EMU broke apart, Germany would realize enormous losses on these claims causing a further rise in public debt. Even if Germany were willing to shoulder the loss, the strength of its currency having shed the periphery would likely cripple its export dependent economy. Whereas, the surplus countries may be able to withstand defaults in Greece, Ireland and Portugal because they are small they cannot afford to allow large countries like Spain and Italy to default. This is an enormous incentive to keep the eurozone intact.
Second, the EMU is ill-prepared for federalism. It lacks a cross-border governance structure and popular support. Some periphery countries are far away from the standards of government competence observed in surplus countries that fiscal union might entail. To its credit, Italy has consistently run a primary budget surplus while in the eurozone. But it has failed to implement structural reforms, done little to eradicate corruption and even less to rein in the size of its shadow economy. So long as countries like Italy do not address these problems and so long as surplus country taxpayers cannot trust that their transfers are used wisely, we believe Eurobonds and other forms of fiscal union would be economic suicide for the surplus countries. Eurobonds would likely tighten spreads and buy the eurozone time, but without structural reforms today’s problems will come back to haunt in a few years.
Reforms, a Policeman and Vision
Repeated attempts to solve the eurozone’s sovereign crisis have failed, reflecting a coordination problem among its fiscal authorities and between the ECB and governments that has manifest itself in the one slice at a time response. Imagine for a moment a coordinated response where these parties cooperate and pull together:
- Low-growth countries implement structural reforms to boost potential rates of economic growth and employment;
- Current account deficit countries lower unit labor costs to regain international competitiveness and reduce dependence on external finance;
- Current account surplus countries simplify tax systems to boost domestic demand and reduce reliance on exports;
- All countries commit to restore balanced budgets over the medium-term and address future funding deficits in their public pension and health-care systems;
- Insolvent countries reduce debt overhangs to manageable levels;
- The International Monetary Fund (IMF) provides technical expertise to design reforms and the enforcement of conditionality against loans;
- The EFSF uses part of is uncommitted capital to guarantee bonds issued by periphery countries and another part to recapitalize banks that fail real stress tests;
- The ECB unequivocally fulfills its role as lender of last resort, committing to underwrite all of the above via unlimited liquidity and purchases of government bonds if needed.
Having the right tools is necessary, but alone they are not sufficient. For the task ahead, sequencing, execution and a long-term plan are also required. Sovereign balance sheets need to be stabilized either before or at least simultaneously as recapitalizing banks, for example. There is little point in mandatorily recapitalizing banks against default in Greece when markets do not fully trust Italian government bonds.
To ensure execution, eurozone governments should embrace the IMF as their enforcement agent, in our opinion. So far they have thrust this role upon a reluctant ECB. But the ECB cannot be both policeman and lender of last resort. The IMF instead can lend credibility to Europe: for its expertise in designing and implementing reforms and for the conditionality it can enforce in return for bridging finance. Italy and Spain should not shy away from applying for the Fund’s Flexible Credit Lines.
Today’s EFSF and ECB intervention are a bridge toward fiscal union. They will be a bridge to nowhere if not connected to a long-term road map on how to achieve a federal structure. Jacques Delors laid out the road map to Economic and Monetary Union in 1989 with a three stage plan that led to the irrevocable fixing of exchange rates ten years later. Jean-Claude Trichet hinted at the vision of fiscal union in his Charlemagne Speech in Aachen earlier this year. Markets need orientation. Now more than ever is the opportunity to steer them by giving substance to that vision.
Implemented together, this plan stands a reasonable chance of shocking Italy and Spain back to a good equilibrium and crowding in the private sector. Until we have a sense that the policy response is credible, PIMCO will continue to invest cautiously in the periphery. We are voiding Greece, Portugal and Ireland and we are cautious in our exposures to Italy, Spain, Belgium and France – the next possible dominos to fall. Buy the rescue rumor, sell the announcement popularity continues. For the sake of Europe, it’s time for that to change.