The perils of European debt crisis: divergence, retreat or decline?

Recent debacle at the summit of Bruselles in the midst of the political intervention of the EU leaders to facilitate the institutional agreement between the European countries towards the formation of the European fiscal union has caused not only a long-standing dissolution of the “core countries” of the Eurozone and the UK but, more importantly, a non-solvable puzzle on the end scenario of the European debt crisis that pervaded both the eurozone and the countries outside it ever since the beginning of the 2008/2009 financial crisis. The anatomy of the European debt crisis is a multifaceted process that is heavily interrelated with the economic principles of the process of European integration and the unintended consequences that erupted in the recent debt crisis.

The introduction of Maastricht criteria that stipulated fiscal prudence by obliging EU member states to adhere to the level of public debt below 60 percent of the GDP and low fiscal deficit boosted the expectations of stable macroeconomic environment, partly sustained by the European Central Bank which, since its inception in 1999, successfully maintained price stability. Despite an enviable achievement in the stabilization of inflation expectations, the EU Treaty did not stipulate stringent fiscal rules in case of the breach of treaty obligations on behalf of EU member states, neither has European Growth and Stability Pact (EGSP) provided selective mechanisms that would hinge on the EU member state in case Maastricht criteria were not fulfilled. On the other hand, the gradual enlargement of the European union did not finalize in the economic union characterized by the realization of four basic freedoms.

In 1977, Portugal and Spain were acceded into the European Union. Four years late, Greece was admitted as the 12th member of the European community. Over time, the EU grew from an integrated area of 15 Western European countries into a conglomerate of nations that did not impinge of the full-fledged liberalization of the internal market in 1988 but, moreover, has evolved into the spiral that accelerated the community toward the political union. In the mean time, member states of the Eurozone have continuously breached the rules laid out by Maastricht treaty. In bearing the fiscal consequences of the reunification, Germany repeatedly breached the Maastricht criteria both in public debt and fiscal deficit which postponed the introduction of the Euro, following a large shock from gigantic fiscal transfers from high-income West Germany into low-income East German regions. In a similar manner, until 2005, France did not manage to reduce the debt-to-GDP ratio under the 60 percent threshold stipulated by the Maastricht criteria.

Nevertheless, peripheral countries such as Spain and Portugal entered the Eurozone at an overvalued exchange rate relative to German mark before the introduction of the common currency. In the following years, these countries, notably Spain, accumulated significant current account surpluses resulted from the inflows of direct investment from the core countries such as Germany and France. These surpluses were, of course, artificial in the sense that the downward convergence of interest rates in the peripheral countries stimulated the over-leveraging of the financial sector which triggered a balloon in the housing sector.

For years, Italy and Greece have repeatedly breached the Maastricht treaty in the fiscal sense. Prior to adjoining the European Monetary Union, Greece repeatedly experienced volatile inflation rates and default on its external obligations and subsequent Drachma depreciation. Italy’s macroeconomic stabilization hinged on the discretion of government spending which, after excessive rises under various transition governments, cumulated in one of the highest debt ratios within the EMU. How could EMU countries, despite a stringent set of rules delineated by the Treaty of Maastricht, pursued discretionary fiscal policies and jeopardized the macroeconomic stability of the national economies and the Eurozone?

Prior to the onset of the financial crisis by the end of 2007, little was known on the perils of excessively leveraged balance sheets which investment banks used to seek high rates of return on high-yield and relatively risky peripheral regions. Until 2007, the exposure of major German investment to over-leveraged financial sector in countries such as Spain and Greece generated sizeable spillover effect. Before the onset of the financial crisis, Spain enjoyed sizeable current account deficit resulted from excessively high and robust overall investment. In 2007, Spain’s investment-to-GDP ratio (31 percent) was roughly comparable to developing Asia. In such highly volatile environment where economic growth departed from its long-run fundamentals, even small-scale macroeconomic shocks can result in a substantial loss of economic activity, notwithstanding the spillovers in the banking system and labor market.

The asymmetry in political structures and underlying macroeconomic fundamentals across member countries casts significant doubt in the long-term stability of the Eurozone as an area with common monetary policy. The necessary condition for the inception of common monetary policy does not hinge on the political initiatives that pervaded the process of European integration but on the careful consideration whether adjoining countries adhere to the macroeconomic criteria as denoted by the Maastricht Treaty. The failure to adhere to the contours of fiscal prudence and budgetary discipline by the major EU member states, with few notable exceptions such as the Netherlands, Austria and Finland, lies at heart of the underlying reasons why significant asymmetry and non-coordination in fiscal policy resulted in the adoption of dispersed economic policies whereas the adverse outcomes were not foreseen neither by the politicians neither by policy advisers and academics.

To a large extent, as the recent debt crisis has succinctly demonstrated, the ultimate goal of the European monetary integration was the build-up of political union. But whereas European politicians were preoccupied with all-embracing design of the EU as unitary political union, they forgot to acknowledge that political union would require the full convergence of economic policies including the integration of the labor market which hardly any political initiative within the EU deemed feasible.

The non-coordination of fiscal policymakers was highly evident in the division of member states on the core countries and EU periphery. Considering the peripherical countries, Italy, Spain, Portugal and Greece repeatedly proved ill-disciplined in managing the levels of public debt and the magnitude of the budgetary imbalance. Portugal is often the case in point. Prior to the introduction of the Euro, Portugal experienced unprecedented economic boom. Between 1995 and 2001, economic growth averaged 4 percent per annum and the unemployment rate reduced from 7 percent to 4 percent by the end of 2001.

At the same time, nominal wages grew rapidly without the necessary productivity growth compensating for the increase unit labor cost. Alongside the overheating of economic activity, driven by construction boom, current account deficits increased significantly, lowering domestic savings rate. After the country experienced a mild recession in 2003 when domestic output decreased by 1 percent on the annual basis, the slowing of artificial economic growth driven by the Euro boom, turned from temporary into permanent. In the period 2002-2010, growth of domestic output averaged at the level of no more than 1 percent per annum with stagnating productivity and significant pressure on nominal wages. Since the size of the labor cost is the major deterrent on growth, the cure for Portuguese ailing economy is the structural adjustment in the public sector such as the reduction of public debt by generating substantial primary fiscal surpluses and the lowering of government spending. Similarly, the experience of Greece, Spain and Italy suggests the evolution of the same pattern evolving over time although Italy has been known as low-growing economy during the boom time.

However, fiscal policymakers in peripheral countries repeatedly produced ill-conceived fiscal mismanagement of public finances. In 2008, the level of budgetary deficit in Greece exceeded 13 percent of the GDP whereas the country has not adhered to Maastricht criteria ever since the introduction of the Euro. After the depreciation, the net debt as percent of GDP in Greece reached 85 percent of GDP and increased to 110 percent of GDP by the end of 2008. As IMF’s recent forecasts suggest, by 2012, Greece’s public net debt could reach 175 percent of GDP.

The failure to adhere to the common set of principles as delegated by the Maastricht treaty and EU Stability and Growth Pact in the peripheral countries stemmed largely from the mismanagement of public finances and structural rigidity of the public sector with resulting increases in the burden of the labor cost. In addition, the adoption of extraordinary measures embedded in the public sector such as very low effective retirement age and substantial bonuses for civil servants exacerbated the burden of the public debt with unforeseen net financial liabilities of governments which have not mitigated the persistent burden of public debt that grew substantially over time in the EU periphery.

A natural question is whether the exclusion of peripheral countries from the Eurozone might be feasible and whether Greece’s default on external obligations might help overcome country’s mountainous strain on public debt. First, the re-adoption of domestic currencies is hardly a solution to overcome the intricacies of debt crisis. If Greece re-introduced drachma, external obligations would be strained by a painful and enduring bank run since investors would withdraw the deposits from the portfolio and invest it into safer holding with less volatility and uncertainty ahead. Another argument in favor of Greece exiting the Eurozone is that a devaluation of drachma would boost inflationary expectations and consequently reduce the burden of the public debt but given junk score on government bonds, a rather immediate bank run would follow the devaluation of drachma rather than macroeconomic stabilization.

In addition, when Greece’s domestic output is growing far below the long-term potential, inflationary expectations is not a feasible tool to revive the economy from deflationary trap with 16 percent unemployment Moreover, the only feasible and meaningful short-term strategy to boost growth is the reduction of the size of the public sector including the privatization of inefficient state-owned enterprises to generate substantial fiscal surpluses since this is the only plausible measure to tackle the increasing burden of the public debt. As the history of financial crises suggests, the eruptions of banking crises occurred mostly when governments rested on currency devaluations as the ultimate tool to reduce the burden of external debt. In addition, if Greece defaulted on its external obligations, CDS spreads could indicate a snowball effect where Spain, Portugal and possibly Italy could follow the same track.

The question is whether non-coordination between European fiscal policies helped facilitate over-leveraged financial sectors which asked for the bailout by central governments in the wake of the 2008/2009 financial crisis. Over-leveraged financial sectors were attributed to the determinants of various extent. Some argued that over-leveraging is the outcome of innovative financial engineering where fancy mathematicians and physicists applied VaR models to calculate the probability of losses in the portfolio distribution of returns whereas the financial derivative schemes developed by advanced and complex mathematical models were so complicated that nobody, sometimes even mathematicians themselves, could understand sensibly.

On the other hand, the monetary policy perspective of over-leveraged financial sectors has been rather overlooked in policy discussions since periodically low interest rates encourage excessive risk-taking which further facilitated the construction of portfolios with excessively volatile returns that increasingly relied on VaR assumptions whilst fundamentally ignoring the instability of returns from over-leveraged investments. But a more intriguing question pertaining to the banking perspective of financial crises is whether more prudent financial regulation as envisaged from recent stress tests by European Banking Authority can be achieved by raising capital adequacy standards. Unfortunately, the history of Basel accords demonstrates that the banking sector has been prone to search alternative channels to avoid raising capital adequacy ratios through innovative accounting tricks whereas neither Basel I and II envisaged the adverse outcomes from excessive risk-taking. As stress tests indicated, capital adequacy ratios should be increased substantially but, moreover, the regulatory framework should not only build on increasing criteria on Tier I capital and common equity but also on the safeguard despositary insurance of contingent liabilities to mitigate liquidity risk that led to the systemic crisis.

The solution to revive the Eurozone economy and revive it from a decade of flawed political imperatives should not exclude multiple options. The focal point of the Eurozone’s recovery from debt crisis should be to help peripheral countries establishment fiscal prudence, discipline and soundness of the public finances. In fact, the recovery from the debt crisis will endure for more than a decade. The structural adjustment does not rest on the ability of the EU to provide financial assistance to peripheral countries but on the principled and coordinated action to reform inefficient public sectors which are at the heart of the debt spiral since years of generous entitlements to civil servants have tremendously raised the net present value of public debt to the point that peripheral countries are on the brink of default on its external obligations. Without generating substantial fiscal surpluses, there is no feasibility and no realistic scenario under which public debt level would be brought under the control in the near-term perspective. Hence, recent discussions of the consequences of debt crisis in Europe have simply overlooked the importance of growth-enhancing measures as the real cure for growing debt-to-GDP ratio where the measures do not apply to peripheral countries only.

First, in the wake of fiscal insolvency of public pension systems, effective retirement age should be raised substantially for men and women alike. The studies have shown that under the increase in effective retirement age to 65 years, long-term fiscal obligations would reduce and consequently an important step towards long-term macroeconomic stability would be achieved. Nearly every European country is facing low-fertility trap followed from increased affluence and generous early-retirement policies from 1970s onward. Consequently, European government have amounted a mountain of net financial liabilities that exceeded the size of GDP by several times, respectively. Decreasing the size of net liabilities to contemporary and future generations of retirees, requires a robust increase in effective retirement age. Higher retirement age threshold would substantially increase working-age population by encouraging labor market participation among the elderly. Current levels of effective retirement age are unsustainable in the long-run since a growing burden of pension obligations can seriously threaten the stability of the public finance and increase the probability of fiscal insolvency.

Second, European countries suffer from low productivity growth. In some countries, such as Italy productivity growth has remained stagnant over the course of recent two decades while elsewhere productivity growth is to slow to compensate for the increase in nominal wage rates. The evidence, in fact, overwhelmingly suggested that high tax rates are the prime obstacle to greater labor market participation, particularly among the elderly who face high implicit tax rates on work. In particular, to facilitate the channels of productivity growth, marginal tax rates should be decreased substantially. At current levels, marginal tax rates restrain labor supply significantly. In the Netherlands, the top marginal income tax rates reached 52 percent in 2011 which is a serious hinder on the working activity. In this respect, bold tax reforms should be complemented with more flexible labor markets which remain saddled with employment regulations and distort labor supply incentives. Less regulated labor market to supplement greater labor force participation, especially among women, elderly and the youth is vital to enhance productivity growth since living standards by the end of the day are determined by productivity improvements.

Ultimately and most importantly, peripheral countries should be given a free choice whether to withdraw from the EMU since recent financial crisis has shown that Eurozone is a suboptimal currency area which emerged from non-cooperative fiscal policies among its member states that caused adverse outcomes and asymmetric adjustment where macroeconomic stabilization outcomes are mutually exclusive among member states. Asymmetry adjustment that currently threatens the existence and stability of Eurozone lies at the heart of Eurozone’s debt crisis. As a general matter, economic policies have failed to recognize that structural measures in the labor market and fiscal policy regime could facilitate growth enhancement and provide the necessary impetus to stabilization of crisis-impeded monetary union. Recent suggestions by France and Germany for EU member states to form a fiscal union have led to sustained resistance from the UK which dissolved from the fiscal pact.

The ultimate grain of truth in the fiscal union is that a monetary union necessarily requires the coordination of fiscal policies to prevent adverse and asymmetric policy outcomes within the union. The fateful conclusion from recent EU debt crisis is that without the integration of the labor market on the EU level, the monetary integration cannot exist in coherence with asymmetric fiscal policies. In the future, stricter adherence to budgetary discipline will be necessary through budgetary authority. In this respect, countries that fail to adhere to Maastricht criteria and deviate from the fiscal discipline either marginally or substantially should be condemned and pay for their actions of fiscal imprudence by withdrawing from the monetary union.

Can the Eurozone survive?

The ongoing difficulties in overcoming the persistence of debt-to-GDP ratio in EU countries highlight the question whether the European Monetary Union can survive the set of shocks which prevailed since the 2008/2009 economic and financial crisis. Recently, European Commission has prested the 2010 review of public finances in EMU (link), suggesting that macroeconomic outlook for Eurozone economies has deteriorated in the light of a growing debt-to-GDP ratio.

The launch of government bailouts in various European countries has added considerable amount to the stock of public debt across the Eurozone. Since 2008/2009, general government balance in Eurozone countries has continually resulted in persistent government deficits which further added to the stock of debt. Since public debt is by definition the sum of previous deficits, the European macroeconomic outlook suffers significantly from downgraded stability of public debt.

The anatomy of sluggish economic recovery in Eurozone consists of different set of economic policies. Countries at the European periphery (Portugal, Ireland, Greece, Italy, Spain) seem to be hit most by the sluggish economic recovery. From the viewpoint of macreconomic stability, the economic policymakers in these countries have pursued the most discretionary economic policies to mitigate the effects of decline in GDP on employment, earnings and tax revenues. In addition, highly expansionary monetary policy by the European Central Bank provided a bulk of quantitative easing, resulting flooding liquidity to supplement the interbank lending and, hence, to contain the effect of overleveraged financial sector on macroeconomic stability. In Ireland, income per capita in 2010 notably decline back to 2004 level (link). As I previously emphasized in one of my previous posts (link), the depth of the economic crisis in Ireland is largely attributed to the overleveraged banking sector, vulnerable to the interbank interest rate increases. Since the sovereign CDS spread on Ireland exceeded 500 basis points in late September this year, the Irish public finance outlook deteriorated significantly in the light of the innate ability of the Irish government to bailout Anglo-Irish Bank. Recently, the IMF estimated (link) that by 2012, Irish debt-to-GDP ratio would reach 67 percent, up from 12 percent in 2005.

A prudent reduction in debt-to-GDP would be accomplished only under restrictive fiscal policy based on the reduction in government spending and a permanent fiscal rule on budget surplus at a given target level. If Irish government set the surplus target at 3 percent of GDP in the next ten years, debt-to-GDP ratio could be considerably reduced within the range of Maastricht fiscal criteria.

The macroeconomic outlook in peripheral countries suffers from high fiscal expenditures and rigid labor market institutions. By 2012, Portugal's debt-to-GDP ratio is expected to reach nearly 85 percent of GDP. In addition to soaring public debt, the Mediterranean part of the EMU suffers heavily from high unemployment rate. Eurostat recently reported that, by October 2010, the unemployment rate in Spain reached an astonishing 20.7 percent. Double-digit unemployment rate in Spain, Greece (12.2 percent) and Portugal (11 percent) hamper the economic recovery since, in the past, these countries exercised expansionary fiscal policy and the policy of automatic stabilizers to mitigate the effects of high unemployment on aggregate consumption decline. In the aftermath of financial crisis, these countries experienced recessionary output gap in which economic contraction is marred by unchanged inflationary pressures.

Since EMU countries withheld domestic currencies and adhered the adoption of the Euro, the macroeconomic adjustment to the recovery is possible only by a prudent fiscal policy. High unemployment rates and a persistent divergence of economic policies in EMU countries could substantially increase discretionary fiscal policies that would eventually result in the serious possibility of country default. The economic crisis in Greece resulted in 11 percent cumulative GDP decline between 2010 and 2012. In the same period, government net debt is expected to reach the 120 percent of GDP thresold. A divergence between Member States towards highly discretionary fiscal policy would probably alleviate the persistence of high unemployment but at the expense of bold increase in the rate of inflation as well as in the persistence of debt-to-GDP ratio and large government imbalances. Hence, the survival of the Eurozone would depend on the ability of EU Member States to adjust government balance by reducing fiscal expenditure and adopt the fiscal rule to pursue fiscal surplus in the coming years as to reduce the stock of public debt.

Even though a common fiscal policy could accomplish the goals of stabilization policy, the mitigation of fiscal asymmetries would be easily accomplished by labor market integration. A currency union between different countries implies integrated and assimilated labor markets under relatively homogenous preferences. It would be nearly impossible to envision the European Monetary Union without these key macroeconomic features.

WELFARE STATE AND THE FUTURE OF EUROZONE

The $140 billion rescue package to Greece is a milestone in the European Monetary Union. A lively debate on recent macroeconomic imbalances in the weakest economies of the Euroarea - Greece, Italy, Spain and Portugal - in the Eurozone has reopened the old debate on whether the Eurozone is an optimum currency areas (here, here, here and here). The idea of optimum currency areas was first proposed by Nobel-winning economist Robert Mundell. In general, if several countries form a currency union, they should have at least four common macroeconomic features as essential framework of the currency union. In this article, I'll review the labor market criteria and fiscal adjustment criteria in the light of a recent imbalances in the Euroarea, and leave production diversification and export criteria for future discussion.

First, there should be a high degree of labor mobility between countries in the currency union. The basic idea behind the labor mobility criteria is that the lack of labor mobility triggers divergence of productivity growth rates and asymmetric adjustment of wages. If inter-country productivity divergence persists, there is an upward pressure on wages adjustment given the lack of exchange rate adjustment since the countries share a common monetary policy. The formation of the currency union in the United States was relatively straightforward given the fact that labor mobility between the states is very high. In Europe, the level of labor mobility is relatively low. The lack of labor mobility has a lot to do with labor market institutions in European countries. Workers from the European periphery can hardly move to Germany, Netherlands or Denmark as they do not speak the same language. The lack of inter-country mobility resulted in significant wage premiums and rise in rents since European labor markets share a pretty high degree of monopoly power since European workers can't switch easily between labor market structure. The resulting outcome of the lack of labor market competition was a significant "union capture" of the labor market, leading to rigid wage determination and high market switching costs.

Paul Krugman recently argued (link) that the major problem behind the European Monetary Union is the lack of common fiscal policy. To a very large extent, the absence of common fiscal policy seriously affects the future prospects of the European Monetary Union. Common fiscal policy could easily absorb asymmetric shocks withing the Euroarea. However, instituting the policy could not alter the trade-off between fiscal autonomy and asymmetric shock intensity. In other words, the main problem of the Euroarea right now is the free-riding of Eurozone's most problematic countries on a common monetary policy using disrectionary fiscal policy. Before the economic crisis, Spain had a budget deficit while, at the moment, the 2010 budget deficit forecast is more than 8 percent of the GDP. The estimate Greece's balooning public debt in 2009 ranges from 110 to 115 percent, depending on the consensus forecast. If the EMU countries unified a fiscal policy, the countries would not have an incentive to free-ride on discretionary fiscal policy and further increase the stock of public debt. The major impediment on the recovery and long-term economic outlook of Eurozone countries is largely dependent on how these countries will reform the pension systems in the light of a growing old-age dependence and a near fiscal insolvency of the pay-as-you-go (PAYG) pension schemes. It will be impossible to reverse the aging population and its persistent pressure on an increasing public debt. The integration of fiscal policy would require a sizeable harmonization of taxes given high costs of coordination and sufficient incentives for moral hazard. Without the reversion of long-term public debt pressure from aging, discretionary spending and entitlements, countries such as Greece, Spain and Portugal would leave the Eurozone.

EMU: RECOVERY OR DECLINE?

NY Times recently reported on the agreed financial rescue assitance to Grecce from EMU (€110 billion) and IMF ($145 billion). Alongside Ireland and Mediterranean countries, the economic recovery of EMU is hampered by a high mountain of public debt and unfavorable macroeconomic data on growth, employment and current account.

Public debt in the European Union in 2009

Source: Eurostat (2009)

The graph I attached, shows the level of public debt in EU countries in 2009. Solid horizontal blue line shows the 60 percent debt-to-GDP ratio required by Maastricht criteria for each EMU entrant.

The underlying data (link) on economic recovery in the US point out a strong and robust recovery. The data from Bureau of Economic Analysis show that the US economy grew by 3.2 percent in Q1:2010 continued from a remarkable 4.6 percent growth in Q4:2009. While private consumption expenditure growth increased by 2 percentage points from the previous quarter, private domestic investment rebounded by 14.8 percent in Q1:2010 after a remarkable 46.1 percent increase in Q4:2009. In addition, labor productivity in Q4:2009 increased by 6.9 percent - the largest quarterly increase since Q3:2003 (link) On the other side, recent revision (link) of quarterly growth rate in the EMU has shown that quarterly GDP in Q1:2010 increased by 0.0 percent, revised from 0.1 percent. Industrial confidence, an important measure of manufacturing outlook, further decline by 12.2 index points.

The macroeconomic outlook for the EMU is downsized by high public debt and negative budget deficit which led 10-year bond premium spread between EMU economies and Germany (link). The premium spread between Greece and Germany stood at 8.57 percentage points on April 28 while the spread between Ireland and Germany was at 2.54 percentage points.

High level of fiscal deficits restrains the economic recovery of the EMU countries. In 2009, Spain, Ireland and Greece faced the highest deficit-to-GDP ratio while Denmark's 2 percent deficit-to-GDP ratio was the lowest in the European Union. NY Times recently collected annual dataset on public debt and budget deficit (link) in which an overview of key public finance indicators is availible.

The prospects of economic recovery in the EMU are further downgraded by unfavorable growth forecast. One of the key questions during the ongoing debt crisis has been whether the EMU will sustain fiscal discrepancy within the EMU since asymmetric fiscal policy undermine the ability of the common monetary policy. Even though Greece's debt crisis is the core of the debate regarding future viability of the single currency, growth estimates for Spain and Italy in 2010/2011 will determine the mid-term macroeconomic stability of the eurozone. European Commission recently updated the quarterly economic growth estimates for eurozone countries (link). Depending on the absorption of financial market spillovers into investment and net exports, economic growth estimates for Italy and Spain are quite pessimistic. After an estimated 0.1 percent growth rate in Q2, Spain's economy is likely to contract in Q3 by -0.2 percent and experience a slight rebound in Q4:2010. Quarterly economic forecast for Italy is positive throughout the year although the economic growth rate is likely to be close to zero. However, Italy's economic growth rate is likely to keep the increasing pace towards the end of the year although current macroeconomic outlook deters consumption, investment and inventories' contribution to GDP growth mainly because of high unemployment rate and sluggish productivity growth.

Robust economic growth is essential to the cure of high public debt. Since EMU countries have adopted a single currency, policymakers cannot trigger exchange-rate adjustment through currency depreciation. The latter would spill into higher inflation and modestly reduce the volume of public debt. Due to high unemployment and slower recovery of inventories, inflation rate is unlikely to rebound to pre-crisis levels.

EMU's most problematic countries' recovery is unlikely to be robust given public debt and deficit constraint on quarterly growth outlook. Without a prudent fiscal tightening, lower government spending, there will be a bleak economic outlook for the future of EMU countries which could result in a decade-long period of low growth, high unemployment and Japan-styled deflationary persistence.

THE EURO CRISIS

Paul Krugman has blogged an interesting analysis of the anatomy of the recent economic crisis in Europe (link).

Europe's difficult macroeconomic situation in the aftermath of the financial and economic crisis has exacerbated rising fiscal deficits and public debt alongside strong deflationary pressures. These pressures were triggered by the highly negative output gap - the difference between the economy's potential output and the real output. In fact, a brief observation of the output gap estimates (link) shows that the sick men of Europe (Portugal, Greece, Spain, Italy, Slovenia) are likely to face negative output gaps. In 2010, Spain is likely to reach -2.12 percent output gap. Slovenia, Italy and Greece will also face a negative output gap. The negative output gap triggered strong deflationary pressures since the nominal aggregate demand is insufficient, causing a decreasing price level.


Before the financial and economic crisis of 2008/2009 evolved, Europe's peripheral economies faced strong asset price bubble. As real estate prices were soaring, these economies attracted significant capital inflows which lead to inflationary pressures. Before the crisis, the inflationary dynamics in the peripheral countries of the Eurozone were strong. In Greece, Spain and Slovenia, consumer prices increased by more than 3 percent on the annual basis. The asset bubble was further spread by low interest rates. The asset price inflation in these countries was very high. In Slovenia, five-year asset prices increased by 500 percent (see: IMF, International Financial Statistics). As the increase in asset prices widened, Europe's sick men were faced with rising current account deficit.

In 2007, Spain's current account deficit amounted to more than 10 percent of the GDP. In such circumstances, a clever monetary policymaker would push up interest rates. As interest rates were at historic lows during the pre-crisis period, the real cure was on behalf of the fiscal policy. Before the crisis, Spain's fiscal picture was very well indeed. From 2004 to 2007, Spain was running a fiscal surplus which reached the level of 2 percent of the GDP in 2006 and 2007. However, massive capital inflows were not sterilized by raising interest rates which further inflated the real estate bubble and overheating of Spain's economy.

Independent fiscal policies and a common monetary policy - which is an economic model of the EMU - cause asymmetric shocks. During the years of high growth, these shocks are mostly neglected. However, during the crisis these shocks might cause a serious trouble in the macroeconomic adjustment. Greece, which recently declared a worrisome possibility of debt default, is a typical case of what happens when asymmetric shocks persist.

As Greece, Spain, Italy, Portugal and Slovenia now face high fiscal deficits and poor economic growth, these countries will likely face years of deflationary pressures and high unemployment. The fiscal policymakers already exhausted the ability of governments to boost spending. Further growth of government spending is impossible unless European countries want the Greek debt episode to evolve in a domino effect throughout the Eurozone. The ECB will sooner or later this year raise the baseline interest rates to avoid the inflationary swings in Germany, Austria, Netherlands and other countries with current account surplus.

The macroeconomic outlook for the Eurozone is backlashed by the debt crisis in Mediterranean countries. An economic recovery may include indepedent monetary policies to adjust interest rates and prevent another asset bubble episode as well as to target current account balance. However, European countries will have to rethink the role of indepedent and discretionary fiscal policies pursued by the sick men of the Eurozone.

THE ORIGINS OF GREECE'S DEBT CRISIS

Paul De Grauwe published a very good article (link), discussing the macroeconomic origins of the current debt crisis in Greece.

"The period 1999-2009 has been organised in periods of booms and busts: the boom years were 1999-2001 and 2005-07; the bust years were 2002-04 and 2008-09.

One observes a number of remarkable patterns.

• First, private debt increases much more than public debt throughout the whole period (compare the left hand axis with the right hand axis).
• Second, during boom years private debt increases spectacularly.

The latest boom period of 2005-07 stands out with yearly additions to private debt amounting on average to 35 percentage points of GDP.

• During these boom periods, public debt growth drops to 1 to 2 percentage points of GDP. The opposite occurs during bust years. Private debt growth slows down and public debt growth accelerates."

EUROPE'S BLEAK MACROECONOMIC OUTLOOK

The Economist published a very lucid analysis (link) of the recent macroeconomic instability in the Euroarea, following the outbreak of Greek debt crisis (link) and disappointing quarterly data on GDP growth (link):

Barely had the ink dried on a statement by European leaders supporting Greece in its struggle to finance its debts when more bad news emerged from the euro zone. Figures released on Friday February 12th showed that GDP in the 16-country currency zone rose by just 0.1% in the three months to the end of December compared with the previous quarter. That there was any improvement at all was largely down to France, where a burst of consumer spending lifted the economy by 0.6%. In the region’s other big countries, GDP was either flat—as in Germany—or falling, as in Italy and Spain.

BEN BERNANKE AND THE GREAT RECESSION OF 2008/2009

Writing an op-ed for NY Times, Nouriel Roubini discusses the role of Ben Bernanke in this year's recession (link).

ECONOMIC RECOVERY AND THE FUTURE OF EUROZONE

Martin Feldstein offers some interesting thoughts on whether the eurozone will survive the economic recovery (link).

AUSTRALIA'S INFLATION, RECOVERY AND INTEREST RATE

Reserve Bank of Australia decided to continue the increase in benchmark interest rates by 25 basis points to 3.75 percent in the light of short-term inflationary expectations (link). Here (link) is a brief macroeconomic outlook of Australia.

DEFLATION - JAPAN'S FIRST BIG "D"

The Economist discussed the return of deflation in Japan (link). Meanwhile, the Bank of Japan has published an interesting publication of macroeconomic overview of the Japanese economy (link).

JAPAN: THE LAND OF DEFLATION

The Economist updated the report on the Japanese economy which again suffered from monthly deflation (link). The forecasts for the end of the year forsee deflation as a structural problem of the Japanese economy and not as a short-term phenomena that would reflect temporary declines in domestic or foreign demand. True, the financial crisis and the recession depressed Japanese exports but the real cause of the deflationary persistence is to be found in the design of the monetary policy which pushed the Japanese economy in deflationary trap back in early 1990s.

The OECD's preliminary report on the Japanese economic outlook (link) suggested the Bank of Japan to keep interest rates low and immediately implement quantitative easing measures to boost the economic activity as long as the expected inflation remains firmly positive.

In 2009, the IMF's inflationary forecast is -1.1 percent. Recently, Deutsche Bank released an interesting report on the Japanese economy (link), emphasizing annual decrease in output by 7 percent country's record high public debt as well as its tearing debt scenario. Japan easily maintained high public debt because of low interest rates. In fact, most of the net value of the public debt has been denominated in yen which reduced government's interest payment risk and decreased the probability of government's debt default. Before the crisis, gross government debt stood at 172 percent of the GDP. The net debt, for instance, stood at 87.7 percent of the GDP mostly because public pension assets are counterbalanced by spending commitments.

The question is how to tackle Japan's disease of low output growth and persistent deflation that last well over the latest decade?

First, it is difficult to implement further quantitative easing for the Bank of Japan. If the Bank eventually decided to do so, the interest rate would go beyond zero ground, leading to higher future value of bond payments and, hence, higher indebtedness of the Japanese government. The Bank of Japan recently left the interest rate steady at 0.1 percent and decided to purchase government bonds to keep the monetary policy strongly accomodative.

Second, the Japanese experience with a long period of falling prices began when the Bank of Japan kept driving the expansionary monetary policy when temporary shocks in domestic and foreign demand led to lower capacity of the Japanese corporate sector. When output and prices started the recovery, excess reserves were compensated by further lowering of the central bank's policy rate. Low interest rates were not offset by the closing of the output gap so the measure to boost the aggregate private consumption, investment and exports hindered the goals of the economic policymakers. The result was a depressing decrease in the price level that couldn't be offset by quantitative easing and fiscal stimulus. The former would cause negative real interest rates while the latter would increase government spending, cause crowding-out effect and further increased the country's soaring public debt.

And third, Japan's unfavorable demographic trend pose a significant risk on the sustainability of government's pension system. As Japan's population is in decline, the overall private consumption decreases which leads the retail sector to cut prices to gain the market share. The rising aging population certainly endangers country's public finances, marred by budget deficits and the highest public debt in the OECD.

Japan's looming public debt and deflationary trap are the main inhibitors of country's long-term macroeconomic recovery. Pulling the economy out of deflation rate would require huge steps to reflate the prices such as charging banks for deposits at the central bank. That would raise the interest rate at the expense of decline in aggregate investment. However, the goal is not the mission impossible. What can save the Japanese economy from double D-trap is strong, persistent and high productivity growth. It would surely ease the burden of public debt, since the Japanese government's revenues would grow and thus, its borrowing abroad and raising the level of public debt were anchored. It would also allow for greater spending cuts. On the other hand, Bank of Japan could finally pursue the real credibility of the monetary policy and avoid the mismanaged quantitative easing.

U.S ECONOMIC RECOVERY AND MACROECONOMIC OUTLOOK IN 2009/2010

The latest macroeconomic data from major world economies suggested that the recessionary contraction is likely to be ended in the light of positive news on GDP growth and midterm macroeconomic outlook. However, the road of the economic recovery remains uncertain. The policymakers responded to the great contraction of 2008 by decreasing interest rates close to zero rate. Massive injections of monetary stimulus boosted liquidity and attempted to accelerate credit expansion. However, monetary stimulus such as TARP in the U.S encouraged excess reserves. Thus, the banking sector published significant quarterly results as the stimulus package covered the overall losses from the credit crunch and subprime mortgage crisis of the previous year. In this brief article, I outline the economic recovery in the U.S in the ongoing year.

In Q3, the U.S economy grew by 2.4 percent despite the negative unemployment figures. While the U.S productivity grew by 6.8 percent in Q2:09 and by 9.8 percent in Q3:09, the unemployment rate is expected to reach 10.5 percent in December. The $787 billion stimulus from Obama administration to the ailing industries did little to prevent the fallout of demand and the financial difficulties of many firms. In fact, most of the stimulus has not already been spent. In spite of enormous fiscal emergency aid, the Obama administration effectively nationalized the auto industry as Detroit's auto industry declared bankruptcy. The auto industry is likely to recover gradually. Eventually, the fall of Detroit's giants was more likely a consequence of auto industry's inability to cope with high labor cost and fringe health and pension benefits.

The underlying economic theory and evidence teach that massive government intervention in the economy is inefficient as if government bailout hadn't occured. In Q3:09, financial industry posted significant quarterly earnings. Monetary stimulus inflated another asset bubble which translated into highly prospective annual data and higher volatility. Morgan Stanley's annual stock return currently stands at 133.4 percent (link). On the other hand, stock markets rallied in the light of significant quarterly earnings of the banking and financial sector. In one year, Dow Jones Industrial Average grew by 18.27 percent (link), S&P 500 increased by 22.16 percent (link) while Nasdaq Composite's annual growth rate stands at 36.91 percent (link). Stock markets rallied in the light of favorable earnings projections and cost reductions.

On the macroeconomic level, the U.S economy is likely to face a long L-shaped recovery. The underlying conditions are extremely low interest rate, high unemployment rate and high quarterly productivity growth rate. Much of the confidence in fiscal stimulus and expansionary fiscal policy was based on the initial assumption that spending multipliers will exceed 1 and boost short-term output and investment to reduce the negative output gap. Nevertheless, fiscal policy outlook remains sluggish and the prevailing evidence suggests that spending multipliers are hardly positive, except for when the unemployment rate exceeds 12 percent, causing a major fallout of capacity utilization. Robert Barro and Charles Redlick recently estimated the cost of fiscal stimulus. The Obama administration has already expressed commitment to raising the marginal tax rates. Tax increases are the unfortunate midterm alternative because excessive borrowing and the estimated 9.9 percent of the GDP fiscal deficit in 2009 (link) has already downgraded sovereign U.S debt outlook. Redlick and Barro showed that one-period lagged increase in the average marginal tax rate reduces, GDP growth by 0.56 percentage point. The overall effect on consumption purchases is -0.29 and the overall effect on investment is -0.35, both statistically significant at 99 percent.

The U.S dollar further depreciated against the euro (link), increasing the U.S inflation rate above the expected target, partly as a result of the increase in short-term yield on Treasury bonds. Purchases of Treasury bonds effectively increased demand for U.S dollars and triggered short-term depreciation trend. An effective reduction of fiscal deficit in the coming years is a necessary condition for mitigating the negative effects of U.S current account deficit. As fiscal deficit raises demand for imports in the U.S, real depreciation of the real effective exchange rate raises relative prices in the tradable sector compared to non-tradable sector. The main highlights of U.S economy recovery will be focused on restrictive fiscal policy and policy interest rates. Zero interest ground is a real disadvantage in economic recovery, mainly because the negative output gap and the Fed is likely to face hard time trading-off between higher inflation if interest rates remains at historic lows while the real sector's credit demand could surge and potential output contraction in the coming quarterly periods if the Fed will raised targeted federal funds rates. In the latter scenario, the U.S economy could repeat the Japanese disease from the 1990s, being faced with long, sluggish and slow economic recovery that could last for several years.

HOW FISCAL AND MONETARY POLICY LED TO THE GREAT DEPRESSION

In the recent edition of WSJ, Arthur Laffer highlighted (link) how mismanaged fiscal policy during Hoover and Roosevelt administration led and prolonged the Great depression, and how contractionary monetary policy let it happen.

THE ECONOMIC SURVEY OF ICELAND 2009

The OECD has released The Economic Survey of Iceland 2009 (link), discussing the origins of the banking crisis that eventually led to the collapse of the country's oversized banking sector relative to its GDP and the prospects of fiscal and monetary policy in the aftermath of the financial crisis and the recession.

U.S TRADE DEFICIT AND CHINA

Today, Bloomberg reported (link) that April's trade deficit in the U.S increased by 2.2 percent. The recession in major trading partner sharply reduced external demand for U.S exports. As trade deficit has continued to grow, the U.S experienced significant investment inflows due to Fed's and external demand for Treasury bonds by which Chinese central bank accumulated massive foreign currency reserves. Consequently, the U.S dollar depreciated against the yuan, pushing up trade deficit. In the last three months, the yuan appreciated by 0.3 percent. In spite of the recession, the Chinese economy is set to expand by 7.5 percent annually in 2009. Thus, it is hard to understand why some U.S politicians repeatedly say that the yuan is overvalued.

RUSSIA'S MACROECONOMIC OUTLOOK

The WSJ reports that Russia's economy recorded nearly 10 percent output contraction in Q1:2009 (link). In spite of surging oil prices and strong increases in stock market index, the midterm macroeconomic outlook on Russia is not favorable in terms of economic growth, fiscal policy and macroeconomic recovery. While the local currency appreciated 0.3 percent against the U.S dollar (link), the slow recovery in the financial sector is likely to deteriorate the macroeconomic outlook. The main ailing problems of the financial sector remain high credit and liquidity risk as well as default risk. The central bank could possibly mitigate the shocks in the financial sector by building up foreign reserves to act as the lender of the last resort. However, Russia's persistent obstacle to macroeconomic stability is high inflation rate and dismal fiscal policy record. When the inflation rate is high, building foreign currency reserves may be risky, letting domestic currency overvalued. Reduction in public spending and tightening of the monetary policy to stabilize the inflation rate could essential pursue stable midterm outlook.

WILL BOND PURCHASE SPUR GROWTH?

The Fed declared that it would buy as much as $300 billion of long-term treasury securities and even more in mortgage-backed securities. While the Fed has already targeted federal funds rate to 0,25 percent, the prices on US Treasury debt have soared, pushing the yield on 10-year notes from 3 percent to 2.53 percent. The WSJ reports:

The Fed will buy as much as $300 billion in long-term Treasurys in the next six months. It will increase the ceiling on purchases of mortgage-backed securities guaranteed by Fannie Mae and Freddie Mac to $1.25 trillion, up from $500 billion. The Fed also is doubling potential purchases of their debt, to $200 billion (link).

Zero-ground interest rate is a serious concern regarding the long-term conduct of the monetary policy. While the major central banks have already plummeted into a liquidity trap, it is surprising that stock markets and macro data on employment and output are not responding to the proposed policy measures. If the Fed is likely to buy more long-term Treasury securities in the following months, an unparalleled increase in government debt may occur which could deteriorate the state of macroeconomic stability which is unlikely to be mitigated by neither fiscal nor monetary policy. If the Fed really aims to tackle the economic recovery, then it should set time-consistent policy rule, declaring a stop to further policy rates with a clear and indisputable statement in mind.

SLOVAKIA ADOPTS EURO

On January 1, 2009, Slovakia left ERM II and became the 16th country of the eurozone (here and here). While fiscal consolidation has been sustained through capped deficit spending, inflationary pressures have been normalized due to substantial currency appreciation which also capped import prices. Reviewing data and macroeconomic forecast (here, here and here), output growth is expected to outperform the average of the Euroarea. Until 2013, output is expected to grow at an annual 5 percent rate. Robust output growth is partly due to continuing real convergence in output per capita and partly as a result of koruna appreciation and inflow of foreign direct investment. However, it will be interesting to observe inflationary pressures over the medium term. It is also essential for policymakers to capture fiscal surplus and set medium-term public spending cap. Nonetheless, competitive labor market is required to soften the inflationary pressures which could deteriorate in case of expansionary monetary policy while output gap is expected to close until 2010 despite robust short-term fluctuations.

WILL DEFLATION RESURGE?

Fed chairman says (link) deflation might resurge as a worrying threat to the U.S economy.