Debt Consolidation Can Work, but It Will Hurt: Goldman
Amid signs that the European debt crisis — which already has seen Greece, Ireland and Portugal seek aid from the European Union and International Monetary Fund — is now spreading to Italy, analysts at Goldman Sachs are predicting that while painful, debt consolidation will succeed as soaring borrowing costs force governments to act.
“Given the current economic conditions in the periphery and based on past experience, the probability of fiscal consolidation being sustained in Greece, Portugal, and Ireland appears high,” said Lasse Holboell W. Nielsen, an economist at Goldman Sachs in a research note.
“An important driver of this result is the strong incentive to tighten fiscal policy created by high bond yields," he said.
"On our calculations, Greece has around a 70 percentage point greater probability of continued consolidation than if real bond yields were equal to those of Germany.” Seeing a similar effect, though to a lesser extent, in Portugal and Ireland, Nielsen said he the same effect might not be seen in Spain, where yields are sharply lower.
“Given its lower bond yield, the implied probability of a large adjustment in Spain is somewhat lower but nevertheless high," Nielsen said.
New governments elected since the debt crisis started will allow Portugal and Ireland more freedom to push on with unpopular reform, according to Nielsen.
The problem though is the impact of higher borrowing costs on growth, not just the incentive they provide to consolidate debt.
“A credible consolidation, that reduces bond spreads can thus act to minimize the negative impact of consolidation on GDP growth,” said Nielsen.
It remains to be seen if the bond market will allow rates to come down significantly while debt restructuring and losses for private investors remains such a possibility for any country forced to ask the EU and IMF for help—a problem market watchers have seen with Greece.
But Nielsen said if everyone is doing it, the impact on growth will be more muted than if individual states act alone.
“As lower GDP growth implies lower government revenues, 1 percent of GDP consolidation is likely to imply a smaller than 1 percent of GDP improvement in the budget.
Given the potential for ‘slippage’ to occur, governments should therefore aim to consolidate by more than the total adjustment needed to restore fiscal balances," he said.
That is current policy in Greece, Ireland, Portugal, Italy and even the UK, and getting debts paid down as quickly as possible is necessary as far as Nielsen is concerned if governments want to be credible.
“The pace of fiscal consolidation in the periphery would appear too fast under ‘normal’ circumstances.
That said, these are far from ‘normal’ circumstances, and a significant degree of front-loading may be necessary to signal credibility," he said.
Fail to gain credibility with the market, and you can be caught between a rock and a hard place.
“Where the adjustment is very front-loaded but fails to ease market tensions, yields remain elevated and GDP growth suffers, and market scepticism is vindicated,” said Nielsen.
As it stands, the UK is experiencing the opposite, given austerity measures put in place before the bond market vigilantes attacked the gilt market.
With several EU governments attempting to consolidate debt by relying on multi-year cuts and a high degree of fiscal surveillance, Nielsen is confident about attempts of governments to cut their way out of trouble.