Will the master plan agreed by the leaders of France and Germany on Monday work?
The “Merkozy Plan”—as some traders are calling it, after German Chancellor Angela Merkel and French President Nicolas Sarkozy—seeks to impose budget discipline across the euro zone and faces a lot of obstacles. The most serious of these is that European leaders may underestimate how far their debt levels need to come down to restore market confidence.
The proposal would create a permanent bailout fund for Eurozone states in distress. In exchange for access to the fund, governments that fail to keep their deficits under control would be subject to automatic penalties. The details are set to be released Wednesday.
The familiar objections to this are two-fold. In the first place, it requires European nations to surrender even more of their national sovereignty to the European Union, something many have been reluctant to do. In the second place, it would require Germans to fund the past spending of European nations regarded in Germany as “tax sinners” and “profligate government.”
But the deeper problem with the plan is that it might not go far enough to accomplish its deeper goal—restoring access to capital markets for Europe. National governments of Italy and Spain have recently had to pay very high interest rates to attract investors.
Banks and some corporate issuers have seen various doorways into the international capital market slammed shut.
The European leadership believes that this is caused by national budget deficits that are too high. They hope that by reducing the budget deficits they will be able to “restore confidence,” attract investors to fund their governments and businesses, and build a path to economic growth.
Paul Krugman calls this idea “expansionary austerity.”It is apparently very popular in the finance ministries of Europe—despite a lack of evidence that it works. The Krugmanites of the world would argue that it can actually backfire. Cutting government spending and raising taxes to reduce budget deficits slows economic growth, which means that GDP diminishes right along with—or even faster than—spending. So the budget deficit grows.
In many ways, the focus on budget deficits seems misplaced. A budget deficit is just the difference between what is taxed and what is spent. Eurozone governments need to borrow this difference by issuing bonds. The ability to service the debt does not depend, in any given year, on a particular budget deficit but on the overall level of indebtedness. The budget deficit in a given year is just a proxy for the direction of overall debt.
Look at it this way. Suppose Luxembourg, which has a debt to GDP ratio of just 20 percent, suddenly had a massive but temporary plunge in its government revenues. Perhaps a horrible flu devastated productivity for one flu season. If Luxembourg greatly expanded its deficit to make up for the lost revenue, this would probably not undermine market confidence at all. Overall debt levels would still be low, and the one-year budget deficit wouldn’t be a problem.
Similarly, locking countries into “automatic” mechanisms that prevent adjustments to debt levels when real shocks happen seems unwise. There may be times when it makes more sense for a Eurozone government to borrow more rather than tax more. Why load the dice in favor of higher taxes? Isn’t this just the false morality of tax-funded expenditures being somehow better than debt-funded expenditures?
Once we realize that it is overall debt that is a problem, however, we need to ask how much debt needs to shrink to comfort the market.
There’s reason to suspect that the “acceptable” level of debt for Eurozone countries might be much lower than even the Germans believe.
Keep in mind that the Eurozone is a creature unlike any ever experienced. We have advanced, industrial economies that do not control their own currency. They are trying to manage advanced economies and governments with a currency-debt situation that resembles that of emerging market countries, which typically have to borrow (both privately and publicly) from external markets.
Unlike Japan or the United States, Eurozone governments do not have access to a central bank that is willing to buy the debt they issue to target an interest rate. Their treasuries cannot spend new money into existence.
Eurozone governments and European corporations—including its bloated financial system—borrow in euros, which are controlled by the European Central Bank. The ECB has a mandate of price stability, which it has concluded means keeping inflation steady and just under 2 percent.
When a government wants to spend more than it collects in taxes, it competes with all the other governments and corporations that borrow in euros. Similarly, the corporations compete with all the other corporate and government borrowers for a limited supply of euro funding.
In their paper “Growth in a Time of Debt,” economic historians Carmen M. Reinhart Kenneth S. Rogoff examined how total external debt effects growth for emerging market countries. They found that when combined private and public debt exceeds 60 percent of GDP, growth slows.
My argument here is that because the Eurzone nations have transformed themselves from “advanced” currency-issuers to emerging market-like currency-users, they likely face similar constraints on total private and public debt faced by the countries Reinhart and Rogoff studied.
The level may be higher than 60 percent—but that is almost irrelevant since almost all of the big Eurozone nations are way out beyond 60 percent combined private and public debt.
The Maastricht Treaty currently governing the Eurozone calls for public debt to be not more 60 percent of GDP. That means that Eurozone governments may be able to run up debts that would push up against the Reighart-Rogoff growth barrier on their own—without even taking into account private borrowing.
In other words, debt may have to come way, way down before market confidence is restored. Perhaps not as far as say, California, which is experiencing budgetary problems despite having a GDP-to-debt ratio of just 5 percent. But much further than the Europeans seem to anticipate.
“And while the Germans aren’t entirely wrong in their belief that lower deficits would restore funding capacity, I don’t think they recognize that as currency users debt to GDP ratios may need to be under 30% to get to that point,” economic theorist Warren Mosler points out on his blog.
There’s no practical way for Eurozone nations to get down to those GDP levels. Raise taxes by enough and you’ll shrink, undermining the attempted debt to GDP reduction. Same with cutting spending.
Of course, the alternative would be to restore something like a modern monetary system for Europe, abandoning the hope that a centralized bureaucracy can manage the money supply for 17 different nations. But that alternative is currently off the table for Europe’s finance ministers.
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