The 4 Trillion Euro Fantasy

By Peter Boone and Simon Johnson
Some officials and former officials are taking the view that a large fund of financial support for troubled eurozone nations could be decisive in stabilizing the situation.  The headline numbers discussed are up to 2-4 trillion euros – a large amount of money, given that German GDP is only 2.5 trillion euros and the entire eurozone GDP is around 9 trillion euros.
There are some practical difficulties, including the fact that the European Financial Stability Fund (EFSF) as currently designed has only around 240 billion euros available (although this falls if more countries lose their AAA status in the euro area) and the International Monetary Fund – the only ready money at the global level – would be more than stretched to go “all in” at 300 billion euros.  Never mind, say the optimists – we’ll get some “equity” from the EFSF and then “leverage up” by borrowing from the European Central Bank.
Such a scheme, if it could get political approval, would buy time – in the sense that it would hold down interest rates on Italian government debt relative to their current trajectory.  But leaving aside the question of whether the ECB – and the Germans – would ever agree to provide this kind of leverage and ignoring legitimate concerns about the potential impact on inflationary expectations of such measures, could a, for example, 4 trillion euro package really stabilize the situation?
To answer this question, think through the “best case” scenario in which the big package is put in place and, at least initially, believed to be credible.  Proponents of this approach argue that in this case the “market would be awed into submission”, business as usual would prevail – meaning that Italy and other potentially troubled sovereigns could resume borrowing at low interest rates – and the 4 trillion euro fund would not actually need to be used.
This seems implausible.  If the big government money shows up and this pushes down yields on Italian government debt, what will the private sector holders of that debt do?  Some of them will sell – taking advantage of what they worry may only be a temporary respite and, for those who bought near the bottom, locking in a capital gain (as interest rates fall, bond prices rise – there is an inverse relationship).
So the European/IMF bailout fund would acquire a significant amount of Italian, Portuguese, Spanish and other debt (including perhaps Greece and Ireland).  If the credit utilized from this fund, with its ECB backing, reaches – let’s say – 1 trillion euros, how will the Germans feel about the situation?  Their worries will only be exacerbated by ongoing budget deficits, exacerbated by recessions, throughout the periphery.  Someone will need to finance those deficits, and the stabilization fund is likely to be the financier.
On current form, the Italians will have promised moderate austerity but delivered little.  The life styles of rich and famous Italian leaders will start to grate on north European taxpayers.  Stories about corruption in Italian public life – perhaps exaggerated but with more than a grain of truth – will become pervasive.
In fall 1997, the IMF – with US and European backing – provided what was then regarded as a substantial package of support to the Suharto government in Indonesia.  But then the government refused to close banks as agreed – and after one of President Suharto’s sons finally lost one failed bank, he immediately popped up again with another banking license.  Stories about Indonesian official corruption and the ruling family were on front pages of major newspapers in the US.
Donor fatigue set in.  In January 1998, when the Indonesian government announced a budget that had slightly less austerity than planned, it was roundly castigated by the international community.  This set off a further sharp depreciation in the Indonesian rupiah, which worsened the debt problems of the Indonesia corporate sector – which had borrowed heavily and at short maturities in dollars.  Panic set in, social unrest became increasingly manifest, and the real economy declined further.
Italy is not Indonesia and Mr. Berlusconi is not President Suharto – who ended up leaving office.  But the comparison is still has value.  Will the countries backing the enhanced and highly leveraged EFSF be willing to face substantial potential credit losses, i.e., actual and ongoing transfers from their taxpayers to Italians and others?
Lech Walesa famously remarked, it is easier to make fish soup from fish than to do the reverse.  So it is with fiscal crises – once fear prevails and markets start to think hard about the stress scenario, it is hard to solve the problem simply with reassuring words or financial support that never needs to be used.
Crisis veterans like to say, quoting former President Ernesto Zedillo of Mexico: When markets overreact, policy needs to overreact in the stabilizing direction.   But what really matters is not overreacting; it is making sure you do enough.
In Europe, the first thing peripheral governments need to do is stop accumulating debt, and quickly.  Italian fiscal plans to balance the budget in 2012 look implausible as they assume unrealistic growth.  The currently planned Greek debt restructuring and increased taxes will not turn that economy around — nor prevent Greece from accumulating even further debt.  Despite all the reported austerity, the Irish  government is still running a budget deficit near 12% of GNP in 2011 while nominal GNP actually declined in the first half of 2011.
Europe’s periphery also needs to recognize that it signed up to a currency union, and that requires a new approach to adjustment.  Instead of having massive devaluations like Zedillo’s Mexico, or Suharto’s Indonesia and Walesa’s Poland, Europe’s troubled nations need to improve competitiveness through reducing local costs.  That must primarily come through wage reductions and more competitive tax systems.  In Ireland a pact with the major unions is preventing further wage reductions, while in Greece the government is strangling corporations with taxes in order to avoid deeper wage and spending cuts.  The proposed Portuguese “fiscal devaluation” – meaning lower payroll taxes to reduce labor costs and increase VAT to replace the revenue – looks like a weak attempt to avoid talking about the need to much more sharply cut public spending  and wages in real, purchasing power terms.
Putting in place a huge financial package is not enough.  Policies have to adjust across the troubled eurozone countries so that nations stop accumulating debt, and the periphery moves rapidly from being least competitive nations in the euro area, to the most competitive and this includes lower real wages, even if debts are restructured appropriately. The European leadership is a long way from even recognizing this reality – let alone talking about it in public.
An edited version of this post appeared this morning on the NYT.com’s Economix blog; it is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.