Europe’s Depressing Prospects

By Michael Pettis

Normally I don’t like to write about European prospects in the midst of a very rough patch in the market because in that case there isn’t much I can say that isn’t already being said.  I find it more useful to wait for those recurring periods in which the markets recover and optimism rises.  Still, given the conjunction of political uncertainty in Beijing, low Chinese growth numbers, and another round of deteriorating circumstances in Europe, I will spend most of this issue of the newsletter trying to outline the possible paths countries like Spain must face.

For several years I have been saying that Spain would leave the euro and restructure its external debt.  I should say that I specify Spain because it is the country in which I was born and grew up, and so it is also the country I know best.  When I say Spain, however, I really mean all the peripheral European countries that, like Spain, are uncompetitive, have high debt levels, and suffer from low savings rates that had been forced down in the past decade to dangerous levels.

Spain had a stronger fiscal position and healthier bank balance sheets than many of its peers when the crisis began, so any argument that applies to Spain is likely to apply more forcefully to its peers.  As an aside I will add that France is for me the dividing line between countries that will be forced into devaluation and restructuring and those that won’t – in my opinion France could go either way and we will get a much better sense of this in the first year of Hollande’s presidency.

There are two reasons why I was and am fairly sure that Spain cannot stay in the euro (or, which amounts to the same thing, that Germany will leave the euro instead of Spain).  The first has to do with the logic of Spain’s balance of payments position, and the second has to do with the internal dynamics that drive the process of financial crisis.

To address the first, I would start by noting that thanks to excessively loose monetary policies driven primarily by German needs over the past decade, Spain has made itself wholly uncompetitive in the global markets and in so doing has run large current account deficits for nearly the entire past decade.  Its fundamental problem, in other words, has been the process by which its savings rate has collapsed, its cost structure forced up, its debt levels soared, and a great deal of investment directed into projects, mostly real estate, that were not economically viable.  As I have discussed often enough in previous issues of this newsletter, I think all of these problems are related and are the automatic consequences of the same set of policy distortions implemented in Spain and in Germany.

“Germany has a potentially huge debt problem on its balance sheet”

Until Spain reverses its savings and consumption balance and drives down its current account deficit into surplus, which is what a reversal of these distortions would imply, it should be pretty clear that Spain will continue struggling with growth and will continue to see debt levels rise unsustainably.  But the balance of payments mechanism imposes pretty clear constraints on the process of adjustment.  In that sense there are really only three ways Spain can regain competitiveness sufficiently to raise savings and reverse the current account:

1. Germany and the other core countries can take steps to reverse the policies that led to the European crisis.  They can cut consumption and income taxes sharply in order to reduce domestic savings and increase domestic consumption.  These would lead to a reversal of the German trade surpluses and higher inflation in Germany, the combination of which would allow Spain to reverse its trade deficit and regain competitiveness via lower inflation relative to that of Germany and a weaker euro.
2. Spain can force austerity and tolerate high unemployment for many more years as wages are slowly pushed down and pricing excesses are ground away.  It can also take measures to reduce costs by making it easier to start businesses, reducing business taxes, and by improving infrastructure, but these latter provide too little relief except over a very long period, especially given the difficulty Spain will face in financing infrastructure and reducing taxes.
3. Spain can leave the euro and devalue.  This would leave it with a problem of euro-denominated debt, whose value would soar relative to GDP denominated in a weakening currency.  In that case Spain would almost certainly be forced to halt debt payments and restructure its debt.

I want to stress that these are, practically speaking, the only three ways for Spain to regain competitiveness.  There are other ways that could in theory also work, but they are too unlikely to consider.  One could assume for example that the rest of the non-European world – most importantly the US, China and Japan – take steps to stimulate their domestic economies sufficiently to force up consumption and run in the aggregate large and growing trade deficits.  These deficits, whose counterpart would be a very large European trade surplus, would then bail out the whole eurozone by generating GDP growth rates that exceed the debt refinancing rates.

I think most of my readers will however agree that this is pretty unlikely. The rest of the world is also struggling with growth and in no hurry to run large trade deficits.  Another possibility is that we suddenly see a rapid and dramatic move towards full fiscal union in Europe, in which sovereignty, for all practical purposes, is fully transferred to Brussels (or Berlin).  But that probably won’t happen either – the rise of nationalism throughout Europe has made this always-unlikely prospect even less likely.

So we are left largely with these three ways of allowing Spain to regain a cost structure that makes it competitive and allows it to amortize its debt while growing.  Anyone who rules out two of the three ways listed above must automatically imply that Spain will follow the third way.  So which will it be?

Humpty Dumpty economics

The first way is for Germany to reverse its surplus and begin running large deficits.  This is by far the best way, but I think it is very unlikely.  Berlin has made no indication that it is prepared to do what would be necessary for it to run large deficits and, on the contrary, it is even talking about the need for more austerity.

In part this is because Germany has a potentially huge debt problem on its balance sheet.  As a consequence of its consumption-repressing policies during the decade before the crisis, Germany’s domestic savings rate was forced up to much higher than it otherwise would have been and Germany has had to export the excess capital.  Not surprisingly, given European monetary dynamics, this capital has been exported largely to the rest of Europe in order to fund the current account deficits of peripheral Europe that corresponded to the surpluses Germany so badly needed to grow.

It did this not by accumulating euro reserves, which it could not do anyway, but rather by accumulating loans to peripheral Europe through the banking system.  As a result of all of these loans, Germany is rightly terrified that a wave of defaults in Europe will cause its own banking system to require a state bailout if it is not to collapse, and so it does not want to cut taxes and reduce savings because it believes (wrongly) that austerity will make it easier to protect its creditworthiness.

But German’s anti-consumption policies are leading it towards a debt problem in the same way that similar US policies in the late 1920s created an American debt crisis during the next decade.  In that light I thought this very illuminating quote from then-presidential candidate Franklin Delano Roosevelt might be apposite:

   A puzzled, somewhat skeptical Alice asked the Republican leadership some simple questions:

   “Will not the printing and selling of more stocks and bonds the building of new plants and the increase of efficiency produce more goods than we can buy?”

   “No,” shouted Humpty Dumpty, “the more we produce the more we can buy.”

   “What if we produce a surplus?”

   “Oh, we can sell it to foreign consumers.”

   “How can the foreigners pay for it?”

   “Why, we will lend them the money.”

   “I see,” said little Alice, “they will buy our surplus with our money.  Of course these foreigners will pay us back by selling us their goods.”

   “Oh not at all, “said Humpty Dumpty.  “We set up a high wall called the tariff.”

   “And,” said Alice at last, “how will the foreigners pay off these loans?”

   “That is easy, said Humpty Dumpty. “Did you ever hear of a moratorium?”

   And so alas, my friends, we have reached the heart of the magic formula of 1928.

Humpty Dumpty’s grasp of the balance of payments, it turns out, is no more naïve than that of many European policymakers, and I suppose Germany will follow the historical precedent set by the US – and so many other countries that confuse trade surpluses with moral vigor.  By refusing to take steps that seem on the surface to undermine its creditworthiness, Berlin will only ensure the debt moratorium that will probably demolish its creditworthiness anyway.

And of course without a major reversal of German’s current account position the balance of payments constraint absolutely prevents net repayments from peripheral Europe.  This game will go on as long as the core countries continue financing the periphery, but once they finally stop, the peripheral countries will almost certainly default or restructure their debt.

To take a brief detour before returning to discussing the three paths Spain can take, I think Berlin is betting that if they can prolong the crisis long enough, while pretending that the problem is one of liquidity, not solvency, they can recapitalize the German (and other European) banks to the point where they eventually are able to recognize the obvious and take the losses.  This was, after all, the strategy followed by the US during the LDC Crisis of the 1980s, when it waited until 1989, seven or eight years after the crisis began, to arrange the first formal debt forgiveness (the Mexican Brady Bond).  During that time a steep yield curve engineered by the Fed allowed the US banks to earn sufficient profits to recapitalize themselves to the point where they could finally formally recognize what had long been obvious.

There are at least two reasons however why this strategy won’t work for the European banks.  First, the hole in the European banks’ balance sheets dwarves the equivalent hole in the balance sheets of the American banks during the LDC crisis.  It would take them much longer then seven or eight years to fix the problem.

Second, postponing resolution of the debt crisis is extremely painful for the debtor countries, who have to bear the full brunt of the adjustment that both debtor and creditor countries really need to make together.  This reduces maneuvering space for Europe because the political system in Europe is less able than that of Latin America during the 1980s to accommodate this very painful process.  Well-functioning democracies, after all, make it harder for bankers and elites to force the cost of the adjustment onto the middle and working classes.

Can Spain adjust by itself?

This is also the reason why Spain cannot follow the second of the three paths described above.  The second path requires that Spain bear the full brunt of the economic adjustment, which in reality Spain and Germany should bear together.  Spanish voters, however, will not permit (and rightly so) that Madrid force such economic pain on its citizens in the name of an ideal of “responsible behavior” (i.e. remaining within the euro) that is both mistaken and extremely painful.

The adjustment will require that Spanish wages and prices are forced down substantially until Spain can reverse the higher price differential relative to Germany from which it suffers. Figuring out how to do this is not very hard – we have plenty of historical precedents upon which to draw.  To simplify substantially, there are basically two things that have to happen in order to force a relative decline in prices.  First, unemployment must remain very high for many years so that wages either decline, or rise by less than inflation and relative productivity growth.  This is pretty straightforward.

Second, there must be some way to deal with the real increase in the domestic debt burden.  Why?  Because there are two ways relative prices can be forced down, and both of these result in a real increase in the debt burden.  First, high inflation in Germany can exceed lower Spanish inflation, and second, Spain can deflate.  In both cases the real cost of debt must increase substantially – in the former case because high German inflation will force up euro interest rates so that Spain’s refinancing cost will exceed its domestic growth rate, and in the latter case because deflation automatically increases the real debt burden.

How will we deal with the rising debt burden?  Typically we do so by confiscating the wealth of small and medium enterprises or by confiscating the savings of the middle classes, and usually we do both.

So for Spain to adjust we need both very high unemployment for many years and we need to undermine the middle classes.  Any policy that requires an enormous and unfair burden on both the workers and the middle classes is unlikely to be rewarded at the polling booths.

The huge unpopularity of the newly elected Prime Minister Mariano Rajoy, in that context, should not be a surprise.  I wrote last year just after the election that this would happen, although I thought it would take a year or two before the population really turned on him and made it impossible for him to govern.  But Spaniards, from business leaders down to workers, are furious at the Rajoy government and this anger will continue until either the two major parties eject those of their leaders who continue to demand that Spain behave in a “responsible” way, or harder line extremist parties replace the two parties themselves.

I place the word “responsible” in quotation marks not because I am opposed to responsible behavior but rather because the attempt to tighten the budget and impose austerity in the name of remaining on the euro is being presented as the “responsible” thing to do.  It is, however, no more responsible than the policies France used in the 1920s to revalue the franc to pre-War parity, which were also sold to the French public as the “responsible” thing to do.

In both cases (and in many other deluded attempts to protect hopelessly overvalued currencies underpinned by rising eternal debt), policymakers did not understand that their policies were guaranteed to fail and were based on a misunderstanding of the causes of the underlying crisis.  The responsible thing to do is to acknowledge that the euro is indefensible and that Germany’s refusal to share the adjustment burden, after it absorbed most of the benefits of the mismanaged monetary position it imposed on the rest of Europe, means that Spain will be forced to take on far more than its share of the cost.

But whether or not everyone agrees with my analysis of what really is “responsible” behavior, I think it most people will agree that, rightly or wrongly, Spanish voters are unlikely to accept high unemployment and an assault of middle class savings for many years without rebelling at the polls.  Spain simply cannot accept the full burden of adjustment.

This means that the first two of the three paths I listed above cannot be followed.  If I am right, we are automatically left with the third.  Spain (and by extension many other countries) must leave the euro.  It will be very painful and chaotic for them to abandon the euro, but the sooner they do it the less painful it will be.

The death spiral

I said at the beginning of this newsletter that there were two reasons why I was certain Spain would leave the euro, the first of which has to do with the logic of Spain’s balance of payments position and the second with the internal dynamics that drive the process of financial crisis why I was certain that Spain would leave the euro.  To address the second, I think Spain will leave the euro because it seems to me that the country has already started on the self-reinforcing downward spiral that leads to a crisis, and there is no one big enough to reverse the spiral.

How does this process work?  It turns out that it is pretty straightforward, and occurs during every one of the sovereign financial crises we have seen in modern history.  When a sufficient level of doubt arises about sovereign credibility, all the major economic stakeholders in that country begin to change their behavior in ways that exacerbate the problem of credibility.

Of course as credibility is eroded, this further exacerbates the behavior of these stakeholders.  In that case bankruptcy comes, as Hemingway is reported to have said, at first slowly, and then all of a sudden, as the country moves slowly at first and then rapidly towards a breakdown in its debt capacity.

What is key to understanding the process is to see that stakeholders will behave for perfectly rational reasons in ways that politicians and moralists will decry as wholly irrational.  Rather however than respond to appeals that they stop behaving irrationally, stakeholders will continue making conditions worse by their behavior as they respond the distorted incentives created by the erosion of sovereign credibility.  To do otherwise would almost surely expose them to disaster.

To summarize what the self-destructive and automatic behavior of the stakeholders is likely to be, it is worth identifying some of the major stakeholders and to suggest how they typically react to a rise in the sovereign’s default risk:

1. Private creditors.  As Spain’s credibility deteriorates, private creditors will demand higher yields on their loans to Spain even as they change the form of their lending to reduce their own risk, for example by shortening maturities.  This has a double impact on making conditions worse.  First, higher interest rates mean that debt rises more quickly than it otherwise would.  Second, shorter maturities and other changes in the loan structure mean greater balance sheet fragility and a rising probability of default.
2. Official lenders.  As they are forced into providing liquidity facilities, official creditors typically demand and receive seniority.  This of course increases the riskiness for other lenders and creditors by pushing risk downwards, and so worsens balance sheet fragility and increases private sector reluctance to lend.
3. Depositors.  As the probability rises that Spain will leave the euro, and that bank deposits will be frozen and redenominated in the weaker currency before any abandonment of the euro is announced, depositors respond rationally by taking money out of the banking system.  As they do, banks are forced to contract lending, to increase balance sheet liquidity, and to reduce risk, all of which act as a drag on economic growth.
4. Workers.  Rising unemployment and the prospects for an unequal sharing of the burden of adjustment cause unions to become increasingly militant and to engage more often in various forms of industrial action, which, by raising uncertainty and costs for businesses, force them to cut output and employment.
5. Small and medium businesses.  One of the sectors most likely to be penalized in a debt crisis is the small and medium enterprise sector.  Owners of small and medium businesses know that they are vulnerable during a crisis to an expropriation of their wealth through taxes, price and wage controls, and other forms of indirect expropriation.  They try to forestall this by disinvesting, cutting back on expenses, and taking money out of the country.
6. Political leaders.  As time horizons shorten and politics becomes increasingly radicalized, policymakers shift their behavior in ways that reduce credibility further, increase business uncertainty, and raise national antagonisms.

It is important to recognize the almost wholly mechanical nature of credit deterioration once a country is caught in this kind of spiral.  Deteriorating creditworthiness forces stakeholders to adjust.  Their adjustment causes debt to rise and/or growth to slow, thus eroding creditworthiness further.

The combination of these and other actions by stakeholders, in other words, can’t help but reduce GDP growth, increase debt, and increase the fragility of the balance sheet, all of which of course undermines credibility further, so reinforcing the suboptimal behavior of stakeholders.  All of the exhortations by politicians, the church, public intellectuals, bankers, etc. – and there will be many – that stakeholders put personal self-interest aside and act in the best interests of the nation will be useless.  Slowing this behavior is not enough.  It must be reversed.

But how can it be reversed?  No one is big enough credibly to guarantee the creditworthiness of all the afflicted countries, and without a credible guarantee the downward spiral will occur, more or less quickly, until it is clearly unstoppable.

Only connect…

It is pretty clear that all of this is already happening in Spain and it is also pretty clear that every few months when the government announces the latest batch of economic and debt data, these numbers always turn out to be worse than expected and much worse than originally projected, which is, ironically, exactly what we should expect under the circumstances.  Here is an article from Saturday’s Financial Timesthat shows just how bad it is:

Nearly one Spaniard in four is unemployed, according to data released on Friday, as the country’s economic and financial predicament prompted a government minister to talk of a “crisis of enormous proportions”.  The data from the National Statistics Institute showed 367,000 people lost their jobs in the first three months of the year. That means more than 5.6m Spaniards or 24.4 per cent of the workforce are unemployed, close to a record high set in 1994.

The data, which follow a sovereign credit rating downgrade, prompted José Manuel García-Margallo, foreign minister, to say that they were “terrible for everyone and terrible for the government”.  He compared the European Union to the doomed liner Titanic, saying that passengers would be saved only if all worked together to find a solution.

It is interesting that Garcia-Magallo is openly discussing the possibility of the “passengers” not being saved.  Usually in the beginning of a sovereign debt crisis we spend an unfortunately long time in which policymakers insist that the market is overreacting to bad news and that the problem – inevitably a short-term problem driven largely by illiquidity – can be resolved with patience and hard work.  There is no discussion of contingency plans because the contingency is unimaginable.

At some point however it becomes possible at least to acknowledge formally that policymakers might be forced into the contingency.  Once this happens, the debate becomes much more intelligent and the resolution of the crisis is speeded up.  I have no idea if we have reached that stage in Spain, but in that light I found an articlelast month, by Ambrose Evans-Pritchard of the Telegraph, both very worrying and, at the same time, comforting.  In the article he says:

Articles calling for Spain to withdraw from EMU – or at least exploring the idea – are no longer rare. They are appearing every day.

…What is striking is the response on the comment threads of such pieces. My impression over the last month is that a large bloc of informed Spanish opinion has reached the conclusion that EMU is dysfunctional, and increasingly destructive for Spain. Many posters seem extremely well-informed, using terminology such as “debt-traps”, “internal devaluations”, and “relative unit labour costs”.

Many point the finger directly at Germany, correctly stating that Berlin seems to think it can lock in a current account surplus with Club Med in perpetuity. Clearly, such as an arrangement is mathematically impossible within a currency union – unless Germany is willing to offset the surplus with flows of money for ever, either through fiscal transfers or loans or investment. These flows have been cut off.

Opinion is divided, of course. The pro-euro camp is still a majority. But the smothering conformity of past years has been obliterated.

As recently as six months ago one didn’t discuss in polite company in Madrid the possibility that Spain would leave the euro and restructure its debt.  The prospect was unthinkable and like many unthinkable things it could not be discussed.

This made it very unlikely that anyone except the radical parties of the left or right would be able to control the discussion and of course this was likely to lead to a more disorderly resolution.  But now perhaps things have changed.  If responsible policymakers, advisors, the press, and public intellectuals are indeed discussing and debating the future of the euro now, I am pretty sure that a real and open debate about Spain’s prospects will quickly move the consensus towards abandoning the euro.

And that is why the article is comforting.  The historical precedents suggest that typically policymakers postpone the decision to reverse the monetary straightjacket for as long as they can, and in the process they erect barriers towards such a reversal in the name of shoring up credibility.  These barriers work by increasing the cost of a policy reversal, and the point of this is to improve credibility in investors’ eyes by increasing the cost of “misbehavior” by policymakers.

Mexico did this for example in 1994 when, in order to convince an increasingly skeptical investor base that the central bank would not devalue the peso against the dollar, the Ministry of Finance shifted its domestic borrowing from peso-denominated funding to dollar-denominated funding, which of course would increase the debt-servicing cost of a devaluation for the government.  Unfortunately, when policy is reversed anyway, as was the case in Mexico in 1994, the cost indeed ends up being much higher, and it takes longer for the economy to recover.  In that sense the sooner Spain prepares for an abandonment of the euro the less painful it will be.

But of course it won’t be painless.  Whenever an analyst predicts that Spain will soon leave the euro he is almost always countered by someone who earnestly explains that Spain cannot leave the euro because the process will be too painful.  In 1993-94 of curse we were told that this was why Mexico could not possibly devalue, and in 2000 and 2001 this was why Argentina could not possibly break the currency board. It would have been too painful to devalue.

But of course Mexico and Argentina both did devalue and, yes, it was a very painful experience but they did it because the alternative was worse.  And likewise while it is true that Spain cannot leave the euro without experiencing a very painful process, the point is not that anyone is arguing that Spain should willingly and irrationally choose to endure pain.  Spain will leave the euro because the alternative is worse.

Michael Pettis is a Senior Associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management, where he specializes in Chinese financial markets. He has taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business.  He is also Chief Strategist at Guosen Securities (HK), a Shenzhen-based investment bank.

Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups. He has also worked as a partner in a merchant banking boutique that specialized in securitizing Latin American assets and at Credit Suisse First Boston, where he headed the emerging markets trading team. Besides trading and capital markets, Pettis has been involved in sovereign advisory work, including for the Mexican government on the privatization of its banking system, the Republic of Macedonia on the restructuring of its international bank debt, and the South Korean Ministry of Finance on the restructuring of the country’s commercial bank debt.

Pettis has been a member of the Institute of Latin American Studies Advisory Board at Columbia University as well as the Dean’s Advisory Board at the School of Public and International Affairs. He received an MBA in Finance in 1984 and an MIA in Development Economics in 1981, both from Columbia University.

He can be contacted at michael@pettis.com.