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Europe faces vicious circle that can lead to economic stagnation
By Nouriel Roubini |
March 17, 2010, Wednesday
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Print Edition
Print Edition
THE Great Recession of 2008-2009 was triggered by excessive debt accumulation and leverage on the part of households, financial institutions, and even the corporate sector in many advanced economies.
While there is much talk about de-leveraging as the crisis wanes, the reality is that private-sector debt ratios have stabilized at very high levels. By contrast, as a consequence of fiscal stimulus and socialization of part of the private sector's losses, there is a massive re-leveraging of the public sector.
Deficits in excess of 10 percent of GDP can be found in many advanced economies, and debt-to-GDP ratios are expected to rise sharply - in some cases doubling in the next few years. As Carmen Reinhart and Ken Rogoff's new book "This Time is Different" demonstrates, such balance-sheet crises have historically led to economic recoveries that are slow, anemic, and below-trend for many years.
Sovereign-debt problems are another strong possibility, given the massive re-leveraging of the public sector. In countries that cannot issue debt in their own currency (traditionally emerging-market economies), or that issue debt in their own currency but cannot independently print money (as in the euro zone), unsustainable fiscal deficits often lead to a credit crisis, a sovereign default, or other coercive form of public-debt restructuring.
Iceberg's tip
In countries that borrow in their own currency and can monetize the public debt, a sovereign debt crisis is unlikely, but monetization of fiscal deficits can eventually lead to high inflation. And inflation is - like default - a capital levy on holders of public debt, as it reduces the real value of nominal liabilities at fixed interest rates.
Thus, the recent problems faced by Greece are only the tip of a sovereign-debt iceberg in many advanced economies (and a smaller number of emerging markets).
Bond-market vigilantes already have taken aim at Greece, Spain, Portugal, the United Kingdom, Ireland, and Iceland, pushing government bond yields higher. Eventually they may take aim at other countries - even Japan and the United States - where fiscal policy is on an unsustainable path.
In most advanced economies, aging populations - a serious problem in Europe and Japan - exacerbate the problem of fiscal sustainability, as falling population levels increase the burden of unfunded public-sector liabilities, particularly social-security and health-care systems.
Low or negative population growth also implies lower potential economic growth and therefore worse debt-to-GDP dynamics and increasingly grave doubts about the sustainability of public-sector debt. The dilemma is that, whereas fiscal consolidation is necessary to prevent an unsustainable increase in the spread on sovereign bonds, the short-run effects of raising taxes and cutting government spending tend to be contractionary.
This, too, complicates the public-debt dynamics and impedes the restoration of public-debt sustainability. Indeed, this was the trap faced by Argentina in 1998-2001, when needed fiscal contraction exacerbated recession and eventually led to default.
Painful reforms
In countries like the euro-zone members, a loss of external competitiveness, caused by tight monetary policy and a strong currency, erosion of long-term comparative advantage relative to emerging markets, and wage growth in excess of productivity growth, impose further constraints on the resumption of growth.
If growth does not recover, the fiscal problems will worsen while making it more politically difficult to enact the painful reforms needed to restore competitiveness. A vicious circle of public-finance deficits, current-account gaps, worsening external-debt dynamics, and stagnating growth can then set in.
Eventually, this can lead to default on euro-zone members' public and foreign debt, as well as exit from the monetary union by fragile economies unable to adjust and reform fast enough.
(The author is professor of economics at the Stern School of Business, New York University. The views are his own. Copyright: Project Syndicate, 2010.www.project-syndicate.org)
While there is much talk about de-leveraging as the crisis wanes, the reality is that private-sector debt ratios have stabilized at very high levels. By contrast, as a consequence of fiscal stimulus and socialization of part of the private sector's losses, there is a massive re-leveraging of the public sector.
Deficits in excess of 10 percent of GDP can be found in many advanced economies, and debt-to-GDP ratios are expected to rise sharply - in some cases doubling in the next few years. As Carmen Reinhart and Ken Rogoff's new book "This Time is Different" demonstrates, such balance-sheet crises have historically led to economic recoveries that are slow, anemic, and below-trend for many years.
Sovereign-debt problems are another strong possibility, given the massive re-leveraging of the public sector. In countries that cannot issue debt in their own currency (traditionally emerging-market economies), or that issue debt in their own currency but cannot independently print money (as in the euro zone), unsustainable fiscal deficits often lead to a credit crisis, a sovereign default, or other coercive form of public-debt restructuring.
Iceberg's tip
In countries that borrow in their own currency and can monetize the public debt, a sovereign debt crisis is unlikely, but monetization of fiscal deficits can eventually lead to high inflation. And inflation is - like default - a capital levy on holders of public debt, as it reduces the real value of nominal liabilities at fixed interest rates.
Thus, the recent problems faced by Greece are only the tip of a sovereign-debt iceberg in many advanced economies (and a smaller number of emerging markets).
Bond-market vigilantes already have taken aim at Greece, Spain, Portugal, the United Kingdom, Ireland, and Iceland, pushing government bond yields higher. Eventually they may take aim at other countries - even Japan and the United States - where fiscal policy is on an unsustainable path.
In most advanced economies, aging populations - a serious problem in Europe and Japan - exacerbate the problem of fiscal sustainability, as falling population levels increase the burden of unfunded public-sector liabilities, particularly social-security and health-care systems.
Low or negative population growth also implies lower potential economic growth and therefore worse debt-to-GDP dynamics and increasingly grave doubts about the sustainability of public-sector debt. The dilemma is that, whereas fiscal consolidation is necessary to prevent an unsustainable increase in the spread on sovereign bonds, the short-run effects of raising taxes and cutting government spending tend to be contractionary.
This, too, complicates the public-debt dynamics and impedes the restoration of public-debt sustainability. Indeed, this was the trap faced by Argentina in 1998-2001, when needed fiscal contraction exacerbated recession and eventually led to default.
Painful reforms
In countries like the euro-zone members, a loss of external competitiveness, caused by tight monetary policy and a strong currency, erosion of long-term comparative advantage relative to emerging markets, and wage growth in excess of productivity growth, impose further constraints on the resumption of growth.
If growth does not recover, the fiscal problems will worsen while making it more politically difficult to enact the painful reforms needed to restore competitiveness. A vicious circle of public-finance deficits, current-account gaps, worsening external-debt dynamics, and stagnating growth can then set in.
Eventually, this can lead to default on euro-zone members' public and foreign debt, as well as exit from the monetary union by fragile economies unable to adjust and reform fast enough.
(The author is professor of economics at the Stern School of Business, New York University. The views are his own. Copyright: Project Syndicate, 2010.www.project-syndicate.org)
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