Tuesday, 2 July 2013

Eurozone periphery: one deficit that counts. And the coalition of the unwilling

A popular view these days is that Eurozone's peripheral countries will not consider leaving the Euro as long as they run a public primary deficit (deficit before interest payments). Leaving the Euro would force them to adjust their public finances even faster than staying in the Euro as they would be suddenly cut off from international financial markets and unable to finance the public deficit. It would be austerity at the power of 2. As soon as the primary public deficit is eliminated, however, leaving the Euro will become a serious option. No additional adjustment in public spending would be needed and the devaluation of the new local currency relative to the Euro would quickly improve external competitiveness allowing for a speedier economic recovery.

As popular as it might be, the focus on the public (primary) deficit is misplaced. Analysts are looking at the wrong deficit. The deficit that counts is not the public one. It is the external one: the current account deficit.

This is why:

1. If a country decides to leave the Euro and re-introduce its local currency, it will be easily able to finance its public deficit. Not matter how large it is. The central bank can buy as much government issued debt as needed to finance the deficit. It's classic public deficit monetisation at work.

2. What the central bank cannot do is to finance the country's external deficit. For that to happen it would have to be able to issue foreign currency (Euro or USD) to pay for the "excess imports" of goods and services - something it cannot do. This means that leaving the Euro while running a current account deficit would force the country to immediately cut down its level of imports. Given that many of the imports are of an essential nature (energy, pharmaceutical products, chemicals, equipment) the pain would be felt straight away. Capital controls would have to be imposed to ensure that essential imports could be financed. The currency would devalue (25%-40% depending on the country). And while the currency devaluation would restore external competitiveness it would take time for its effects to be fully felt (18 to 24 months).

Meaning: leaving the Euro while running a current account deficit would lead to an immediate increase in social discontentment and unrest. Hardly an attractive perspective for any national government considering leaving the Eurozone.

To assess the likelihood of a country leaving the Euro, the relevant question than is: where do the EU's peripheral countries currently stand in terms of current account deficit?

And the answer is: in 2014 all of them are expected (IMF data) to achieve a current account surplus. Ranging from 0%-1% (Greece, Portugal), 1%-2% (Spain) to around 4% (Ireland).

Given that

a) all of them will still be running public deficits in 2014 ranging from 4% (Greece) to 6.5% (Spain)

b) Greece, Portugal and Spain will have to reform their political-administrative apparatus (call it bureaucracies) - including cutting pensions of retired former members of the apparatus - to bring the public deficits sustainably down, reform their tax system and attract foreign direct investment

c) there will be a lot of resistance from the political-administrative apparatus' insiders to reform

the outcome can only be one: a public campaign led by the bureaucracy insiders (countries' local and regional politicians, public servants, organisations with close ties to the public sector) to exit the Euro will gain momentum over the next 18-24 months in Greece, Portugal and Spain. The insiders know that leaving the Euro and monetising the public deficit will enable them to keep the status quo. The fact that the countries are running a current account surplus will further allow them to avoid the disruptions caused by leaving the Euro while running a current account deficit. And thus sell the whole strategy as a way to increase the countries external competitiveness and enable a faster economic recovery to take place.

More remarkable is that they are likely to be joined on their "Euro exit campaign" by the at first sight most unlikely of allies: major shareholders and top management of the countries' financial institutions. Following the EU agreement last Thursday on bank bail-ins, future recapitalisations will be done by wiping out shareholders and debt-to-equity swaps of unsecured debt. Major shareholders of the banks won't be pleased with the new regime. Neither will be their top management as some of it will be replaced once the banks' shareholder structure changes following the bail-ins. Banks' shareholders and top management might not have realised what the new bail-in regime actually means for them. But soon they will.

Once they do, it will become obvious for them that the way to avoid suffering the consequences of the unavoidable bank recapitalisations via bail-ins is for their country to leave the Euro (before 2018, when the bail-in regime becomes mandatory for the whole EU). This will allow the national government to bail banks out with the funds raised by issuing public debt monetised by the central bank.

Public bureaucracy insiders and bankers side by side campaigning for an Euro exit.....what a prospect! Call it the "coalition of the unwilling" (unwilling to bear their share of the costs of structural reform). Like it or not, if you live in Portugal, Spain or Greece you will start very soon to hear from them regularly in the news.

Will the "coalition of the unwilling" succeed in their "Euro exit" attempt? Two powerful barriers will stand in its way:

1. The symbolic value of the Euro for most of the population. People in Southern Europe tend to view the Euro more as a symbol of cultural identity than a currency. Being part of the Euro means being part of modern Europe. This perception will be very difficult to change.

2. Slowly but surely, people in Southern Europe tend to look at the Euro as a protection mechanism against the national/regional public-administrative apparatus. Leaving the Euro would mean giving back the printing press to the apparatus. With all the consequences for discretionary spending and lack of accountability seen in the past. Not a cheerful prospect for most of the population.

Can the "coalition of the unwilling" win nevertheless? As much public visibility and access to the media as it might have, the only plausible way for it to win is by hijacking the "Euro exit" decision process: forming a majority in parliament and take the decision to leave the Euro without consulting the population via a referendum.

Likely to happen? I doubt it. The discontentment with the political system among the population after almost six years of crisis, and uncover of several cases of public funds mismanagement and corruption, is too widespread for the system insiders to get away with it.  Which means that the Euro will prove to be the most powerful instrument for structural reform that Southern Europe has seen for at least 40 years. Call it "institutional Thatcherism" (I know, Mrs. Thatcher wasn't an Euro fan. Then again, who cares?).

All very bad news for the insiders? Yes. But great news for the peripheral countries' younger generations. They will be the main beneficiaries of structural change.

Cheer up, boys and girls of Southern Europe! Your time has come.


  1. Currency devaluation only restores trade competitiveness when it reduces domestic real incomes. Which takes your simplistic analysis back to square one.

  2. 1. In the 30 years preceding the introduction of the Euro, there have been many currency devaluations in Southern Europe. Show me one where the resulting inflation was not lower than the percentage currency devaluation (meaning: where production costs - and income - measured in foreign currency did not fell)

    2. What has restoring competitiveness via exchange rate devaluation to do with my argument that a "coalition of the unwilling" (to carry out economic reforms and stay in the Euro) is likely to form as the peripheral countries eliminate their current account deficits?

  3. I don't think the turkeys will vote for Christmas.

    Although the well-off in Greece, Portugal etc have been transferring liquid assets to the German Euro, they are holders of Greek assets - property, businesses etc. Even if leaving the Euro were to improve Greece's competitiveness, and the New Drachma incomes of those businesses, the asset-holders will not willingly accept the reduction in value of a lower exchange rate. By staying in the Euro they get higher asset values, but lower revenues, and a slower economy.

    That is the choice that every country has so far made.

    Secondly, devaluations - and by implication Euro exit - typically occur when the external lenders stop lending. It's similar to a company going bust - when the lenders pull their lines, the show goes off the road. Until that point the borrowers continue borrowing - until they are unable to continue. Which is what we see with Greece et al - so as long as the other European creditors are prepared to lend, Greece will continue to borrow and stay in the Euro.

    So I think your view that the absence of an external deficit creates the conditions for exit, ignores what actually drives the exit. Yes it would be easier if there wasn't a deficit - but they don't want to exit.

    Since the Germans have taken the view that any country leaving the Euro would be a disaster for the Euro, expect to see the problem countries staying in the Euro - until the Germans change their minds. And that implies that there will be more write-offs of Greek debt after the German elections. And if the numbers still don't add up, expect more debt write-offs.

    This is how German re-unification proceeded - East German assets were converted one-to-one with West German; East Germany was uncompetitive but West Germany picked up the tab - and whilst the German taxpayer didn't enjoy the experience, would they do it differently now?

    1. I don't think that Greece & Co will exit. I just think that some local forces will lobby for an exit. Namely all those that will be hit by reforms: bureaucracy insiders (at risk of losing their jobs or at least some privileges) and bank shareholders, who will be wiped out in case of a debt restructuring and bank recap via debt-to-equity swaps. Plus banks' top management, part or the entirety of which will be substituted in case of bail-ins.