29 January 2012

Wolfgang Münchau: Fiscal treaty could trigger a debt explosion

The best thing that one could say about the treaty is that it is not necessary. Everything we are likely to see in the final version is either in existing treaties or in legislation, notably the so-called “six-pack”, a set of policy surveillance measures passed earlier this year. The rest could easily be introduced through new secondary legislation.

While I have yet to meet anybody who can explain what good the treaty will do – except as part of some circular logic – the damage it will do is more evident. Just think of the entirely unnecessary fight with David Cameron, UK prime minister. But the British problem pales in comparison with the treaty’s truly destructive powers. It will encourage eurozone Member States to adopt extremely pro-cyclical policies.

This is already happening in Spain. Until last week, the government said it would not keep piling one austerity measure on top of another to meet the agreed deficit targets. That seemed a sensible policy. Spain’s economy is shrinking at a faster rate than forecast for reasons outside the country’s control. Under these circumstances, it would be sensible to let the automatic stabilisers work. That is what the eurozone Member States did in 2009. It ensured that the recession, while very deep, was at least not excessively long.

Richard Koo, chief economist at the Nomura Research Institute, recently took a look at the impact of the deleveraging in the US, the UK and the eurozone[1]. Spain is experiencing an extreme version of what he calls a “balance sheet recession”, on a much greater scale than the US or the UK. Since the third quarter of 2007, the Spanish private sector has reduced its debts by 17.2 per cent as a ratio of GDP, while the public sector partially compensated the private sector’s deleveraging with an increase in debt of 11.8 per cent of GDP. The difference came in the form of a positive contribution from the external sector – in other words, from a fall in the current account deficit.

Mr Koo makes the point that – as in Japan during the 1990s – it is essential that European governments support the economy during a phase of private-sector deleveraging to avoid what would otherwise lead to a deep depression.

So if Spain were to follow the example of Greece, and ignore what happened in Japan, the most likely result would be a severe and prolonged recession. To me, that is a much larger threat to the eurozone than any of the various crisis offshoots that excite us momentarily. In the big scheme of things, it really does not matter whether Greek bondholders agree on a voluntary participation. If Spain were to fall down a black hole, no rescue fund, however large, would be able to drag it out.

The irony is that a fiscal treaty that set out to reduce the eurozone’s debt could be the cause of a debt explosion, because it greatly increases the risks of a semi-permanent slump in large parts of southern Europe. If that were to happen, nothing could save the eurozone.

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[1] ‘The world in balance sheet recession: causes, cure, and politics’

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