Europe’s Despair Alley

Keyword: 
Financial crisis
Topic: 
Financial Economics

The current situation in the euro zone is reminiscent of what several Latin American countries suffered during the mid 80’s and late 90’s.  The possible outcomes are rarely pretty and the policy choices during such times are almost never politically and socially acceptable.  Some European Union (EU) members seem to be walking towards the “Despair Alley”.  A country finds itself in this alley when it has problems in three areas: stocks, flows and populace tolerance. 

A stock problem arises when the debt size or leverage is unmanageable. For instance, the U.S. has a stock problem in the banking sector partly caused by low-rated mortgage debt but it does not have a sovereign debt stock issue, yet. The situation in Greece, Ireland and Italy are more worrisome. These countries suffer from a severe sovereign debt stock problem, measured in terms of their GDP or exports. Of course, if a country has only a stock problem the solution is relatively straightforward, at least from a theoretical standpoint – it only needs to restructure the debt. This either requires a default or some form of voluntary reduction in the burden of the debt and, of course, the word voluntary is used quite loosely here!

A flow problem arises when a country has a current account or fiscal deficit. The US has this problem--the fiscal deficit has remained very large and the forecast is that things are unlikely to change. It already has a current account deficit that has been running larger with every passing decade. Again, if a country has only a flow problem the solution is relatively “easy”. If the problem is that the fiscal deficit is too large, then the government needs to either increase taxes, or reduce expenditures, or both. If the problem is on the external accounts, a real depreciation can be engineered, accompanied by a reduction of domestic aggregate demand if necessary etc. 

In other words, a flow problem is reflected in the need to borrow while the stock problem occurs when such borrowing has already reach very high levels. Therefore, a prolonged flow problem leads to a stock issue. When a country suffers from both a flow and a stock problem, the solution becomes more cumbersome. In fact, what could solve one exacerbates the other. 

For example, to solve the problem of flows (current account deficit) the country needs a reduction in domestic aggregate demand, which usually increases the relative size of the debt making the stock problem bigger. Imagine, on the other hand, that the country tries to solve the stock concern by defaulting. After the default, the problem of the debt burden has been reduced, but how is the country going to be able to borrow to finance the flow issue? A default leads to an exclusion from financial markets that likely intensifies the cost of the flow problem. 

How can these problems be solved? There are three possible solutions. First, implement structural reforms to produce robust growth. If the economy grows, the fiscal and current accounts improve, and the debt shrinks in relative terms. In the end growth solves both problems at the same time. What is the challenge of this solution? Producing growth is not easy – especially growth that will be sustainable for a foreseeable period. Furthermore, structural reforms in general have a negative impact in the short run. Hence, solving the stock and flow problems with growth requires patience from market participants and citizens. 

Second, there is a relatively benign solution that we call the “Benevolent Bail-outer”. The idea is that a country restructures its debt to solve the stock problem – but because this leads in general to some exclusion from international financial markets, a benevolent institution finances the whole operation. So, even though the country implements a tight fiscal policy, the aggregate demand contraction is not too deep. The country is mostly presenting a “plan” on how to reduce the flow problem, and finances the medium run deficits internationally. For most Latin American countries the World Bank (WB) or the International Monetary Fund (IMF) played this role. Although some will never characterize the IMF as “benevolent”, the fact that it is willing to lend to a country when financial markets are closed indeed qualifies it as “benevolent”.

Third, if markets and citizens are impatient, then the solution implies isolationist policies. In fact, this alternative usually requires a plethora of policies all working in tandem. This is perhaps the most distortionary alternative. The country defaults on the debt to solve the stock problem; it goes through a massive exchange rate depreciation to solve the current account problem; usually suffers from inflation which reduces the real value of all liabilities (if they are denominated in domestic currency); and it finances the fiscal deficit internally through the banking sector causing some form of financial repression. The picture of this approach is not nice, but a short run solution can be delivered to citizens who have no tolerance to wait for growth to appear.

So the options are growth, isolation, or bailout. From these three, it is clear that growth is the best treatment and isolation is the worst.  This situations discussed already seem extraordinarily difficult to solve, but a country only suffering from these two issues i.e. stock and flow is not yet in the Despair Alley. 

The third dimension, the tolerance problem, negates the very few benign policy actions countries might adopt to solve the situation when flow and stock problems exists. A tolerance problem appears when citizens are exhausted of processes of reform (Latin America after the 90’s), exhausted of adjustment programs (the periphery countries in Europe), exhausted of bailout discussions (the Germans…). When the citizens are exhausted they become impatient and they demand short run benefits. Implementing a structural reform to wait until growth appears is unacceptable; bailout discussions are out of the question. In the end, countries are trapped into a corner and their only solution is isolation.

Europe is heading there. The only question is how the depreciation is going to take place – either a complete dismemberment of the Euro, or a partial one. The only benevolent and patient bail-outer seems to be the ECB, and they do not look easygoing or willing. 

The situation in Europe has turned to the worse. In December 2011 Spain elects a new direction. Full of enthusiasm! And that lasted until April? If the honeymoon is only 5 months, it is difficult to envision growth – that requires years and sometimes even decades – is going to be even considered as a possibility.

 
 
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