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EU Flags the Risk of Debt Snowballs in Southern Europe – Irony or Tragedy?

As it seems that we are finally about to get something which resembles a stable summer here in Denmark it may seem strange to suddenly start talking about snowballs. Yet, the idea of debt snowball is very relevant in the current environment as it relates to the potentially unstoppable development in public/domestic debt levels despite a country’s best efforts in the form of austerity measures. Specifically, the combination of a year long loss of competitiveness, excessive domestic debt levels (private as well as public) and being caught up in a fixed currency union means that as austerity measures enforced to rein in debt levels also push the economy into deflation and growth, by virtue of the loss of competitiveness, remains absent the debt problems essentially worsens despite efforts to the contrary. Recently, I penned a paper on, in part, this very subject and the following passage sums up the main learning point;

Thus, Greece et al are effectively caught in a catch 22. Specifically, the need to simultaneously rein in fiscal stimulus in order to preserve long term debt sustainability as well as to correct an external deficit proves a decisively unattractive macroeconomic medicine which may not only prove difficult to administer, but also effectively impossible to pull through in the current Eurozone setup. The vice which then locks in uncompetitive economies in the Eurozone is twofold.

First, the deflation in prices and wages needed to restore external competitiveness and thus growth must be relative in excess of other economies’ correction. In this sense, Greece et al are fighting a moving target in the form of relative deflation compared to other member economies and indeed other global economies facing similar pressures to deleverage. In short, the battle for relative market share on export markets will increase in conjunction with the amount of economies pursuing a deliberate export oriented growth strategy. Second, deflation increases the real value of overall government debt thus requires even more in the way of austerity measures to keep the debt level sustainable. Moreover, and as a complicating factor, Greece, Spain, and Portugal are currently paying a large premium over the base rate (German Bunds) for lending money.

This may sound terribly complicated, but the argument is apparently not too complicated to make it into a recent EU draft report according to Bloomberg, which has obtained a copy of the report. Specifically, the report notes that while the measures already taken are the right way to go, they may not prove enough;

(quote Bloomberg)

Debt levels in Spain and Portugal may “snowball” in coming years and additional budget cuts are needed to meet deficit targets announced just a month ago, according to a draft European Commission document. The deficit-reduction measures announced by the two nations as part of a European Union agreement on May 10 to create a 750 billion-euro ($920 billion) financial backstop for indebted countries aren’t sufficient, the report obtained by Bloomberg News said. Spain pledged to cut the EU’s third-highest deficit to 9.3 percent of gross domestic product this year and to 6 percent in 2011. Portugal vowed to lower its shortfall to 7.3 percent of GDP in 2010 and to 4.6 percent in 2011.

“While the newly announced measures are significant and the targets imply impressive budgetary consolidation, more measures are needed to meet those targets, in particular for 2011,” according to the draft report, which is dated May 26. The document, titled “Consolidation Requirement in Spain and Portugal,” was prepared by the European Commission, the EU’s executive arm, for the region’s finance ministers.

Really, I think it is important that you appreciate the irony and tragedy in all this. Consequently, while the process of internal devaluation (which is really what the Eurozone periphery is embarking on) is the underlying cause of the potential debt snowball in Spain, Greece and Portugal, what the draft report is saying is essentially that this process should be speeded up. Now, in the internal logic of policy making in the EU it is important to understand that this is the only possible solution within the confines of the Eurozone where currency devaluation is impossible. However, in the specific context of avoiding a debt snowball, the discourse falls apart since the very suggestion made by the EU here will only exacerbate the snowball.

In other words; you cannot restore growth and rein in debt levels at the same time through an internal devaluation from within a setup such as the Eurozone. At some point there will be an inflection point and short of some form of Eurozone breakup it will come with a large bout of ongoing deflation in the Eurozone periphery which, I reckon, will end with a wide private and public sector default.So, I will give a C for realizing, while belatedly, the risk of a snowball in itself, but an F for the proposal.

However, the most important thing I think is this is in fact the only viable policy option the EU can propose to the South. Whether this is irony or tragedy, I will leave to you.

Claus Vistesen

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Claus Vistesen is a Danish economist who specialises in macroeconomics. His primary research interests include demographics, macroeconomics and international finance.