I was on BNN’s News of the Day panel with The Globe & Mail’s Brian Milner and presenter Paul Waldie on Monday. We were talking about Spain and the euro crisis. As much as I would like to talk about something else, Europe is sucking up the headlines with its continuing sovereign debt crisis. The video is below, but let me say a few words on the crisis here first.
Marshall did a good job of putting the macro picture into perspective with his post warning that Spain is the new Greece. What he means is that Europe’s policy response to the sovereign debt crisis is a textbook trigger for debt deflation. The global recession in 2008-2009 made private debt in Europe and the US a problem. High levels of private debt have forced a deleveraging in many European countries, weakening public sector receipts. Euro governments’ lack of fiscal space as currency users has meant public cuts. This austerity must meet the private sector’s desire to increase net savings and be resolved one way or another. Because defaults loom in the private sector, deleveraging will continue and austerity invariably induces an additional reduction of private demand. And so austerity ends with more private sector defaults, higher unemployment and a potential for boomerang onto asset prices. That’s what we have seen in Greece and are now seeing in Spain and other peripheral nations. And that’s how austerity works in a fixed currency system.
In New York Times articles over the past six months I have warned how destructive this economic policy path was. In October, I indicated that Europe was already likely in a recession. This has since proved true. I also wrote that the upshot of the recession, due to the potential debt deflation dynamics I outlined above, was concern for Europe’s undercapitalised banking sector as the debt crisis continued. Indeed, just a month later Spain and Italy had re-coupled to the periphery and Europe was in an existential crisis. I said at the time that unless the ECB intervened in some way that this could be the end of the euro. Fortunately, the ECB did find a way to intervene and the problems in Italy and Spain died down. However, the crisis resurfaced in Portugal and has now come back to Spain. And while it encourages me to see Portugal fade from the headlines instead of becoming the next Greece, it discourages me to see Spain take Portugal’s place as the next Greece.
All the while, the root problem has been the same: the common currency without ECB support for sovereign debt has meant that European governments lack the fiscal space afforded by sovereign currencies to run countercyclical fiscal that partially offsets the private sector deleveraging. Instead European economic policy must be pro-cyclical in order to meet a deficit target even during a deep downturn. Given the balance sheet recession in countries like Spain, the situation in Europe cannot improve without significant private sector defaults and writedowns of debts at European banks. Output, employment and property prices must then go lower. And that necessarily puts Spanish banks – and the potential for sovereign contingent liabilities – into view.
The situation with the euro is completely unworkable. Despite best efforts to cut deficits, we are seeing now that individual European economies are actually getting worse, not better.
European policy makers are shifting their policy stances, though. And while the shift is slow, I am hopeful Europe will eventually get things right before debt deflation really takes hold. But there is the liquidity crisis and then there are the solvency issues that are inherent in the euro’s design. Are European leaders ever going to solve this fundamental flaw? I certainly hope so. But we have a long way to go politically before we get there. In the meantime, expect more negative headlines from Europe.
Video with more specifics on Spain below
I will be on RT’s Capital Account with Lauren Lyster today talking about many of the same issues. Tune in. First broadcast is at 4:30 PM EDT.