The EU, the world’s largest economy, is presently a source of great instability to itself and to the world economy. The policy framework put in place through the EU/IMF adjustment programmes is, in my view, inconsistent and dangerous.
Diagnosis: Nature of the crisis
Europe’s sovereign debt crisis is really a balance-of-payments and external debt crisis (Sinn 2011, Cabral 2011). While the EU as a whole does not have external imbalances to speak of, the external imbalances of numerous individual member countries have reached levels which are unprecedented in previous balance-of-payments and external debt crises. In fact, Table 1 and Figures 1 and 2 suggest that potentially 12 member countries may have excessive net external liabilities.
Table 1. Net external debt/ liabilities for 12 peripheral countries seem higher than levels considered sustainable (of up to about 40% of GDP)
Source: National Central Banks/National Statistical Offices IMF SDDS program. Data for 4Q2010, except * 3Q2010 and ** 4Q2009. Net external debt data excludes FDI debt claims. Net external liabilities is the symmetric of the International Investment Position. Ireland: non-IFSC data only. Luxembourg: Includes financial center data. See Cabral (2010) for methodology.
Figure 1. Peripheral countries with relatively high trade and income balance deficits, but trade deficits have improved
Figure 2. Peripheral countries’ total and public sector net borrowing requirements
Many experts would argue that a country could afford to pay and sustain a level of gross external debt of up to about 40% of GDP (Reinhart et al. 2003, Manasse and Roubini 2009). Several EU member countries have levels of net (rather than gross) external debt more than twice that, much higher than historical precedents (Cabral 2010). Their external debt is on an unsustainable trajectory. Past precedents indicate that these countries’ external debt will inevitably be restructured.
The EU/IMF policy response to the crisis
In recent years, the EU and the IMF have put in place adjustment programs in 6 member countries.1 Hungary, Latvia, Romania, Greece, Ireland, and Portugal have high net external debt and, with the exception of Ireland, have or had high trade deficits. Hungary, Greece, Ireland, and Portugal also have high income-balance deficits. These arise mainly, but not only, from large interest and dividend payments on the outstanding stock of external liabilities.
A country’s public plus private net borrowing requirements are approximately equal to the sum of the trade and the income-balance deficits, plus two other smaller components. Since the intervened countries have high trade and income-balance deficits, they also have high net borrowing requirements (Ireland is again the exception).2
The EU/IMF’s focus is on measures to reduce and bring budget deficits into compliance with the Stability and Growth Pact targets. However, this is in my opinion misguided and counterproductive. To understand why, note that this formula which determines a country’s (public plus private) net borrowing requirements is an accounting identity; it is the closest thing in macroeconomics to 1+3=2+2. The EU/IMF adjustment programmes do not sufficiently target reductions in the trade and the income-balance deficits (the two largest components of the affected countries’ net borrowing requirements). Therefore, it is hard to see how it is possible to lower public sector net borrowing requirements in a sustainable manner. In such a context, budget reduction measures are unlikely to succeed.
For example, Portugal’s trade deficit in 2010 was 6.5% of GDP. Its income-balance deficit was 4.6% of GDP. Much because of these two large deficits, Portugal’s net borrowing requirements (public plus private) were approximately 8.5% of GDP. To achieve a sustainable reduction in the budget deficit, the EU/IMF adjustment programme should have targeted a reduction in the trade deficit. If done well, such a reduction would have had a marginal impact in Portugal’s economic activity (just about corresponding to the reduction in the trade deficit). In addition, the adjustment program should have targeted a reduction in the income-balance deficit through a realistic debt restructuring.
Instead, the EU/IMF adjustment programme affects the entire internal demand indiscriminately (106.5% of GDP). It is, in effect, like using a sledge-hammer to crack a nut. Only by chance or accident, or through drastic reduction of economic activity, will the adjustment programme be able to reduce the trade deficit by anything close to 6.5% of GDP and thus achieve, as necessary, a sufficiently large reduction in the country’s net borrowing requirements. Moreover, given the sheer number of measures foreseen in the adjustment programme, the likelihood for policy mistakes is very high.
In addition, the EU/IMF adjustment programmes pay insufficient attention to the income-balance deficit. Average interest rates on the peripheral countries’ external debt may rise, rather than fall.3 Therefore, the income-balance deficits of these countries may increase, putting upward pressure on net borrowing requirements and thus on the budget deficit.
In practice, the EU/IMF adjustment programmes are not likely to result in a substantial reduction in net borrowing requirements, but instead in a change in their composition. Public sector net borrowing requirements may fall in the short run, but private sector net borrowing requirements will likely increase. Since the private sector is unable to increase borrowing in the current context4, the adjustment programmes will simply result in an unprecedented and pointless destruction of private sector activity. These businesses’ failures will also reduce tax revenue, exacerbating the situation while causing unnecessary and self-defeating hardship upon the populations of these countries. This is, by the way, what we have seen in Greece and Ireland. It is what we are about to see in Portugal.
Moreover, the EU/IMF adjustment programmes, by refusing to consider the option of significant debt restructuring, allow no adjustment through the income balance. Therefore, in practice, the only “safety valve” through which the affected countries can sustainably reduce their public deficit is through massive improvements in the trade balance. This is tantamount to promoting beggar-thy-neighbour policies. By definition, not all countries can run a trade surplus. The current attempt to do so by a growing number of EU member countries is likely to throw most of the EU into recession.
A possible alternative to reduce budget deficits in the peripheral countries
The EU faces a situation where less is actually more. Implementing smaller, more targeted adjustment programs and treading more carefully is likely to yield far better results than drastic action.
The aim of the adjustment effort should be to stabilise the peripheral countries’ external debt levels by reducing these countries’ (private plus public) net borrowing requirements.
I believe the external adjustment effort for the peripheral countries should be designed to minimise the impact on domestic economic activity as well as on the economies of these countries’ trading partners in the EU and elsewhere. External adjustment by so many countries on the geographic periphery of the EU is, nonetheless, bound to have a substantial macroeconomic impact at the EU level, and to affect the peripheral countries’ economies harshly.
In Portugal’s case, for example, the external adjustment that is currently necessary to stabilise its external debt levels may be around 8% of Portugal’s 2010 GDP. A combined reduction in the trade and in the income-balance deficits of that magnitude would, all other things equal, reduce Portugal’s net borrowing requirements to approximately 0% of GDP5. Under these conditions, Portugal would be able to reduce its external debt burden slowly through nominal economic growth. A budget deficit reduction policy would then be far more effective. Moreover, the Portuguese government would be able to fund a far greater proportion of its budget deficit domestically.
About half of the adjustment suggested above should be done through improvements in the trade deficit (through fiscal devaluation policy), with the remainder accomplished through improvements in the income-balance deficit (through a debt restructuring).
Fiscal devaluation policy aims at replicating, through the rebalancing of a country’s tax structure, the effect of currency devaluation. In contrast to earlier proposals, the proposal I make (Cabral 2011) argues for a far greater rebalancing of the existing tax structure, and argues that VAT rates should be reduced, not increased. The idea is that, since tax and social security receipts represent, on average, around 40% of GDP in Eurozone economies, then they represent, on average, the largest cost factor of every single economic activity.
On the demand side, the aim would be to rebalance taxes to increase the price of imports and to reduce the price of domestic products. On the supply side, the aim would be to lower the tax costs of firms in tradable goods and services sectors, and to increase the tax costs of firms in sectors of the economy that do not face international competition.
This is accomplished through changes in tax rates, rather than through changes in the tax structure. This means that the policy measures could be put in place quickly and would yield results in the short run.
The aim of the debt restructuring would be to lower income-balance deficits to more sustainable levels. It could be based mainly on maturity extension and interest rate (coupon) reductions. However, it should be sufficiently large to ensure that the peripheral countries would be able, on their own, to return to the international credit markets, even if subject to much higher interest rates on any new loans. In addition, a US-type bank resolution process (Special Resolution Regime) should be rapidly legislated and implemented (Nguyen and Praet 2010; Strauss-Kahn 2010; Cabral 2010).
The current policy response to the crisis is misguided and dangerous. The EU/IMF adjustment programs are bound to fail to achieve sustainable budget deficit reductions. In the process, they will result in an unprecedented and pointless destruction of private sector economic activity. This will result in unnecessary and self-defeating hardship.
The peripheral countries, in practice, can only reduce their budget deficits if they are able to significantly improve their trade and income balances, and as a result, improve their economies’ net borrowing requirements. Therefore, the EU policy response to the crisis should explicitly target improvements to these balances.
It should focus on the small share of internal demand associated to the trade deficits, rather than to seek radical changes to the country’s entire public and private economic structure. It should also seek to address these countries’ high external debt directly, through debt restructuring designed to reduce the income-balance deficit.
Such an approach is far more likely to succeed by directly addressing what is, in my opinion, the main cause of Europe’s sovereign debt crisis.
Editor’s Note: This column is an adapted version of a prepared written testimony presented at the Public Hearing on “Economic Governance and Crisis Management in the EU”, October 17, 2011 in Brussels, before the Economic and Monetary Affairs Committee of the European Parliament.
Cabral, Ricardo (2010) “The PIGS’ external debt problem”, VoxEU.org, May 8.
Cabral, Ricardo (2011) “The troika should target the trade and the income balance deficits”, VoxEU.org, May 15.
Manasse, Paolo and Nouriel Roubini (2009), “`Rules of thumb´ for sovereign debt crises”, Journal of International Economics, 78:192-205.
Nguyen, Gregory and Peter Praet (2010), “Which banking resolution authority for Europe?”, VoxEU.org, 16 April.
Reinhart, Carmen, Kenneth Rogoff, and Miguel Savastano (2003), "Debt Intolerance”, Brookings Papers on Economic Activity, 1:1-74.
Sinn, Hans-Werner (2011), “How to rescue the euro: Ten commandments”, VoxEU.org, 3 October.
Strauss-Kahn, Dominique (2010), “Crisis Management Arrangements for a European Banking System: Building a Crisis Management Framework for the Single Market”, Keynote speech, European Commission conference on Cross-Border Crisis Management, Brussels, 19 March.
1 Though not yet an EU member country, Iceland has also requested a stand-by arrangement ($2.1 billion loan) from the IMF.
2 Ireland’s net borrowing requirements and budget deficit are lower in part because Ireland benefits from a large subsidy through Eurosystem liquidity providing operations. I have estimated that the Eurosystem loans resulted in improvements in Ireland’s net borrowing requirements of about 4.3% of GDP (Cabral 2011). Thus, the Irish government budget deficit is probably significantly lower than it would have been otherwise. Moreover, the impact on the IMF/EU adjustment program on the Irish economy is thereby likely softened. Greece and Portugal also benefit from Eurosystem provided liquidity at low interest rates, but in much smaller proportion of GDP.
3 The initially agreed interest rates on the EFSF loan was around 5.8%, which was much higher than the average interest rate these countries paid on maturing sovereign debt (Portugal: 3.5% in 2010; Greece: 4.4% in 2009). This issue has been to some extent addressed by the July 21st, 2011 European Council decision that lowered interest rate on EFSF loans to approximately 3.5%. However, the EU/IMF loans only cover a fraction of these countries external borrowing requirements. Some of the borrowing is done through the Eurosystem liquidity providing operations at much lower rates. But the remainder is financed at increasingly higher interest rates in the market. Therefore, it seems likely that the average interest rate on these countries external debt will rise.
4 Among other reasons, because the EU/IMF adjustment programs mandate the deleveraging of the peripheral countries’ banking system.
5 This is an approximation. Net borrowing requirements were 8.5% of GDP in 2010. However, the trade deficit has since fallen in part through robust export growth, reducing the country’s net borrowing requirements somewhat.