Can Europe Be Saved?
Time is running out to rescue the economies of Portugal, Ireland, Italy, Greece, and Spain.
Posted Monday, May 16, 2011, at 4:12 PM
The countries known collectively as the PIIGS—Portugal, Ireland, Italy, Greece, and Spain—are burdened with increasingly unsustainable levels of public and private debt. Portugal, Ireland, and Greece have seen their borrowing costs soar to record highs in recent weeks, even after their loss of market access led to bailouts financed by the European Union and the International Monetary Fund. Spanish borrowing costs are also rising.
Greece is clearly insolvent. Even with a draconian austerity package, totaling 10 percent of gross domestic product, its public debt would rise to 160 percent of GDP. Portugal, where growth has been stagnant for a decade, is experiencing a slow-motion fiscal train wreck that will lead to public-sector insolvency. In Ireland and Spain, transferring the banking system's huge losses to the government's balance sheet—on top of already-escalating public debt—will eventually lead to sovereign insolvency.
The official approach, Plan A, has been to pretend that these economies are suffering from a liquidity crunch, not a solvency problem. The hope is that bailout loans, with fiscal austerity and structural reforms, can restore debt sustainability and market access. But this "extend and pretend" or "lend and pray" approach is bound to fail, because most of the options that indebted countries have used in the past to extricate themselves from excessive debt are not feasible.
For example, the time-honored solution of printing money and escaping debt via inflation is unavailable to the PIIGS, because they are trapped in the eurozone straitjacket. The only institution that can crank up the printing press is the European Central Bank, and it will never resort to monetization of fiscal deficits.
Nor can we expect rapid GDP growth to save these countries. The PIIGS' debt burden is so high that robust economic performance is next to impossible. Moreover, whatever economic growth some of these countries might eventually register is contingent on enacting politically unpopular reforms that will work only in the long run—and at the cost of even more short-term pain.
To restore growth, these countries must also regain competitiveness by achieving a real depreciation of their currency, thus turning trade deficits into surpluses. But a rising euro, pushed higher by excessively early monetary tightening by the ECB, implies more real appreciation, further undermining competitiveness. The German solution to this conundrum—keeping wage growth below that of productivity, thereby reducing unit labor costs—took more than a decade to yield results. If the PIIGS started that process today, the benefits would be too long in coming to restore competitiveness and growth.
The last option—deflation of wages and prices to reduce costs, achieve a real depreciation, and restore competitiveness—is associated with ever-deepening recession. The real depreciation necessary to restore external balance would drive the real value of euro debts even higher, making them even more unsustainable.
Lowering private and public consumption in order to boost private savings, and implementing fiscal austerity to reduce private and public debts, aren't options, either. The private sector can spend less and save more, but this would entail an immediate cost known as Keynes' paradox of thrift: declining economic output and rising debt as a share of GDP. Recent studies by the IMF and others suggest that raising taxes, cutting subsidies, and reducing government spending—even inefficient spending—would stifle growth in the short term, exacerbating the underlying debt problem.
If the PIIGS can't inflate, grow, devalue, or save their way out of their problems, Plan A is either already failing or bound to fail. The only alternative is to shift quickly to Plan B: an orderly restructuring and reduction of the debts of these countries' governments, households, and banks.
This can happen in a number of ways. One can carry out an orderly rescheduling of the PIIGS' public debts without actually reducing the principal amount owed. This means extending the maturity dates of debts and reducing the interest rate on the new debt to levels much lower than currently unsustainable market rates. This solution limits the risk of contagion and the potential losses that financial institutions would bear if the value of debt principal were reduced.
Nouriel Roubini is chairman of Roubini Global Economics and professor of economics at New York University's Stern School of Business.
Stephen Mihm is co-author, with Nouriel Roubini, of Crisis Economics: A Crash Course in the Future of Finance.