After a Trillion Dollar High, Reality and Deflation Dawn in Europe

May 13, 2010 6:30 PM

It did not take long for the trillion dollar rescue in Europe to stir second thoughts in global financial markets. Late Sunday night in Brussels Europe assembled its "BIG package" to fight its sovereign debt crisis and any contagion from Greece. On Monday global markets rallied. Yet since Tuesday, the euro has weakened again. Evidently even a trillion dollars bought only the briefest of respites.1

This is probably not too surprising, since the purpose of the package was to contain the contagion risks in Europe, without addressing the immediate cause of the problem, Greece's insolvency.

In recent days we have gotten a number of significant new pieces of information and announcements in Europe, all bearing implications for how this crisis will develop.

First, the International Monetary Fund (IMF) has published its detailed economic analysis [pdf] of the Greek restructuring program. It makes for truly grim reading. The analysis highlights substantial risks even under the IMF's somewhat optimistic economic assumptions. In table 4, for instance, the IMF indicates that even with the bailout package from the eurozone and the fund, Greece is expected to cover part of its public financing need through a rollover of short-term debt in the private financial markets as soon as Q3 2010, i.e., next month. In today's markets, that will be tricky.

The IMF also envisions that Greece will be able to roll over long-term debt as soon as Q1 2012, at a time when Greece is expected to have a total debt burden of 145 percent of GDP. This will almost certainly prove impossible at interest rates that will not cause Greece's required primary deficit to explode. The IMF itself assumes in its baseline scenario a 1 percent primary surplus in 2012 and total Greek interest payments of 7.5 percent of GDP—i.e., an implied cost of refinancing of 5 percent or so for 145 percent of GDP of debt.2

Even if everything else goes right for Greece, the IMF's timetable is just not credible. It would require Greece to reduce its total debt burden before 2012, even under the IMF's own baseline scenario. More on this in a later posting.

Second, on Wednesday, a remarkable turnaround came from Madrid, where the government of Prime Minister José Luis Rodríguez Zapatero—having been in denial throughout this crisis so far—has awakened to the need for action. Zapatero will now cut public wages by 5 percent in 2010, freeze them in 2011, suspend a pension rise promised during the last election, scrap a €2,500 subsidy for new parents, trim foreign aid assistance, and let public investments fall by €6 billion in 2011. In addition, the cabinet members themselves will see their wages cut by 15 percent to achieve a 6 percent deficit by 2011, down from 11.2 percent in 2009.3

For a socialist government, this is true "shock and awe"—not least toward its own supporters! Zapatero may be signing his own political death sentence as these measures are sure to infuriate his party's traditional allies among the Spanish labor unions, and lead to massive public protests on the streets of Madrid and elsewhere.

Even so, the Spanish government should go further and act to solve not only the immediate fiscal issue, but also Spain's underlying problem, its low medium-term growth outlook. Having already antagonized its union allies, it should first implement drastic labor market reform to end the insider-outsider labor market,4 with its history of unemployment rates of 20 percent or more.

Spain's immediate and credible austerity measures so far indicate the kind of political concessions that the European Central Bank (ECB) won in return for its extraordinary policy actions over the weekend. Clearly the bank wasn't bluffing when it said that it would, if necessary, purchase public and private debt securities, with a proviso that:

"In making this decision we have taken note of the statement of the euro area governments that they ‘will take all measures needed to meet [their] fiscal targets this year and the years ahead in line with excessive deficit procedures" and of the precise additional commitments taken by some euro area governments to accelerate fiscal consolidation and ensure the sustainability of their public finances."

The willingness of Spain to fall on its sword so swiftly shows the effectiveness of ECB pressure and greatly adds to the bank's longer-term credibility.5

Spain's agreement to pursue "legislated wage deflation" follows in the footsteps of both Latvia and Ireland. Together these steps have placed significant additional pressure on other eurozone governments, not least Portugal (which has already signaled additional measures that will raise "social tension") but also Italy. The entire eurozone is now feeling the heat to accelerate fiscal austerity efforts and bring down primary deficits. Spain, unlike Greece, at least embraces such deflation with a relatively low debt burden.

Indeed, in the wake of the Spanish announcement, it seems more likely that the entire southern part of the eurozone will fall into outright deflation in the short to medium term. This should ensure that the ECB keeps interest rates low for the foreseeable future. Moreover, that prospect makes the IMF assumption that Greece will increase its exports of goods and services by 4.5 percent in 2010 and by more than 5 percent annually thereafter utterly unrealistic. The problems a Southern European deflationary move poses for Greece are already manifest in the fact that February's unemployment rate rose to 12.1 percent, already above the IMF projection of 11.8 percent for 2010 as a whole.6

Third, the European Commission (EC) published its proposals for reinforcing economic policy coordination in Europe on May 12, a step that was designed to reinforce a "fiscal austerity domino effect" [pdf] in the region. The EC's proposals are clearly aimed at giving the failed Stability and Growth Pact (SGP) more teeth and credibility.

Thus the EC is calling on member states to implement fiscal plans that "reflect the priorities [pdf] [e.g., austerity] of EU budgetary surveillance." Here one cannot help but conclude that the commission seeks to make the EU "more like Germany," which last year adjusted its constitution to outlaw German government deficits after 2020.7 The EC further proposes the creation of a countercyclical mechanism of "interest bearing deposits" to be made by member states in case of inadequate fiscal policies in good times. This step will make it easier to block disbursements of funds from the common EU budget to a fiscally errant member state, and to bring EU and national budget expenditures into compliance with the agreed EU fiscal sustainability goals.

While the precise formulation of the European Union's new reinforced economic policy coordination remains to be negotiated among the EC, member state governments, and the European Parliament,8 its general direction is clear.

In the first decade of the euro, there was quite a lot of ad hoc coordination among eurozone members as they broke or bent the original SGP rules. Now what might be called "coordinated austerity," with an obvious deflationary impact, will likely be the order of the day. Europe seems poised to bring fiscal policy "back to Maastricht Treaty basics," increasing the likelihood of deflation in the eurozone in the short term.

So far so good for Europe, but the necessary newfound willingness to implement painful and politically costly austerity will not be enough on its own. Europe, in particular the Mediterranean countries, also needs to improve its growth prospects. This means the EC must focus not only on ensuring austerity measures, but with equal zeal on policing the EU Internal Market, a cornerstone of any possible improvement in Europe's potential growth rate.

Lastly, there are a couple of implications to draw from Europe's new zeal for austerity.

First, we might actually finally get to see if the original Maastricht Treaty framework could work as originally intended. Many commentators, including prominent Nobel Prize winners, have claimed that recent events in Europe show how poorly conceived the original economic and monetary union was, and that it would prove impossible to manage the euro in the long run without a common European fiscal policy, and that Europe is not an "optimal currency area," etc.

Until now, however, the original Maastricht criteria were never actually adhered to. The original sin was the political necessity at the launch of the euro to bring Italy and Belgium (i.e., Brussels itself) into the currency and therefore ignore the 60 percent debt stock criteria. Most German and French politicians conveniently forget this now, but it was Gerhard Schroeder of Germany and Jacques Chirac of France who destroyed what little credibility the original Maastricht criteria had in 2005 when they ignored the 3 percent deficit ceiling and forced the rest of the European Union to go along.

As a result, the proposition that a monetary union of countries with genuinely sustainable fiscal policies is possible in Europe has never been tested. Now that the financial markets are demanding such discipline, the test of the original Maastricht criteria is possible. It may turn out that the "half-built European house" is not itself flawed, as long as countries play by the rules. A combination of financial market pressure and redesigned European institutions may give new life to the idea and practice of a European monetary union.

The ECB seems to hope that is true, having shed the old narrow "Bundesbank prescriptions" of price stability and now become a more "normal central bank" willing to serve as a lender of last resort "in extremis." The bank's decision to add this crucial role to its function will itself work toward ensuring the long-term stability of the euro.

Europe is not actually alone in having to consolidate government finances. The fact that Europe now seems headed down that path (helped by a new British government with an austerity mandate) puts it ahead of the United States and Japan in that respect. Figure 1 shows how Europe seems not only to be moving sooner than the United States and Japan, but also from an overall less acute position of fiscal stress.

figure 1

Figure 1 shows how the eurozone as a whole has lower net total debts9 and a considerably smaller total necessary adjustment of its primary surplus10 relative to the United States and Japan. The fact that several of the sickest "PIIGS (Portugal, Ireland, Italy, Greece, and Spain) men" of Europe are moving decisively toward fiscal consolidation suggests a more positive, longer-term outlook for the region as a whole. By moving faster toward consolidation, moreover, Europe may be able to rely on the additional American and Japanese export demand—at least until they too are forced to deal with their fiscal deficits.


1. This posting has benefitted greatly from my ongoing discussions of these issues with my Peterson Institute colleagues Angel Ubide, Anders Åslund, Carlo Bastasin, Michael Mussa, Morris Goldstein, Nicolas Véron and Joe Gagnon.

2. See [pdf] table 2, page 27.

3. In addition, the Zapatero government is implementing an increase in the Spanish value-added tax and has not ruled out additional tax increases.

4. An insider-outsider labor market is characterized by a relatively large group of well-protected "insiders," typically prime-age men in secure, well-paying jobs who are extremely difficult to lay off, and a large group of "outsiders," usually young workers, older workers, women, and immigrants, who have only sporadic attachment to the labor market and suffer from perennially high levels of unemployment. Such outsiders are unlikely to acquire the skills needed to get a well-paying job, putting them at risk of becoming a permanent low-skilled, low-wage labor pool. Combined with the difficulties for companies in restructuring their hard-to-fire/hard-to-assign-new-tasks "insider labor force," an insider-outsider labor market poses a significant long-term risk for a country's growth potential.

5. Sorry, it is unlikely that President Obama's highly publicized phone call to Prime Minister Zapatero had much to do with the Spanish government's volte-face. 

6. See [pdf] table 1, p. 26.

7. See,s01=1.html. Other EU countries like Sweden have similar national budget rules that are far more strict that the SGP itself.

8. I regard it as highly unlikely that EU countries with sound national fiscal policies today will let their national parliaments be "looked over the shoulder" by an EU among whose members are obvious fiscal laggards. As such, the EC's proposals will surely change a lot before the end of the process. This, however, will not change their general thrust in the direction of more European austerity.

9. Net debt Data from the OECD Economic Outlook 86 Statistical database. See,3343,en_2649_34573_2483901_1_1_1_1,00.html.

10. IMF data from a presentation by Olivier Blanchard at the Peterson Institute February 19, 2010.