Solving the eurozone crisis is a piece of a cake. I was reminded of that last week when I heard an economist cutting through all the complexity with a classic what-goes-up-must-come-down-type argument.
Germany improved its relative competitiveness against the eurozone during the first decade of the 21st century through wage moderation. But now German wages are rising at a slightly faster speed than those in Spain and Italy. Depending on your favourite metric for competitiveness and your own personal estimate of the required scale of adjustment, you can do the maths on how long it will take to complete the reversal.
Austerity drives this adjustment. It has turned current account deficits into current account surpluses by depressing imports. As countries deflate, exports become more competitive and, proponents of this view hope, growth will begin to rise slowly – exactly what happened in Germany in the 2000s.
The latter expectation, however, is wrong because it underestimates two factors. The first is the self-defeating impact of austerity on growth when interest rates are close to zero, as discussed many times on these pages.
The second factor is the presence of an unresolved banking crisis and an associated credit crunch, which will further depress nominal growth. In an environment of low nominal growth, high debt will not inflate away. The European Central Bank will not accept higher inflation. And Germany will not accept eurozone bonds, not even after its general election in September.
Policy makers are clinging to the hope that banking union will resolve everything. But can this new regime, once it is in place next year, do the job? Can it force a large-scale restructuring of the sector, close down unprofitable institutions, merge others or force partial nationalisations? Of course not.
First of all, the banking union in its initial stages will be mostly nationally funded. It will consist of a central supervisor with a series of nationally co-ordinated resolution regimes, but without a central backstop. This itself would not be half as bad were it not for the renationalisation of finance, which has been the key characteristic of the financial resolution policies of the past few years. What it means is that resolution would end up merely reshuffling debt from one sector of the economy to another. If, for example, you bail in an Italian pension fund that owns Italian bank bonds, the Italian state may end up supporting the pensioners. While the eurozone has some debt-absorption capacity, the indebted peripheral member states do not.
The second reason is more subtle. There is simply no tradition of radical bank resolution in Europe. European bank supervisors are national operators by temperament, not international referees. They see their job as colluding with their national banking sectors to protect them against foreign competition. When a crisis occurs, they let the next economic recovery take care of the problem, rather than resolving it by reducing banking capacity. While I do believe that a banking union constitutes an important reform in the long run, it is very naive to think that the newly appointed bank supervisors are going to resolve the European banking sector with a determination they never displayed in their capacity as national supervisors.
This leaves us with a bank resolution strategy – if you want to call it that – that begins with an inadequate bank recapitalisation, on the basis of dubious stress tests and asset quality reviews, and is followed by further piecemeal steps in later years as the shortcomings of the strategy become more evident. All this will be accompanied by regulatory forbearance. We are already seeing this process at work in Spain.
Leaving it to the next recovery to take care of the problem will not work this time because the credit crunch and debt deflation prevent the recovery. Resolution is a precondition for growth. But since policy makers are in denial over the problem of debt deflation and the wider impact of austerity, I do not expect to see any real radicalism.
What about the resolution of sovereign debt? It will come in the form of a hidden debt mutualisation for peripheral government debt through loan extensions and lower interest rates. Take both to the extreme limits and you end up with the paradox of a perpetual zero coupon bond – meaning a total loss for creditors, never officially recognised. The European Stability Mechanism thus turns into a vehicle to deliver hidden eurozone bonds.
So, overall, we are looking at a mixture of financial and regulatory forbearance, small-scale recapitalisations and deleveraging, a process that will take many years to complete. During this period of financial retrenchment, the private sector will remain weak, while the public sector will be constrained by treaty obligations to run large fiscal surpluses.
On the positive side, I would expect the export sector in the periphery to grow moderately but not nearly enough to compensate for those two effects. We are looking at a decade of low growth and zombie banks, similar to what has blighted Japan in the past 20 years.
Copyright The Financial Times, 2013.