Happy 2013?

By Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

Financial market quiescence has removed pressure for immediate policy action on the Eurozone crisis. Charles Wyplosz, in a recent (Jan. 4^th) VOXEU communique, argues that while important repairs were made in 2012, there are serious problems ahead. Things will have to get worse before they get better, especially if politicians delay making critical decisions.

The situation of the Eurozone is now becoming clearer. This note lists ten observations and draws five consequences. The bottom line is that, even though some important steps were taken in 2012, the most difficult ones still lie ahead.

The observations for the Eurozone problems include: 

·       Prolonged austerity policies have contractionary effects.

·       Debt reduction is a very long process; that takes years or decades

·       The debt-to-GDP ratio is best reduced through sustained nominal GDP growth.

·       In a fiscal union whereby an agency would both coordinate national fiscal policies to achieve a good Eurozone policy mix and organize transfers from the countries that achieve their lowest unemployment rates.

·       The crisis has delivered a surprising degree of wage flexibility and labor mobility.

·       The long-hoped-for awakening of the ECB has produced several miracles, especially a major relaxation of market anguish.

·       In most Eurozone countries, structural reforms are as needed now as they were before the crisis.

·       Banks are at the heart of a negative feedback loop: bank holdings of their national public debts.

·       Massive forbearance has allowed many banks to not fully account for the losses that they incurred in 2007-8, if they deleverage, which leads to a credit crunch, which slows growth down. As the recession spreads and deepens, bank loan quality is quickly deteriorating. This second diabolic loop links banks and the real economy.

·       The ECB is the lender of last resort both to banks and to governments.  This involves massive moral hazard. Moral hazard can be sharply reduced with appropriate institutional measures.

What are the policy implications from these observations? Wyplosz draws five different lessons:

• Sustained real growth should be the number one priority.
• Austerity policies must stop, now.
• Growth will not return unless bank lending is adequately available (1) they must stop lending to their own governments, and (2) they must be shut down if they are unable to raise the capital needed for them to lend to the private sector. But their governments may not have the resources to carry out resolution.
• The ECB may act as lender in last resort to banks and governments, but who will bear the residual costs, as current temporary facilities are too small?
• The only remaining option is public debt restructuring, a purging of the legacy.

This will lead to bank failures. This means that debt reductions must be deep enough to make it possible for governments to then borrow, to shift to expansionary fiscal policies and to bail out the banks that they destroyed in the first place, in effect undoing the negative feedback loop. The ECB is the only institution in the world that can help out. That means massive losses on its balance sheet and therefore negative capital, which is not an economic problem but a potentially severe political one.

There is no easy option for the Eurozone after three years of deep mismanagement. Governments will not accept drastic action unless forced to. This means another round of crisis worsening and since the eventual costs are rising as public debts keep growing, the best hope is that it happens in 2013 rather than in 2014.  It will be a challenging period for risk management.

www.voxeu.org/article/happy-2013