Institutional factors matter for Eurozone solvency, but so does growth
Last week, as of the time of writing, Mario Draghi of the ECB claimed that he will do whatever it takes to save the Euro. This gave a boost to markets and improved sentiment towards the long suffering Eurozone. It’s quite remarkable that such a statement can mean so much, but it simply highlights that investors are aware of the need for institutional changes to occur if the Eurozone is to survive.
The main institutional change inferred from Draghi’s comment is that of the ECB as the lender of last resort (LOLR). If the ECB, with its tremendous firepower, were to make a credible stand behind all the debt of Eurozone countries, it would begin to look more like other Central Banks that perform the same role. This was the main point of a now seminal paper from Paul de Grauwe (The Governance of a Fragile Eurozone, April 2011). By highlighting the difference between the UK and Spain with regard to their respective Central banks, de Grauwe made the clear point of the power of a true LOLR.
Debt dynamics: the Eurozone needs more than the ECB
De Grauwe used a version of debt dynamics calculation to demonstrate the perceived solvency of Spain and the UK. At the time, de Grauwe calculated that Spain needed a primary budget surplus of 2.3% of GDP to stabilise it’s debt. Using actual 2011 data from the IMF World Economic Outlook, combined with long rates data from Bloomberg, de Grauwe’s figures are updated as follows:
Spain now needs a primary budget surplus of 3.14% of GDP, while Italy needs 4.5% and Ireland 6.5%. Obviously these numbers depend on the exact figures you choose for the calculation, but the story of these numbers would not change.
From these estimations it is clear why the Eurozone is in trouble and the perception of these countries solvencies is declining rapidly. But a closer examination of the debt-dynamics formula suggests that it’s not just the interest rate (influenced by institutional factors as discussed above) that matters for solvency, but also growth.
S ≥ (r – g)D
Where S is the primary budget surplus, r is the rate on government debt, g is the nominal growth rate and D is the debt to GDP ratio.
Don’t forget ‘g’
It is obvious that countries like Spain need a lower interest rate on their debt for the Eurozone to survive. But without growth as well, even a lower interest rate will lead to dangerous debt dynamics. If peripheral Eurozone countries could get back to nominal growth rates of 5 or 6%, the perception of their solvency would improve dramatically.
The markets are now reacting to negative GDP news as they should. Policymakers have asked too much austerity from the periphery, especially with little regard to the needed stimulus in the core to offset this. The core may not like it, but they need to spend. Their spending will pull in imports from the periphery and put upwards pressure on their domestic prices, easing the relative price adjustment that the periphery needs to restore competitiveness.
Yesterday, Draghi said that plans were being put in place for the ECB to buy Eurozone debt, even though it will have conditions and be in tandem with the stability fund. They can’t ask for too much more conditionality if that is a code for austerity in the periphery. Equally important as the recognition from Draghi that the bond market needs to be rescued, is the acknowledgment that the periphery needs growth.
It’s a big if, but if the Eurozone manages to return to growth rates mentioned above and made the institutional changes that are necessary, then the Eurozone may just survive, even in its current state.