Welcome to European Tribune. It's gone a bit quiet around here these days, but it's still going.
Display:
Robert Parenteau makes a pertinent argument in Will the Quest for Fiscal Sustainability Destabilize Private Debt?, that a country with a current account balance in deficit cannot run both a fiscal surplus and a private sector surplus as a simple matter of accounting definitions. The set-up for this was posted on ET here. The application to various EU countries remains in his original piece. His Three Sector Map is reproduced again here:

That means at every point on this map where the current account balance is equal to the fiscal balance, we know the domestic private sector financial balance must equal zero. In other words, the income of households and businesses just matches their expenditures (or alternatively, if you prefer, the saving out of income flows by the domestic private sector just matches the investment expenditures of the sector). The dotted line that passes through the origin at a 45 degree angle marks off the range of possible combinations where the domestic private sector is neither net issuing financial liabilities to other sectors, nor is it net accumulating financial assets from other sectors.

Once we mark this range of combinations where the domestic private sector is in financial balance, we also have determined two distinct zones in the financial balance map. To the left of the dotted line, the current account balance is less than the fiscal balance: the domestic private sector is deficit spending. To the right of the dotted line, the current account balance is greater than the fiscal balance, and the domestic private sector is running a financial surplus or net saving position.

This follows from the recognition that a current account surplus presents a net inflow to the domestic private sector (as export income for the domestic private sector exceeds their import spending), while a fiscal surplus presents a net outflow for the domestic private sector (as tax payments by the private sector exceed the government spending they receive).

Accordingly, the further we move up and to the left of the origin (toward the northwest corner of the map), the larger the deficit spending of households and firms as a share of GDP, and the faster the domestic private sector is either increasing its debt to income ratio, or reducing its net worth to income ratio (absent an asset bubble). Moving to the southeast corner from the origin takes us into larger domestic private surpluses.

The financial balance map forces us to recognize that changes in one sector's financial balance cannot be viewed in isolation, as is the current fashion. If a nation wishes to run a persistent fiscal surplus and thereby pay down government debt, it needs to run an even larger trade surplus, or else the domestic private sector will be left stuck in a persistent deficit spending mode. (Author's bold.)

Parenteau notes that a prolonged negative cash flow for the domestic private sector is damaging. They have to assume debt to increase present spending, sell assets or make do with less or all of these. This makes the private sector increasingly fragile.

Spain is currently running a fiscal deficit of about 10%. The Pact for Stability and Growth requires that deficit to be reduced to 3%. This could be done with a massive Current Account (Trade) Surplus, but is highly unlikely with the present or likely value of the Euro. The policy space available to EU countries WITHOUT A CURRENT ACCOUNT SURPLUS is shown in the chart below:

With respect to Spain, Parenteau notes:

Spain already is running one of the higher private debt to GDP ratios in the region. In addition, Spain had one of the more dramatic housing busts in the region, which Spanish banks are still trying to dig themselves out from (mostly, it is alleged, by issuing new loans to keep the prior bad loans serviced, in what appears to be a Ponzi scheme fashion). It is highly unlikely Spanish businesses and households will voluntarily raise their indebtedness in an environment of 20% plus unemployment rates, combined with the prospect of rising tax rates and reduced government expenditures as fiscal retrenchment is pursued.

Alternatively, if we assume Spain's private sector will attempt to preserve its estimated 5.5% of GDP financial balance, or perhaps even attempt to run a larger net saving or surplus position so it can reduce its private debt faster, Spain's trade balance will need to improve by more than 7% of GDP over the next three years. Barring a major surge in tradable goods demand in the rest of the world, or a rogue wave of rapid product innovation from Spanish entrepreneurs, there is an additional way for Spain to accomplish such a significant reversal in its current account balance.

Prices and wages in Spain's tradable goods sector will need to fall precipitously, and labor productivity will have to surge dramatically, in order to create a large enough real depreciation for Spain that its tradable products gain market share (at, we should mention, the expense of the rest of the Eurozone members). Arguably, the slack resulting from the fiscal retrenchment is just what the doctor might order to raise the odds of accomplishing such a large wage and price deflation in Spain. But how, we must wonder, will Spain's private debt continue to be serviced during the transition as Spanish household wages and business revenues are falling under higher taxes or lower government spending?

These policy consequences are not without consequences. Some of those consequences may well redound to the detriment of those most fervently pushing the policies:

It is the height of folly to expect peripheral Eurozone nations to sail their way into the EMU triangle under even the most masterful of policy efforts or price signals. More likely, since reducing trade deficits is likely to prove very challenging (Asia is still reliant on export led growth, while US consumer spending growth is still tentative), the peripheral nations in the Eurozone will find themselves floating somewhere out to the northwest of the EMU triangle. The sharper their fiscal retrenchments, the faster their private sectors will run up their debt to income ratios.

Alternatively, if households and businesses in the peripheral nations stubbornly defend their current net saving positions, the attempt at fiscal retrenchment will be thwarted by a deflationary drop in nominal GDP. Demands to redouble the tax hikes and public expenditure cuts to achieve a 3% of GDP fiscal deficit target will then arise. Private debt distress will also escalate as tax hikes and government expenditure cuts the net flow of income to the private sector. Call it the paradox of public thrift.

As it turns out, pursuing fiscal sustainability as it is currently defined will in all likelihood just lead many nations to further private sector debt destabilization. European economic growth will prove extremely difficult to achieve if the current fiscal "sustainability" plans are carried out. Realistically, policy makers are courting a situation in the region that will beget higher private debt defaults in the quest to reduce the risk of public debt defaults through fiscal retrenchment. European banks, which remain some of the most leveraged banks, will experience higher loan losses, and rating downgrades for banks will substitute for (or more likely accompany) rating downgrades for government debt. A fairly myopic version of fiscal sustainability will be bought at the price of a larger financial instability. (Author's bold.)

As Parenteau noted, policy advocates do not wish to consider the implications of basic accounting, especially, I would note, when they conflict with their political objectives, no less in Europe than in the USA. After having managed to avoid a debt-deflation death spiral after the October 2008 onset of the GFC, dogged pursuit of inappropriate policy objectives might still bring it about. He concludes:

These types of tradeoffs are opaque now because the fiscal balance is being treated in isolation. Implicit choices have to be forced out into the open and coolly considered by both investors and policy makers. It is not out of the question that fiscal rectitude at this juncture could place the private sectors of a number of nations on a debt deflation path - the very outcome policy makers were frantically attempting to prevent but a year ago.

There may be ways to thread the needle - Domingo Cavallo's recent proposal to pursue a "fiscal devaluation" by switching the tax burden in Greece away from labor related costs like social security taxes to a higher VAT could be one way to effectively increase competitiveness without enforcing wage deflation. Cavallo's claims to the contrary, however, it was not the IMF that tripped him up. Fiscal cuts begat lower domestic income flows, which led to tax shortfalls, missed fiscal balance targets, and another round of fiscal retrenchment, in a vicious spiral fashion. But more innovative solutions than these, where financial stability, not just fiscal sustainability, is the primary objective, will not even be brought to light unless policy makers and investors begin to think coherently about how financial balances interact.

Or to put it more bluntly, if European countries try to return to 3% fiscal deficits by 2012, as many of them are now pledging, unless the euro devalues enough, then either a) the domestic private sector will have to adopt a deficit spending trajectory, or b) nominal private income will deflate, and Irving Fisher's paradox will apply (as in the very attempt to pay down debt leads to more indebtedness), thwarting the ability of policy makers to achieve fiscal targets. In the case of Spain, with large private debt/income ratios, this is an especially critical issue. (My bold. ARG)

The underlying principle flows from the financial balance approach: the domestic private sector and the government sector cannot both deleverage at the same time unless a trade surplus can be achieved and sustained. We remain hard pressed to identify which nations or regions of the remainder of the world are prepared to become consistently larger net importers of Europe's tradable products, but it is also said that necessity is the mother of all invention (and desperation, its father?). Pray there is life on Mars that consumes olives, red wine, and Guinness beer. (Author's bold, uno.)

So, is the German dominance of the policies of the ECU, combined with their policy objectives poised to crush the economies of the south and blow up even German banks in the process? One thing in common with the USA is a refusal to acknowledge and deal with both the problems and the power of the big banks.

"It is not necessary to have hope in order to persevere."

by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Fri Mar 5th, 2010 at 12:30:06 PM EST
[ Parent ]
More evidence that the GSP is macroeconomic nonsense...

En un viejo país ineficiente, algo así como España entre dos guerras civiles, poseer una casa y poca hacienda y memoria ninguna. -- Gil de Biedma
by Migeru (migeru at eurotrib dot com) on Fri Mar 5th, 2010 at 12:38:55 PM EST
[ Parent ]
It should be renamed the Stagnation and Collapse Pact. So are the PIGS to be slaughtered by the pig-headed?

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Fri Mar 5th, 2010 at 01:45:49 PM EST
[ Parent ]
I found the references to Irving Fisher's Debt-Deflation Theory particularly alarming and cogent.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Fri Mar 5th, 2010 at 01:47:32 PM EST
[ Parent ]
Couple it with Minsky's debt-mediated Financial Instability Hypothesis and you're set.

En un viejo país ineficiente, algo así como España entre dos guerras civiles, poseer una casa y poca hacienda y memoria ninguna. -- Gil de Biedma
by Migeru (migeru at eurotrib dot com) on Fri Mar 5th, 2010 at 01:54:28 PM EST
[ Parent ]
Last night I re-read Fisher's paper from late '33. Perhaps this week-end I will re-read Steve Keen's paper on Minsky.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Fri Mar 5th, 2010 at 03:37:57 PM EST
[ Parent ]
That is a most excellent paper.

En un viejo país ineficiente, algo así como España entre dos guerras civiles, poseer una casa y poca hacienda y memoria ninguna. -- Gil de Biedma
by Migeru (migeru at eurotrib dot com) on Fri Mar 5th, 2010 at 04:15:54 PM EST
[ Parent ]
After unequivocally claiming priority for the Debt Deflation Theory in the opening paragraph of the paper, the last footnote reads (my bold):
A selected bibliography of the writings of others is given in Appendix III of Booms and Depressions, ... This bibliography omitted Veblen's Theory of Business Enterprise, ...Chater VII of which, Professor Wesley C. Mitchell points out, probably comes nearest to the debt-deflation theory. Hawtreys' writings seem the next nearest. Professor Alvin H. Hansen informs me that Professor Paxson, of the American History Department of the University of Wisconsin, in a course on the History of the West some twenty years ago, stressed the debt factor and its relation to deflation. But, so far as I know, no one hitherto has pointed out how debt liquidation defeats itself via deflation nor several other features of the present "creed". If any clear-cut anticipation exists, it can never have been prominently set forth, for even the word "debt" is missing in the indexes of the treatises on the subject.
See my diary The Credit Bubble theory of the Business Cycle (I: Veblen) (February 13th, 2010)

En un viejo país ineficiente, algo así como España entre dos guerras civiles, poseer una casa y poca hacienda y memoria ninguna. -- Gil de Biedma
by Migeru (migeru at eurotrib dot com) on Fri Mar 5th, 2010 at 04:30:58 PM EST
[ Parent ]
I was thinking of you and techno when I read the part about Veblin. Had you previously come across Fisher's paper?

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Fri Mar 5th, 2010 at 05:51:04 PM EST
[ Parent ]
No, this is a first reading. Now I want to read Booms and Depressions.

En un viejo país ineficiente, algo así como España entre dos guerras civiles, poseer una casa y poca hacienda y memoria ninguna. -- Gil de Biedma
by Migeru (migeru at eurotrib dot com) on Fri Mar 5th, 2010 at 06:59:07 PM EST
[ Parent ]
A book which, shockingly, is out of print! It's available as a PDF from the St. Louis Fed [link to HTML summary page]

En un viejo país ineficiente, algo así como España entre dos guerras civiles, poseer una casa y poca hacienda y memoria ninguna. -- Gil de Biedma
by Migeru (migeru at eurotrib dot com) on Sat Mar 6th, 2010 at 03:57:41 AM EST
[ Parent ]
Thanks. I am coming to love free books. Did you see Lombard Street, a description of the money market by Walter Bagehot, 1873? Same site. A real treasure trove.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Sat Mar 6th, 2010 at 11:47:10 AM EST
[ Parent ]
if households and businesses in the peripheral nations stubbornly defend their current net saving positions, the attempt at fiscal retrenchment will be thwarted by a deflationary drop in nominal GDP

This is Keynes' paradox of thrift at work. But the problem is that we just came out of a debt and asset price bubble with low savings and high indebtedness. Denying households and businesses the ability to deleverage will be painful.

It is not out of the question that fiscal rectitude at this juncture could place the private sectors of a number of nations on a debt deflation path - the very outcome policy makers were frantically attempting to prevent but a year ago.

It is surely wrong to stop fiscal stimulus of even embark on austerity programmes when the economic cycle is yet to unequivocally hit bottom.

Prices and wages in Spain's tradable goods sector will need to fall precipitously, and labor productivity will have to surge dramatically, in order to create a large enough real depreciation for Spain that its tradable products gain market share (at, we should mention, the expense of the rest of the Eurozone members).

Here there's an assumption that the sharing of the Eurozone's trade balance among the various member states is zero-sum. For one country to improve their trade balance, that of some others must worsen.

En un viejo país ineficiente, algo así como España entre dos guerras civiles, poseer una casa y poca hacienda y memoria ninguna. -- Gil de Biedma

by Migeru (migeru at eurotrib dot com) on Fri Mar 5th, 2010 at 03:02:48 PM EST
[ Parent ]

Display:

Top Diaries

Occasional Series