Recent concern over Greece’s sovereign debt has focused attention on some deep-seated problems in Europe.
A RECENT development has been the increasing focus on sovereign debt and creditworthiness. The initial manifestation of this was late last year when Dubai World requested a six-month standstill agreement on its debt repayments.
More recently, the focus has been on Greece, after it was revealed that the Greek government’s current borrowing requirement was much larger than had been previously disclosed. Greece is a small country – accounting for only half of 1 per cent of the world’s GDP. The significance of Greece is that it is a euro area country, which means two things.
First, its adjustment to its predicament cannot involve currency depreciation (unless it were to leave the single currency). The only way it can grow out of the problem is by gaining competitiveness against other European economies via domestic deflation, which will be a difficult and lengthy process. A very large fiscal consolidation is an unavoidable part of this path.
Second, the euro area has an interest in this effort succeeding, which is why there has been intense discussion about whether, and in what form, European assistance might be forthcoming. Any assistance would of course have to pass the test of credibility more generally in Europe, and would need to be applicable under similar terms to other euro area countries if needed. This is obviously a difficult problem, on which the policymakers concerned are continuing to work.
Perhaps the broader significance is that the difficulties facing Greece, while unusually stark, are a reminder of the challenges facing many governments in Europe, and for that matter the US and Britain, over the long haul. Ratios of debt to GDP are rising quite significantly in all these cases. There are several reasons.
The first is the size of the recessions being experienced, which obviously reduces revenues and adds to some categories of spending – the so-called ‘automatic stabilisers’. This effect is relatively larger in some European countries, but it occurs everywhere to some extent.
The second factor is the discretionary budgetary decisions aimed at stimulating demand and injecting capital into banks. In the circumstances, the former was understandable; the latter was unavoidable.
The ‘automatic stabilisers’ will presumably ‘automatically’ move budget positions in the right direction as economies recover. The costs of stimulus and bank rescue measures, while one-off in nature, do leave debt permanently higher. But without such measures, economies might have suffered much deeper downturns and so the extent of budget deterioration could have been much greater, itself leaving an even bigger debt legacy.
If that were the end of the story, we would not want to get too worked-up over debt ratios. Unfortunately, though, there is more to the story.
For several important countries there was a trend increase in debt-to-GDP ratios going on before the crisis occurred. For the domestic audience, let me be clear that Australia has been a conspicuous exception.
Particularly in mainland Europe, the pattern has tended to be for debt ratios to rise quickly in periods of recession, then to stabilise for some years, before rising again in the next recession. No doubt multiple factors are at work but the interaction of changing demographics and generous welfare, health and retirement systems is prominent. The same factors also work, other things equal, to lessen future potential economic growth.
It is certainly not unprecedented for countries to have debt stocks much larger than their annual GDPs. This has usually been seen when they faced the requirements of fighting wars. Those ratios subsequently came down over time. But the situation now is different. The decline in debt ratios seen after World War II, for example, driven by rapid growth in output as population expanded and productivity surged, will not easily be repeated in many of the major countries.
It is these more deep-seated trends, which were in place before the crisis, that are really the greater cause for concern; the crisis has brought them more sharply into focus. The demographic drivers will continue for the foreseeable future, while the unwillingness or inability to tackle the structural trends in earlier ‘good times’ has significantly reduced future flexibility.
So a number of advanced industrial countries face some difficult fiscal decisions over the years ahead. At some point, significant discretionary tightening will be required.
Of course policymakers need to get recoveries well entrenched, which is why many observers warn against attempting an early fiscal consolidation. But unless a credible path to fiscal sustainability can also be set out, rising risk premia built into interest rates could easily stunt growth as markets worry about long-run solvency.
This is not happening as yet; long-term rates in many of the major advanced countries remain quite low.
In the mean time, differences persist in the pace of economic recovery across regions. In the US, most observers still expect only moderate growth this year. In Europe, the momentum of the recovery has been less certain. In both cases the old forecasting cliché about uncertainty applies in spades.
In contrast, it is apparent that the letter ‘v’ is a reasonable description of the trajectory, to date, of important emerging countries such as China, India, Brazil and a number of smaller East Asian countries. We should expect to see some moderation in the pace of growth of production in some of these cases this year. This is usually the case in ‘v-shaped’ recoveries, since the initial pace of expansion is considerably higher than the long-run sustainable growth rate.
The question of what happens to demand in these countries is, of course, distinct from what happens to production. Full employment in parts of the emerging world will probably be reached before full employment in North America or Europe. Productive capacity therefore would remain to meet further demand from the emerging world, via imports of goods and services from the ‘old world’.
The alternative approach would be to seek to slow growth in demand in the emerging world as production there approaches full capacity, so as to maintain internal balance at a given set of exchange rates. But that would leave unused capacity in the industrial countries and emerging world living standards lower than they could be. These are polar cases – it would of course be open to policymakers to steer some path in between.
Among Asian policy makers many factors go into thinking about exchange rates and trade and capital flows. The point, nonetheless, is that current and prospective differences in economic circumstances between significant parts of the world are likely to put strains on the relative settings of macroeconomic policies and exchange rate arrangements.
n This is an edited extract from Reserve Bank governor Glenn Stevens’ recent speech to the ACI2010 49th World Congress in Sydney.