The International Monetary Fund has demolished the intellectual foundations of Europe’s debt crisis strategy.
4:52PM BST 14 Oct 2012
Drastic fiscal tightening in a string of interlinked countries does two to three times more damage than assumed, especially if there is no offsetting monetary stimulus.
Pushed beyond the therapeutic dose, it is self-defeating. At a certain point it becomes pain for pain’s sake.
The error has long been obvious in Greece. The EU-IMF Troika originally said the economy would rebound quickly, growing 1.1pc in 2011, and 2.1pc in 2012, and on from there to sunlit uplands.
In fact, Greek GDP contracted by 4.5pc in 2010, 6.9pc in 2011, and is expected to shrink a further 6pc this year, and 4pc next year. If the Troika were a doctor, it would face manslaughter charges.
The IMF now admits — or rather those in the IMF who always feared this outcome are at last able to say — that this misjudgement goes far beyond Greece. Tightening by 1pc of GDP in rich countries does not lead to a 0.5pc loss of output over two years as thought.
The “fiscal multiplier” is not the hallowed 0.5 assumed by every finance ministry in Europe. The awful evidence since the global bubble burst in 2008-2009 is that the multiplier is between 0.9 and 1.7, or even higher for EMU’s crucifixion belt.
The model constructed over the long boom years — and largely drawn from isolated cases, each able to export its way out of trouble — is dangerously wrong in a 1930s-style excess savings crisis with much of the world is slump.
Steen Jakobsen from Saxo Bank says the IMF’s mea culpa is the “biggest financial story of the year”. Indeed it is. The authorities have repeated the blunders of the Great Depression, but with fewer excuses.
The IMF has now called for a change of course. The Greco-Latins should be given more time to cut their deficits. The AAA creditor bloc should stop cutting altogether until the eurozone is off the reefs.
“Reducing public debt is incredibly difficult without growth,” said the IMF’s Christine Lagarde. “Instead of frontloading heavily, it is sometimes better to have a bit more time.”
One might expect a flicker of recognition from Germany’s Wolfgang Schauble that something must change. But no, with half Europe sliding into a second and more menacing leg of depression, and with unemployment already at 25.1pc in Greece and Spain, and 15.9pc in Portugal, he refuses to brook deviation.
“Increasing public debt doesn’t create growth, it destroys growth,” he snapped back. There is “no alternative” to debt reduction. Always the same pedantry.
He reminds us of the immortal Pfuhl in Tolstoy’s War and Peace: “disposed at all times to be irritable”, and unshaken in his military certainties even after the defeats of Jena and Auerstadt.
“Failure did not cause him to see the slightest evidence of weakness in his theory. On the contrary, failure was entirely due to the departures made from his theory.”
So there will be no change in policy. “Europe is on the way to solving its problems,” insists Mr Schauble.
The Latins will have to bear the full burden of adjustment. They alone must continue closing the North-South chasm in competiveness through an “internal devaluation”, a posh term for a policy that works chiefly by throwing enough people onto the dole to break labour resistance to pay cuts. It redoubles the contractionary bias of the whole EMU system in the process.
Whether or not the Schauble plan shatters on the barricades of civic revolt is the great unknown. Growth forecasts are all over the place.
Is the Spanish government right to pencil in a fall just 0.5pc next year, with recovery starting by the summer, or is the the Spanish employers group right at -1.6pc, or Citigroup at -3.2pc (and -5.7pc in Portugal), or Nomura at -3pc and -1.5pc again in 2014?
Madhur Jha from HSBC fears that a further 1.5m people in Spain could lose their jobs by the end on 2013, pushing unemployment to over 31pc. His optimistic scenario is 28pc.
The Spanish private sector has born the brunt of cuts so far. The axe must now fall on state employees as well, and that will almost certainly be a condition for a sovereign bail-out. “Cutting jobs in the public sector is politically explosive. The flashpoint for the Spanish economy could be approaching,” he said.
The EMU doctrine — expounded by bail-out chief Klaus Regling as he tours world capitals with his charts — is that carping “Anglo-Saxons” will have to eat their words about the perils of internal devaluations.
We are told that Ireland has largely closed the gap already, showing what is possible. Indeed it has, but Ireland has one of the most open economies in the world. Its exports are 127pc of GDP. It has a fat trade surplus.
It has never been seriously uncompetitive in the euro. It does not have a misaligned currency. Ireland tells us nothing about Spain, Italy, Portugal, or indeed France.
Spain clearly faces a much tougher task. It has a closed economy. Exports are less than 30pc of GDP. The current account deficit has narrowed from 10pc of GDP to 2pc — nudging into surplus in July on the reviving tourists trade — but the low-hanging fruit has been picked and the gains are flattening.
I do not wish to belittle the feat of Spain’s formidable companies. They have almost matched the export growth rates of German peers since 2009. Commerce secretary Jaime García Legaz said last week that Spain’s economy would be crashing at a 4pc rate without them.
Yet they cannot work miracles. If EMU policy settings had been more expansionary — if the eurozone had not been forced back into recession by the incompetence of the EU authorities — then perhaps they could have pulled off an export-led recovery. But the handicap imposed upon them is too great.
The credit crunch across Club Med has left Spanish firms facing a borrowing premium of 2pc or more compared to Northern rivals. The North-South gap is becoming hard-wired into the EMU system.
The reality is that even after a collapse in imports, Spain is still in deficit and has net external debts of 92pc of GDP. Trade equilibrium will be attained only with the economy in depression and only with unemployment at levels that no demcoracy can tolerate.
Mr Schauble thinks Spain has no choice. It must take its medicine. “There is no European country that would waste the smallest thought on giving up the common European currency,” he said last week
This is not quite true. The head of the ruling party in Cyprus has openly discussed exit from the euro if Troika rescue terms are unacceptable.
It is also a misjudgement. Every sovereign nation has a choice, and the IMF’s mea culpa changes the landscape. The issue is no longer whether Spain should adhere to the Schauble plan, but whether the plan can work at all.
In fairness, the German government has shifted ground. It is letting the European Central Bank engage in stealth mutualisation of EMU debt by ramping up its balance sheet. This makes it easier for Chancellor Angela Merkel to avoid a bruising showdown in the Bundestag.
Yet such a policy falls between two stalls. It is too fitful, hesitant, and cribbed about with conditions to halt the crisis: but is enough to provoke a backlash from the German people as they realise their country is being smuggled into fiscal union without democratic assent.
The Latin bloc and like-minded allies could of course marshal their voting power in the EU Council and the ECB to ram through a reflation policy.
The effect would be to drive Germany and the AAA-periphery out of EMU by pushing domestic inflation in those countries to unbearable levels. You could argue that this process is already underway, though France is not yet feeling enough pain to force the issue.
Besides, to do that you need a Churchillian figure — or indeed a Juan Pérez Villamil, the hero of the Levantamiento — to raise the flag of defiance. No such leader has yet appeared.