Authored by Jeff Young of Woodbine Capital,
Austerity Is Necessary
Austerity is under attack again, with Cyprus about to enter a program. Critics charge that austerity is self-defeating because it depresses growth, pushing up the debt/GDP ratio. However, austerity is a necessary (although far from sufficient) condition for countries with low national savings Indeed, there is some evidence that austerity is beginning to have positive effects. Higher savings have improved market perceptions of debt sustainability, making countries more resilient to shocks (Cyprus, Italian politics).
What is austerity for?
Austerity is sold as a way to reduce public deficits, but what it is really supposed to do is raise net national savings (savings minus depreciation) in the entire economy (not just the public sector, the private sector too). Certainly one lesson of the rolling European crisis is that excess debt can create funding crises regardless of which sector – the government, banks, households, or corporations – did the borrowing. What is important is, are savings in the entire economy sufficient to finance debt in the entire economy? If no, debt sustainability will be questioned. But if a country increases its internally generated savings, it can service its current debts, and it can invest to create a stream of income to service debts in the future.
In this sense, the commonly used debt/GDP ratio – the stock of debt divided by the current year’s income – is misleading. More relevant is the amount of GDP that will be created over the lifetime of the debt, and this is surely related to the amount of savings generated by austerity. Market perceptions of debt sustainability can improve even though the debt/GDP ratio rises. This will happen when austerity depresses current growth but raises net national savings. After the ERM crisis in 1992-1993, debt/GDP ratios in the hardest-hit countries rose for many years, but bond yields declined rather quickly, as net national savings rose.
To be sure, European governments have been guilty of false advertising. They claimed that fiscal austerity would not hurt growth. But in order to raise savings, it is necessary to consume or invest less (unless a country is lucky enough to enjoy an export or productivity boom). As a result, growth will suffer as a country raises savings. But once savings begin to recover, elements of a “virtuous circle” begin to fall into place. Debt is serviceable and investment can return, which further enhances perceptions of sustainability. Appropriate banking and monetary policies are also necessary, but they do not obviate the need for higher savings.
Which countries are saving themselves?
Let’s look at the performance of the three program countries – Greece, Ireland, and Portugal – and Spain and Italy. Greece and Portugal had negative net national savings in the five years preceding the outbreak of the European sovereign crisis in 2010. This means that they were not even saving enough to maintain their existing capital stocks. Ireland had positive net national savings, although the level declined sharply. Spain looked more like Ireland – positive but declining net national savings – whereas Italy had lower levels.
As of last year, Greece had improved to about -5% of GDP (from -14% in 2011), Portugal to -4% (from a trough of -8% in 2009), and Ireland had managed to maintain small positive net savings. Greece and Portugal in particular have much further to go, but it is noteworthy that both countries managed to raise their net savings last year: gross savings rose, investment declined, and depreciation fell.
Ireland was almost lucky to have had its problem centered in real estate overinvestment. Once the real estate bubble ended and investment crashed, net savings rose more or less automatically. The crash of investment and real estate prices necessitated banking support, but once that was in place, higher net savings allowed the bond market to stabilize. Ireland has even begun to invest again (capital formation rose 2.6% in the fourth quarter of 2012, from a trough of -31% in early 2009).
This is an early sign that the process is entering into a virtuous circle.
Greece is a different story. There, excess consumption (both private and public) had left gross savings chronically low, and there was not a lot of investment to slash. The only way to raise net savings is to cut consumption, which is much more difficult than cutting investment.
Spain resembles Ireland, in that it sported an Asia-like investment rate of 30% of GDP before the crisis, mostly in construction. Since Spain hit the wall, investment has plunged, but almost entirely in construction (-10% of GDP), which has helped repair national savings with only a minimal impact on future growth potential (machinery and equipment investment is down by just 1.5% of GDP). Italian dynamics are less favorable, as savings were lower to begin with, and investment rates are low enough that they cannot be cut much further. This implies that politically difficult cuts in consumption will have to be the primary means to raise savings.
The scale and timing of the required increase in savings is a different question from whether savings need to increase. In some cases an official sector program, or even restructuring, might be necessary. But this does not reduce the need to raise net national savings. It just suggests a different path for higher savings, or in other words, a different dosage of the same medicine, rather than a different medicine altogether.
Limited contagion from Cyprus?
Contagion to other sovereign markets has been muted since the Cyprus crisis flared up, despite poor crisis management and losses on certain classes of claimants (bank depositors and creditors) that constituted about as severe a shock as could be imagined. Perhaps Cyprus is just too small to matter. But perhaps the increase in net national savings in periphery countries has left them in a stronger position to withstand shocks. With a bigger pool of domestic resources available for debt service, contagion is less likely. Much more remains to be done (after all, Portugal and Greece still have negative net national savings), so the improvements might be enough to withstand a really large shock. But they have made the system less fragile.
In a similar vein, the EUR has been largely stable since the Cyprus shock: the EUR is down, but only modestly and in line with cyclical factors, with no contribution from fragmentation and ‘redenomination’ fears. Since last year there have been greater self-efforts to rebuild savings, and a wider mutualized backstop at the European level, effectively reducing (although not eliminating) euro redenomination risks. To some observers, the high reliance on self-help to save a currency union is contradictory and maybe even mutually exclusive, but such is the hybrid that is the EUR.