Europe’s definitional crisis

Method And Manner | Haseeb A Drabu

These truly are unique times. More than the overhyped downgrade of the US, it is the first time in the global economic history that there are more countries than corporations that are perilously close to a default. In fact, even as countries are lunging from one crisis to another, most of the large global corporations are sitting on cash and have rock solid balance sheets. Sooner than later, corporations will have better credit rating than countries.

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What the Standard and Poor’s (S&P) downgrade of the US has done is to announce the end of the global debt super cycle; a phase that has seen the debt-to–gross domestic product (GDP) of advanced economies rise from 46% in 2007 to 70% in 2011. The US alone contributed 37% of the increase in global debt from 2007 to 2011, while its contribution to global GDP was just 8%. Indeed, in the US real GDP without deficits has been flat for 15 years; growth in GDP has come only from the US government’s borrowings.

The real policy challenge has been to strike a delicate balance between supporting weak recoveries while bringing down debt and deficit levels. The absence of such a policy has resulted the euro zone’s crisis spreading from the outer periphery—Greece, Ireland and Portugal—to also include much larger countries such as Italy and Spain, as well as the continent’s banking system.

In the euro zone such a policy response is not possible because all these countries have forgone their sovereign right to create any of its own money. They cannot repatriate their debt or use inflationary means to mitigate it. Thus, these countries have lost a part of their economic sovereignty.

The monetary union is nothing but an agreement to take monetary policy out of national sovereignty. In light of the specific monetary treaties, while the Greek debt situation is a Greek macroeconomic problem, in light of the “shared economic sovereignty”, it is a European policy problem. And it is precisely because of this that ECB doesn’t “monetize” euro debt as it would weaken the euro as a currency and inflationary expectations would increase.

The simple fact is that all the countries facing a debt crisis within the euro zone do not have currency sovereignty. Greece doesn’t create the euro. Nor does Spain or Portugal. All these countries are users, not creators, of the currency. Be it for a government or companies or countries, insolvency is almost always caused, or preceded, by a liquidity crisis. So, when a liquidity crisis strikes, countries without currency sovereignty are bound to get into a crisis because they can’t generate enough cash to fund government spending.

With the sharing of economic sovereignty, all these political sovereigns are becoming credit risks because of their policy disempowerment. As a result, the debt dynamics of “shared sovereigns” is different in impulse and impact on the global economy and markets. It cannot be seen as a “sovereign” default.

A fully empowered sovereign has the authority to devise a policy that can address the issue through, say, the pricing of debt or currency. Policies can be designed to alter market prices of debt or currency through direct intervention, or indirectly through altering the amount of debt or currency demanded at a given price. Sovereigns have the ability to tax, confiscate and enact various forms of financial repression that affect all asset classes, including sovereign bonds. It is because of this that “sovereign debt” is at the core of the modern financial system. It is this that makes it a “risk-free” asset class and is used by all financial institutions as the baseline to value the vast array of available investment options.

The only path to solvency for weaker debtors within the euro zone is fiscal consolidation. While the policy challenge is that fiscal consolidation lowers economic output and, therefore, increases deficits in the short term, the real challenge is political: to work towards a system which at the minimum will coordinate fiscal policies. The ideal solution would be to transfer some sovereignty from national parliaments to the European parliament, which would require a new treaty. A federal arrangement of that kind would complement the common currency, but it is a political impossibility as it amounts to losing sovereignty.

Over the long term, institutional structures for dealing with recessions and economic crises must be formed that are not reliant on artificial constraints such as the stability and growth pact. This has to go beyond cross-border financial regulation or bailouts via a European Monetary Fund that ensures adherence to the existing stability and growth pact.

The problem and the solution have been stated by John Maynard Keynes in the mid-1930s: “Once a nation parts with the control of its currency and credit, it matters not who makes that nation’s laws. Until the control of the issue of currency and credit is restored to government and recognized as its most important responsibility, all talk of the sovereignty of parliament and of democracy is idle and futile”. Herein lies the real answer to the crisis.

Haseeb A. Drabu is an economist, and writes on monetary and macroeconomic matters from the perspective of policy and practice. Comment are welcome at haseeb@livemint.com

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