Illustration by Oliver Munday
How 3 Myths Drive Europe’s Response to Debt Crisis: Harald Uhlig
In many ways, things in Europe look better than they did just a month or two ago. The European Central Bank is providing banks with almost unlimited cash to buy their governments’ bonds. Yields on Italian debt have declined.
This breather is a perfect opportunity to examine some pernicious -- and widely circulated -- myths that have emerged from the crisis and could still do much harm.
Myth No. 1: Italy’s interest burden was unmanageable.
Let’s do some math. On Nov. 25, the yield on 10-year Italian debt was 7.2 percent; it’s around 5.7 percent now. Suppose Italy had to pay that difference of 1.5 percentage points on debt it issues over the next two years that probably amounts to less than half of gross domestic product. That payment would be an additional interest burden of less than 1 percent of GDP, in a country where the government share accounts for half of output.
In December, the Bank for International Settlements conducted a more detailed calculation than mine and estimated that the interest burden would be about 2 percent of GDP; still less than 5 percent of total government spending.
Nonetheless, the Italian government and many commentators hit the panic button, demanded that Europe ride to the country’s rescue and then criticized the markets for being unjustifiably spooked by Italian debt levels. But one has to wonder: Who is spooking whom? With so much drama over so little, is it any wonder that bond investors have doubts about Italy’s ability to pay?
If, instead, the Italian government had confidently explained that it could afford to pay the additional 1 percent to 2 percent of GDP on debt service, the crisis could have been averted.
It still is in Italy’s power to do so. A study I recently wrote with the economist Mathias Trabandt demonstrates that Italy cannot sustain a real interest rate of more than 6.4 percent on its debt for an extended period. But we also concluded that Italy got precariously close to its maximum capacity for tax revenue, according to the Laffer curve. Perhaps it should now climb down and reduce government spending overall. This won’t just make the country produce more efficiently -- it will also provide room for repaying the debt.
Myth No. 2: Fiscal austerity means disaster, or growth policies require spending.
It is nice, of course, for governments to be able to borrow money and sprinkle it generously over its citizens. Once the flow stops, however, it should come as no surprise that the citizens are unhappy. That will happen sooner or later because what has been borrowed almost always needs to be repaid.
Some people believe there is an alternative: Let’s examine what happens if the government can no longer borrow these generous handouts, and instead has to extract these resources from its own citizenry. Will that promote growth? What about that old Keynesian idea of having some citizens dig holes that other citizens then fill: Wouldn’t that do wonders for the economy?
This is wondrous thinking, indeed. Imagine a beautiful island whose inhabitants don’t need to exert themselves to live happily. Each citizen has an apple tree that each day at noon drops an apple sufficiently large to feed its owner. A citizen’s only task is to pick up the fruit and eat it; otherwise he or she can spend the day at the beach. The per-capita GDP of such an economy would be one apple a day.
Apple a Day
Enter a government that decides it needs to tax away the entire harvest every day, and then pays each citizen an apple a day for lying on the beach. They would have done so anyhow, but they now get paid by their government for performing a “service.” GDP has been doubled. The services provided by the government are accounted for by how much they cost -- an apple in this example. It would be easy to keep going and even triple or quadruple the original one-apple-per-day GDP.
Now imagine fiscal austerity is imposed, say, by eliminating the government. Yes, GDP would come crashing down; it would fall 50 percent in this example. The citizens, however, are no worse off: They still get to eat an apple a day, just as before. They may even be better off in cases where the government required them to perform an onerous task in exchange for their salaries, such as sitting in a government office all day. Moreover, if the tax imposed on citizens is a labor tax on collecting the apples, then high tax rates might have been preventing them from collecting the apples in the first place.
I’m not suggesting that Greece, Italy or other countries with large government sectors pay government employees to lie on the beach or sit idly in offices. But it may be worth asking why the government share of their economy has to be so large, and how much truly would be lost if these governments spend less. It also is worth asking how much dynamism would be added to these economies if the burden of future high taxes is removed. In Italy, the government of Prime Minister Mario Monti is on track to remove many implicit burdens created by rules and restrictions in a number of markets, which is good policy.
It is understandable that there will be resistance and protests because being cut from the government payroll will seem punitive to those who are affected. Even though standard national income accounting tells us that GDP declines when government is pruned, it shouldn’t obscure the overall benefit to the economy of such measures.
Myth No. 3: ECB President Mario Draghi masterfully avoided disaster in Europe by providing cheap credit to banks in December, a move that, in turn, encouraged them to hold the debt of their governments.
One element of this operation was truly praiseworthy: the emphasis on stabilizing the financial system and ensuring that credit markets kept functioning.
Indeed, providing credit to the banks rather than purchasing government debt outright is a better strategy for the ECB. But why encourage the banks to use that cash to buy government debt, rather than using it for a useful activity such as giving loans to productive private enterprises or to consumers?
It would have been far better to provide cheap liquidity to the banks while encouraging them to get rid of their government debt. Suppose, for example, that all Greek banks had shed their holdings in their country’s debt. That would mean that even if the government were to default on its obligations, the banking system would be largely untouched and depositors would be safe.
There is a sinister logic at work here: If Italian banks hold Italian debt, then it becomes very dangerous for the government to default because such an event would bring down the banking system and Italian depositors would lose their shirts. In other words, compelling national banks to hold national debt is intended to create fragility in the national banking system. That, in turn, keeps the political costs of a default high (and, hopefully, yields low).
The biggest danger is that there could come a time when the Italian government isn’t as determined as it is now to bring order to its fiscal house. Then, it will be the ECB, and therefore the rest of Europe, that will pick up the bill as the debt loses value. This isn’t a deal that the rest of Europe has agreed to and isn’t part of the ECB’s mandate.
The debt crisis in Europe is, above all, a political problem. Italy wouldn’t collapse if it is required to pay a few extra percentage points of interest on its debt. If that had been made clear to the markets from the beginning -- and if the government had put in place a credible fiscal plan -- the crisis might well be over.
It’s not too late to change course. If political leaders show they are committed to the same repayment plan -- regardless of whether it is their country’s banks holding the debt or someone else -- the euro area’s financial system, banks and currency, as well as the ECB would be secured.
If, however, Europe continues to head down the same path, the current respite might be short-lived.
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