Pork, Sushi, Pie?

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I was naive about the Irish bailout – I figured the issue was fear of haircuts, and that the structure of the Irish bailout would assuage markets, at least until it became clear that the Irish could not, or would not pay.

Last night, the market turned the torch on Spain and Italy … why these two?  What they have in common is that they are uncompetitive rigid economies that need to run large current account surpluses to regain macro-balance.

A little bit of boring background here

Recall                                                                    Y = C + I + G + (X – M)

And                                                                        Y = C + S + T

This says that total spending in the economy is equal to the sum off Consumption, Investment, Government and net exports (eXports less iMports); and that we can divide our income between Consumption, Savings and Taxes.

So                                                                           Y = C + I + G + (X – M) = C + S + T

Cancelling                                                            I + G + (X – M) = S + T

Rearranging                                                         (X – M) = (S-I) + (T-G)

Which in words says: the difference between exports and imports is equal to the sum of the net- private sector position (the difference between savings and investment) and the government’s position (the difference between tax collections and government spending).

It follows that if you want simultaneous private sector and public sector deleveraging – which is certainly required in Spain – you need to sell more than you buy. To do this on a sustained basis, you have to be competitive. What the PIIGS all have in common is that they are not competitive. This is a problem, as all owe the rest of the world lots of money (they accumulated large debts to the rest of the world during the  bubble –>> -ve net IIP).

Practically speaking, most economies have a strong home team bias, so if a contraction is sufficiently large, you’ll get a surplus because imports fall by more than exports. You can then use that money to pay back the foreigners.

A massive recession will probably also make wages &c fall, and aid the process of making an economy more competitive – but it’s a slow and painful process, and it’s not clear that it’s socially tolerable to have 20% unemployment for long periods (do you want a job or more convenient shopping when you summer?).

Spain was the obvious target: they have naughty banks, a deflating property bubble, an over-leveraged household sector, an over-leveraged corporate sector, and though the government was formerly in good shape on current metrics they are deep in Ponzi territory (below the 45′ line is Ponzi: Spain will be further below the line as they have moved right due to the increase in rates).

While debt to GDP is a moderate ~65%, their budget deficit is 9.3% of GDP for 2010 – about 7ppts of which is structural. Forecasts are for that deficit to be ~6.4% in 2011 and ~5.5% in 2012, which will take them to just under ~75% of GDP in 2012 (allowing for some growth); ongoing gradual recovery is expected to take the ratio to ~85% of GDP by 2015.

Total debt to GDP will be middling – so long as there are no financial blowups. That means that there must not be an ‘Irish event’ in the Spanish property sector.

I’d feel a lot more comportable about this risk is Spanish house prices had fallen further. As you can see from the above chart, Spanish house prices have hardly adjusted relative to Irish house prices – if this is hope beating reality, there’s much more pain to come for the banks and hence the Sovereign.

The Spanish Government has a manageble, though difficult task ahead of it; but continued losses on property loans threaten to break the households and banks, which will ultimately break the Sovereign … just as it did in Ireland.

If households and the private sector simultaneously de-lever, the economy will collapse. The only socially and politically sustainable way out is via net exports – which means an internal devaluation, as Spain is presently uncompetitive. 20% unemployment is a start – now we just need wages and prices to fall…

Italy is also are uncompetitive, but less exposed to a financial shocks. The household sector isn’t so much of a problem, but the government is in an unsustainable position. However, this is an accounting trick – the household sector is an unsecured creditor, and they aren’t going to get the age related spending they expected;  the government will ‘default’ on these promises.

To be made whole, the household sector will have to save more. At the same time, the Government needs to spend less and save more. This means Italy needs to run some trade surpluses (to export more than she imports) – but this is difficult as she is uncompetitive.

Of course, the Italian State is in denial. No one is talking about this impossibility.

Perhaps the Germans will pay?

With the German taxpayer’s representatives blinking at every crisis, the smart thing to do for an Italian politician is to run right at the rocks and wait until the market forces a crisis. This will give Italian politicians political cover (it was Ms. Merkel / Mr. Market) when cuts are required – and there’s at least a decent chance that the Germans pay some of the tab.

Perhaps the Italians will even secure the ultimate prize – a single EUR bond. The permanent saddle on the German taxpayer’s back.

Incidentally, take a look at these two charts and notice who else is near the Ponzi PIIGS. The above chart shows the OECD’s estimate of the tightening (as a ppt of GDP) required to stabilise debt to GDP by 2025. The below chart show’s an IMF estimate of the fiscal adjustment presently required against the scale of looming age related spending.

The entre was pork – the main will be sushi; and apple pie is for dessert.


  1. You’re a great writer. Loved reading this. Very good explanation for us non economists at beginning.

    Re net exports – couldn’t that be also a result of having little to no natural resources? Is it norway that has lots of oil? They’re probably a bit more productive than the PIIGS mind you.

    Simon Johnson had article on Baseline Scenario (which I haven’t read yet) about how the market is forcing the fiscal adjustments forward (I think):

  2. Oh the other thing is that knowing a little about Germany, they won’t suck it much as it stands. They don’t need the euro much or if they do they’ll reform it after these uncompetitive basket cases exit and devalue.

    That’s my guess. What happens to the € after that I don’t know.

    1. Yeah I don’t think that’s politically palatable. I can see how the PIIGS would want to leach of Germany, but death by thousand cuts doesn’t work in Germany. You need some big mama cuts. I could very well be wrong and misread Germans. I see that PIIGS are going to need to devalue more than they need to suck up some more Deutschmarks. From your post this would help slot wouldn’t it? Their fx adj would help stabilise out their imbalance. Might be short term painful but better than being Germany’s slave. The Irish people already going that way.

  3. Why would the Irish bailout assuage markets? It has been clear from the moment the southern PIIGS were first embroiled in their debt mess and subsequent embrace of austerity that the Euro was going to be seriously threatened as the flawed design it was 11yrs ago. Austerity is killing these economies because, as you correctly point out, they don’t have access to a trade surplus to match the scale of deleveraging under way in these countries. They need a Euro at 80 or something, not (the still overvalued) 130. They never had policy sovereignty (that countries such as Australia, US, Japan, UK etc still enjoy), yet behaved as if they did, allowing their banking system to go bananas. Well they’ve found out the hard way they can’t save themselves from within the Euro straijacket, and it won’t stop at Ireland because there is no circuit breaker. Deficits keep climbing, and without the policy tools to address the exceptional deficiency in aggregate demand, they can’t defend their economies. Instead, they try the internal devaluation which, quite frankly, is just an appalling solution. In Australia, we know how relatively painless an external devaluation can be via the A$, but doing it internally is just a deflationary minefield. So Spain, Portugal, Belgium, ultimately Italy….all roads lead to the Germans. Will they pay you ask? No way. They can’t afford to bail out “Europe”. The sooner they get it, the better, but they clearly want to stall the inevitable implosion of the Euro as long as possible because they know full well the Deutschmark as a standalone currency will go through the roof and murder their economic model.

  4. All very good analysis that points to an obvious policy recommendation that is left unsaid.

    Surely, the euro must go. It would be much easier to restore competitiveness through devaluation rather than deflation.

    Then again I know you have always had an unhealthy attraction to deflation.

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