Jean-Claude Trichet's Folly
On Friday, ECB President Trichet gave a speech addressing Europe's debt and deficit challenges, but his analysis was incomplete.
Lost amidst the attention surrounding Ben Bernanke's speech at Jackson Hole, Wyoming, on Friday was ECB President Jean-Claude Trichet's speech addressing the challenge Europe faces with regards to its debt and deficit problems. He mentioned three possible solutions to the debt overhang (he immediately ruled out a likely solution: repudiation):
1. Inflation -- disastrous consequences, destroys confidence in the credibility of central bankers.
2. Living with the debt -- in a word, "Japan."
3. Growing out of the debt -- the preferred solution.
Trichet points out that the latter solution has worked quite well in the past, even in Europe's recent history:
"Given the size of the accumulated public debt, fiscal consolidation will have to be ambitious. In the euro area, to reach the reference value of a debt-to-GDP ratio of 60%, a cumulative drop of almost 30 percentage points will be needed. Such reductions are not uncommon. Beside the post-war UK experience, sizeable debt consolidations have been implemented in Belgium, which over a period of 14 years from 1994 to 2007 reduced its ratio from 134% to 84%; in Ireland, which reduced its debt ratio over a 13-year period starting in 1994 by 69 percentage points; and, starting in the mid-1990s, in Spain, the Netherlands and Finland, which saw their debt-to-GDP ratios drop in the range of 20 to 30 percentage points."
Trichet's analysis is incomplete. All of the countries he cited managed to reduce their debt/GDP burdens between the mid '90s and 2007. During this time period, total public and private debt to GDP in the US rose by over 100%, from 230% to 335%. US nominal GDP growth averaged over 5% per annum, and eurozone GDP growth averaged over 4%. The S&P 500 and Eurostoxx indices more than tripled. Home prices increased. Booming economies, a surge in private-sector borrowing, strong asset markets, moderate inflation rates, and a stable social mood made fiscal consolidation a much easier task for determined governments.
Today, all of these trends have reversed. Private sector debt is contracting in the US and Europe. GDP growth rates have fallen. Equity and home prices appear to be rocky for the foreseeable future. Core inflation is zero. Social mood has turned decidedly negative. Even worse, for the European countries in most dire need of fiscal consolidation, their borrowing costs have risen far in excess of their nominal growth rates.
As the chart below shows, borrowing costs for Greece and Ireland now far exceed their countries' nominal GDP growth rates -- the charts are simply year over year (YoY) nominal GDP growth minus the countries' two-year government yields.
Click to enlarge
Greece debt/GDP is currently 115%, and the country is running annual deficits to GDP in excess of 10%. Nominal GDP has been flat in Greece for two years -- the country is getting no help from either inflation or growth. For Greece to lower its debt/GDP ratio, it would have to start running surpluses and hope that somehow GDP stays flat. To think about how big of an austerity punch that would be, imagine the US cutting social security and defense spending to zero -- that's how much it will take.
The economies of Greece and Ireland, and hence the bond markets in Spain and Italy, and therefore the European banking system, and ultimately global capital markets are depending on Jean-Claude Trichet to be right. It's only a matter of time until sovereign debt markets tell Trichet that he's not.
As Mr. Practical likes to say, risk is high.
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