Danske on Eurozone Debt – The Peril of Internal Devaluations

This is really a follow-up to the earlier piece I wrote on my own blog today and my last piece on Eurozone imbalances and internal devaluation. In particular, I want to point you towards two things.

Firstly, Edward has, no doubt after a long hard thought, come to the conclusion that Greece should be sent to the IMF or rather that it is ok to ask the fund for help in order credibly sort out the mess in Greece (and possibly Spain). This is not news as such since the proposition of sending ailing Eurozone countries to the IMF has been on the table for a while now. The main question basically is, as it has always been, whether the program proposed by Greece in conjunction with the EU and set in relation to what ever we might have left of the stability and growth pact (SGP) is really credible as a working solution.

Meanwhile, Danske Bank had a very interesting research note out today on the sovereign situation in the Eurozone and the potential for correcting not only in the immediate short term (i.e. preventing a collapse), but more importantly how to get debt to GDP ratios back on a solid footing within, let us say, a decade or so. As it turns out this is very difficult.

These are challenging times for public finances across Europe. Reducing debt to the Stability and Growth pact’s upper limit of 60% of GDP will not happen any time soon for most euro area member states. Indeed, even 100% of GDP appears an immense task for several countries. The situation is most dire in Greece and Ireland, which are to be found in the fast track lane for default in our mechanical “no change scenario”. However, it is still not too late to avoid default. If the plans put forward by Greece and Ireland are strictly adhered to, it would stop the debt-to-GDP ratio from sky-rocketing.

Now, Danske Bank’s argument is based on some simple algebra of the government’s budget constraint and some equally simple, one would presume, arithmetic. Basically, the gist is as follows and for all the attacks on Neo-Classical economics accounting, this argument is actually pretty solid.

Therefore, high nominal GDP growth and low interest rates on sovereign debt allow a country a larger deficit-to-debt multiple without increasing the debt-to-GDP ratio. A country with nominal growth lower than the interest rate level will on the other hand have to run primary surpluses in order to keep the debt-to-GDP ratio steady.

This is an important point to take away. Basically, it means that if you can maintain a high level of nominal growth (and what ever amount of primary deficit you run (in principle!)) the debt-to-GDP ratio can be kept in check. Well, we need to entertain this possibility a lot here I think and simply note that this is not likely to be relevant for many of the Eurozone economies going forward.

This goes especially for those who are in the biggest trouble right these very days. In fact, the whole rigamole begins by taking to heart chart 4 and 5 in Danske’s research note which shows that while Eurozone economies, in a pre crisis context, enjoyed high GDP growth (nominal) and low funding costs it is expected to be the exact opposite going forward.

This represents a gordian knot since it means that not withstanding the extremely tough austerity that Greece, Ireland and Spain (etc) now need to take in order to get the ship back into the wind through forced primary deficits, they cannot be sure that this in itself will bring the debt to GDP back on track. Much will of course depend on global yields here and the general discourse on fiscal adjustment and how sovereign risk (rising across the board) will quantitatively be reflected in bond yields.

Yet, I don’t want to focus so much on bond yields here (although I do think they are important); rather I would like to focus on the other part of the equation as it were, namely that of nominal GDP. You see, this is where it not only gets complicated but also outright problematic.

Consequently and since Greece, Spain, and Ireland are members of the Eurozone, the have no independent currency and thus the nominal exchange correction that would almost certainly had occured had these economies had a floating exhange rates now must occur through internal devaluation or outright price deflation.

So this is not only about public debt but also about net external borrowing which these economies now have to shed in order to become competitive and essentially in order to achieve growth in nominal GDP. However, in order to reach this point they need a large and severe bout of deflation exactly, one would imagine, brought about in part by running primary surpluses to simply shock-force the economy onto a more sustainable path. Notwithstanding the obvious cost on the employment from this process it has another very tangible costs. Price deflation thus, through its effect on nominal GDP, increases the real value of the debt and it is exactly this mechanism and how it intersects with the perspective offered by Danske Bank which is so damn important to understand here. And incidentally, as an aside, it is this point which Edward has been desperately trying to pass on during the past two month’s worth of writing (see overview from link above).

PS1: I am lining up a paper on Eurozone imbalances (quantifying them essentially) which will also tackle the issues mentioned above in some detail.

PS2: Danske Bank’s piece is worth reading in its entirety.

10 thoughts on “Danske on Eurozone Debt – The Peril of Internal Devaluations

  1. Excellent comments Claus, thank you.
    In the case of Greece one of my brainy colleagues pointed out, that seeing as Greece changed their public deficit forecast for 2009 from 5-6% to 13%, is it possible that they have overstated growth as well? It certainly seems strange that Greece has enjoyed the weakest contraction in Europe, while shipping and tourism, two of the biggest drivers of growth in Greece, have been faltering badly. One explanation could be the massive rise in public expenditure in the last few years, but this will come to a schreeching halt now, so their GDP will most likely plummet, even if it hasn’t been overstated already. There is also the small issue of archaic accounting principles, whereby they don’t count expenditure before they have actually paid the money. This includes the famous three submarines built by Thyssen-Krupp, their 5 bio. EUR debt to the German pharmatheutical industry etc.. I believe this adds another 7-10% to their debt when counted, so all in all haven’t they already passed the point, where they are unable to help themselves ?


  2. The low quality of Danske Research is not surprising; most of forecasts for Baltic have proved to be wrong.

    However, the official Bruxelles voices „Ireland good, Greece bad” are also lacking any real background – why the debt driven implosion in Ireland is better than the debt explosion in Greece? Why there must be any reason that the sinking of the Irish economy into gigantic empty hole left after real estate bubble burst, losing of 200% of national GDP to vacuum NAMA scheme, must be something more advantageous as overexpenditure in Greece? Exactly the opposite is true, because the Greek debt has transformed into submarines, chemicals etc. real goods, whereas the Irish NAMA is a typical Torricelli-named substance. In the worst case scenario Greece can use their submarines to get claim the Smyrna back, whereas Ireland can use the NAMA for nothing.

  3. Welcome to the world of inflationary dilution, or delution. This paper looks a bit like a case of mathematical models gone mad. The key issue being that y and i are not unrelated. Try running a high nominal gdp growth without a high real gdp growth and you will see that interest rate go up. And if you can run a high real gdo growth, then you are very lucky indeed and might dilute the debt by creating real wealth. However this is the classic inflationary tax. You tax the people by devaluing their currency in real terms and therefore diluting the debt. By all accounts it will eventually be a part of the solution to this mess for a most countries. The question in the eurozone is how to do it for individual countries when they do not control the currency. And today the problems is that the different countries are going on at different speeds, a problem the Edward has been writing about (I.e. France vs Spain in a recent post of his).
    So very tricky stuff, handle with care.

  4. Pingback: The Theory Strikes Back | afoe | A Fistful of Euros | European Opinion

  5. Hi all,

    Thanks for the comments.

    “is it possible that they have overstated growth as well?”

    You bet, clearly from reading Danske’s research piece you will see that the incumbent governments’ projections of how to get out this assumes growth rates which, to a large extent, are bogus so in this sense they are simply pushing the problems ahead.

    @govs from Latvia

    Point taken, but this is also about market perception and also ultimately demographics. Ireland has a better scorecard here so far.

    “The question in the eurozone is how to do it for individual countries when they do not control the currency. And today the problems is that the different countries are going on at different speeds, a problem the Edward has been writing about (I.e. France vs Spain in a recent post of his).
    So very tricky stuff, handle with care.”

    Definitely, this is all very complicated especially since fiscal policy can really only work in one direction now; i.e. as a tool of contraction and this will hurt a lot.


  6. Countries could go to the IMF, but would the EU then allow the countries to follow IMF recommendations?

    Documented here earlier is the case of Latvia. Originally the IMF wanted either to fast track Latvia into the Euro – to stabilise both sides of the balance sheet – or the removal of the currency peg.

    The EU wasn’t having either, leading to Latvia’s internal deflation. Latvia seems a good example of what is described here. Only the value of the external debt is increasing, beyond any ability to repay it.

  7. @petersblurb

    There is one big “error” in reasoning about Latvia.

    Latvia did not have a debt crisis at the end of 2008. The gross sovereign debt of Latvia was 19,5% at that moment. Latvia has only 2 Open market bond issues which mature in 2014 and 2018 respectively.

    Latvia was unhappy enough to get a very severe banking crisis at the end of 2008, with the sudden collapse of politically engaged PAREX bank. At this moment EU pressured to bailout this bank, because it was also engaged abroad. The bank bailout has credit immediate budget deficit of magnitude 5% of GDP in just 2 weeks. This was the reason for the IMF+EU program, and EU has defined conditions for this program, which means – unlimited bank bailouts on the costs of taxpayers, and keeping the currency peg. As it is now visible from ICESAVE, Alpe-Adrie etc. cases, EU has not changed the bailout policy, even as there is no economic reason for that anymore.

  8. Quote: EU has defined conditions for this program, which means – unlimited bank bailouts on the costs of taxpayers, and keeping the currency peg.

    Well, the further peril of internal devaluation. When you cut salaries (as much as in half in Latvia), you also cut the tax take and send zillions running off into the black economy. Meanwhile, the cost of supporting the currency peg rises in proportion. When everyone is on the breadline, maybe they’ll realise it isn’t working.

  9. It is NOT working, indeed

    Regarding the internal devaluation it is just policy how to postpone the inevitable. First, this internal devaluation is absolutely missing its objective, because producer prices do not decrease. Because the devaluation of wages, which is indeed real, is not enough. They are overruled with increases in payments for capital and enormous increases in indirect costs. Some prices, for instance, for local transportation, increased in 2010 for 25%. A gigantic price increase is expected to occur in spring. The only summary effect is a catastrophic decrease of consumption and abnormal unemployment.

    In reality nobody here in Latvia believes in a positive outcome of this process, everybody expects a crash soon or later. Only the stalemate situation is so extreme that nobody seems alternatives. Officially everybody is praising the Emperor’s New Clothes.

    Even when everybody will be on the breadline the peg can be kept, because there will be just no pressure on the lat. But the bailouts and debt repayment will be not feasible very soon.

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