The debt levels of advanced economies remains unsustainably high - bringing with it the considerable risk of renewed crisis - and while strong growth is the best way to deleverage, this solution appears out of reach for most (if not all) economies. Financial repression, austerity, inflation, or default are the remaining options - all of which come with considerable costs to economic growth and employment. While 'muddling-through' appears to be heralded as a positive by many market-savants currently, SocGen notes that the line between a virtuous (expansionary fiscal contraction) and vicious austerity trap comes down largely to policy confidence. Most (if not all) advanced economy politicians entirely lack the public's or market's confidence in credible policy direction (and in fact we are seeing policy uncertainty at extremes) which leads to SocGen's conclusion that the muddle-through strategy (which comes with a high price tag economically and socially) is too high a burden politically and will inevitably lead to spillover to core-Europe and the global financial system.
Austerity: Short-term, we are Keynesians
Securing a credible path for future public finances comes with many positives for economic growth. Ricardian equivalence suggests that economic agents “internalise” the governments’ inter-temporal budget constraints. As such whether governments fund expenditure via tax hikes or debt should be neutral as consumers would respond to the latter by increasing savings in anticipation of future tax hikes. This is also the theory behind the idea of “expansionary fiscal contraction”, which suggests that by reducing expectations for future potentially distorting tax hikes and lowering interest rate risk premia, fiscal austerity today can thus encourage private consumption and investment. As the latter is generally seen as more conductive to economic growth than public spending, overall GDP should thus be boosted by austerity. This is very much the philosophy behind the “German Diet” of fiscal austerity, structural reform and wage restraint.
However, this contrasts with what has been observed in the euro area to date; namely that fiscal austerity (at least in the short term) has been dominated by Keynesian effects, i.e. austerity comes at a cost to GDP growth. As a rule of thumb, the IMF (WEO, October 2010) finds that past fiscal consolidation has exerted a multiplier effect of 0.5, i.e. 1% of GDP of fiscal austerity results within two years in a negative short-term drag on GDP of 0.5pp, raises the unemployment rate by 0.3pp and lowers domestic demand (consumption and investment) by 1pp. Recent experience, however, suggests that the drag from austerity – notably in the fiscally weaker euro area member states – may be much higher.
Several factors may explain this, including impaired monetary policy transmission, tighter financial sector regulation, external sector adjustments, large output gaps, the composition of consolidation (the how of fiscal austerity), and critically social unrest.
What’s the cost?
“Some debts are fun when you are acquiring them, but none are fun when you set about retiring them”. Ogden Nash
The many facets of debt deleveraging make its analysis a complex exercise. With the aim to further our understanding of deleveraging, SocGen built the SG 3D (Debt Deleveraging Dynamics) model. To our knowledge, it is the first of its kind exploring deleveraging across all sectors of the economies driven by a set of “policy confidence variables” at the core of the model. As with any model, it has limitations but the results are powerful in clearly illustrating that the muddle-through strategy comes with a very high price tag and is thus unlikely to be sustainable for the long run. It is critical that results are delivered soon so that a scenario of “confidence” can kick in.
Three deleveraging scenarios 2011-2030
To estimate the cost of deleveraging, we run three scenarios over the period 2011-2030 in the SG 3D model (1) confidence, (2) muddle-through and (3) no confidence. In the “no confidence” scenario, euro break-up risk would increase substantially.
- Muddle-through: It will take time to see that the policy strategy of structural reform and austerity in the euro area can (ultimately) work and that this will happen only as successes become visible in places like Portugal and Ireland. In the US, deleveraging Federal debt will remain something of a bumpy ride. The US and the UK, notably, will continue to enjoy the benefits of QE in terms of financial repression and thus lowering “snowball” effects. In muddle-through, interest rate risk premia (positive or negative) will converge only very slowly to long-term equilibrium. Interest rate multipliers are assumed to only improve slowly as banking sector repair gets underway.
- Confidence: Boosted by credible policy, and notably by a fast-tracking of reforms to build a credible banking and fiscal union in the euro area, interest rate risk premia decline sharply, lowering the necessary fiscal adjustment. Trend potential growth is boosted by fast-track structural reform and the interest rate multiplier returns to normal working order as credit channels again become fully functional. Looking at the current Stability and Growth Pact programs, this scenario rather than a muddle-through appears to be closer to what many of the governments have assumed in their forecasts. In our opinion, however, this scenario is unlikely to materialise anytime soon unless there is a sharp and accelerated shift towards more credible polices; something that seems unlikely near-term.
- No confidence: In many ways, this scenario describes the current path with high and growing interest rate risk premia on the European peripherals slowly spilling over to the core markets as confidence is lost in the muddle-through scenario. The economic pain in the European periphery that would result from attempting to target deleveraging under this scenario would be politically unfeasible and, as a result, default would follow. As indicated above, our aim is not to model euro area break-up per se, but in this “no confidence” scenario, it seems reasonable to expect a number of countries would be forced to exit.
The results from the three simulations in terms of GDP growth per capita are summarized in chart 3.1 below. We caution that these results are not intended as forecasts, but as an analysis of the burden of deleveraging in terms of economic growth.
A first positive observation is that under a credible policy framework, returning the advanced economies to healthy levels of per capita GDP growth is easily within reach. For the European economies, in particular, however, this requires achieving structural reforms. The reward comes with both lower interest rate premia and higher growth rates. A confidence scenario would see the crisis quickly behind us and interestingly is in many ways the outcome suggested by history (usually with some muddle-through initially).
Imagining a very bleak scenario of two decades with little, none, or even negative GDP growth does not require much of a stretch of the model variables. For the European periphery, it just requires that current conditions persist medium-term, then spillover to core-Europe and the global financial system. This should serve as a strong warning of the need to act now to prevent such an outcome from materializing. Indeed, while the current muddle-through is survivable for now, it is not sustainable medium-term - since the chart below shows the impact of the 'required' structural reforms which would provide the confidence the market needs...
In the no confidence scenario, the austerity trap hits with full force. Under this scenario, the burden of deleveraging in the European periphery becomes so intense that there is no option but to default, which carries its own cost. The no confidence scenario also sees default in Japan; here, however, the default is primarily “internal”. In an aging population, this would be painful, seeing large chucks of savings wiped out.
While inflation is present in this first version of the SG 3D model, we have opted not to run an inflation scenario as this would also merit the inclusion of a model of exchange rates, a development we plan for the second edition. The mechanics of an inflation scenario have many similarities to a painful adjustment coming with many of the features of an austerity trap. Seniorage is in many ways just an alternative means of defaulting.
Critically then, without policy confidence 'muddle-through' will keep leaking back to unsustainable crises; and with the burden of the required structural reforms (given even aggressive growth expectations) policy-makers are highly unlikely to gain and keep the public's confidence in order to jump the chasm from Austerity Trap to expansionary fiscal contraction.
Source: Societe Generale