Addiction to cheap and easy credit must end

THIS week saw a number of developments in the ongoing eurozone crisis, none of them particularly good news for the currency.

First, and quite startling, we saw the emergence of negative yield rates on German short-term bonds. This in effect means that investors will now pay to hold (sure and safe) German bonds rather than lend to other risky assets.

We saw the Italian yield curve invert, where investors seek a higher rate on short-term loans to Italy than they seek for longer term loans. Such an inversion preceded the bailouts of the existing programme countries, and is generally taken as a decent predictor of a looming slump.

Third, we saw a coordinated can kicking, whereby the central banks of the world, persisting in the assumption that this is a liquidity as opposed to a solvency issue, injected massive amounts of cheap money into the world economy.

It is true that Italy, Spain and France all are still raising small amounts on the bond markets, albeit at increased costs. This reflects less a desire by markets to lend to them and more a demand from banks for assets, relatively cheap (recall that as interest rates rise the value of bonds falls) compared to German assets, to swap or repo for liquidity.

Finally, we saw the publication of a gloomy outlook from the ESRI and an even gloomier one from the OECD.

The approach taken by the central banks is treating a symptom. The drying up of liquidity is a symptom of real concerns about the longer-term prospects of these countries repaying their debts. European banks, sovereigns, companies and consumers are heavily indebted. Banks have to ‘deleverage’, shrink their balance sheets, and in doing so force the deleveraging of non-financial companies and individuals.

Similarly, states need to reduce their debt levels. Italy has a debt/gdp ratio of 118%, France 83%, Spain 62% and Germany 84%. Recall that the oft-noted Reinhardt-Rogoff threshold for distress is 80% and we see that even in the core of Europe we have problems. Italy is already paying over 5% of GDP in interest payments, Greece over 6% and Ireland close to 4%. These burdens will keep growing.

In the ESRI analysis, the sustainability of the debt burden, its stabilisation, depends crucially on the economy achieving growth of between 2.5% and 4.5% in the 2012-5 period, set against projected flat lining for this year and next. Yet growth in Europe in general and Ireland in particular is predicated on sustained export growth. It is evident that any export growth will involve exports to Asia and BRICS, nations where we have muted penetration.

Europe is in many ways like a heroin addict. We have become addicted to cheap, easy credit. Credit is an absolute essential part of the modern economy. Over reliance however causes problems. The hard task for European politicians is how to wean the sectors off cheap credit without a collapse. In that way liquidity is similar to methadone — it can act as bridging element while a longer term solution is generated.

The longer solution must involve three elements: growth, which is important for Iberian countries with their dangerously high levels of youth unemployment; modern administration which means in the case of Greece and Italy that tax compliance is enforced; a proper fiscal union which is not simply ceding to an unelected and unresponsive central power the ability to raise debt and disburse but which involves automatic stabilisers. In the US, a major automatic stabiliser is internal migration.

If there is a recession in Kansas people move. Ireland has experience of this, via mass migration, and it is neither a likely nor desirable nor feasible solution for Europe as a whole. Thus any fiscal union needs to be culturally bounded by the diverse political cultures of Europe, be democratically controlled, and be effective. It is very debatable if that can be created by December 9, this month’s final drop dead deadline.

What will not work is a hodgepodge of measures designed to remove the immediate liquidity crisis without dealing with the long-term solvency; a series of measures that move democracy even further at a remove from the technocratic governments we have seen installed; a one size — German — fits all policy on fiscal austerity; nor a policy that treats symptoms not causes.

Europe needs to move from credit-led to economic led growth, and any policy that does not deliver same will not work.

Brian M Lucey is professor of finance, School of Business Studies, Trinity College Dublin

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