Italian Prime Minister Silvio Berlusconi (R) speaks with Economy Minister Giulio Tremonti during a news conference at the Chigi palace on August 5, 2011 during which he announced Italy will speed up a package of austerity measures approved last month.VINCENZO PINTO
With an extraordinary G7 summit looming on the immediate agenda, let's put the policymakers' options for resolving the crisis to the test.
The ongoing slowdown in economic growth is underpinned by the same force that drove the global recession of 2008-2009 – excessive leverage still carried by the households and companies. Debt costs are rising due to expanding risk premia and funding costs increases. For example, average annual Euribor – a benchmark for many mortgages in the Euro area – have risen between 25.3% and 65.1% since last year. Exacerbating this, many governments have shifted financial sector debts onto the real economy, compounding household debt problems with expected future and ongoing tax hikes.
Based on the IMF optimistic projections, real GDP in the advanced economies is expected to grow at an average rate of 2.5% in 2011-2016 – below 2.9% achieved in the last economic expansion of 2003-2007. Meanwhile, government spending as percentage of the total economy will rise from an average of 39% in 2000-2007 to 42% in 2011-2016.
Secondly, there is a belated realization on behalf of the global investors that years of excessive government and current account deficits have left many advanced economies with the sovereign debt burdens well above the historical sustainability limit of ca 80% of GDP. Again, per IMF data, public debt to GDP ratio stood at 98.7% in 2010 and is expected to reach over 106% by 2014-2015. In the period of 2000-2007, advanced economies average current account deficits were running at almost 1% of GDP annually. For G7 this figure was over 1.5%.
Some 18 months into the European, and now global, sovereign debt crisis, the policymakers are now faced with an impossible choice.
Monetary policy, deployed aggressively to repair balancesheets of financial institutions in the US, Europe and Japan has created a vast liquidity trap. In Euro area alone, financial sector capital and reserves ratio to money in circulation had risen from 229% in 2007 to 254% in 2011 to-date. Real liquidity and credit supply are still scarce, while funds absorbed by the financial institutions over the last three years threaten to unleash an inflationary firestorm. Sterilizing these funds will require hiking interest rates to the levels unseen since 2000-2001, thus derailing any future growth.
Fiscal policy tools are not feasible at this stage in the crisis, as any stimulus will result in a cancellation of the sovereign debt reduction measures. Monetizing public debt through bonds purchases will also be ineffective as the means for stimulating real growth, since much of the funds will flow out of the advanced economies into higher yielding emerging markets and commodities.
This leaves the G7 governments with only one option to resolve the crisis: selective defaults on public and banking debts, selective monetizations of public debt with cancellation of monetized bonds, and injections of cash to write down significant portions of household debts. The amount of firepower these measures will require is awe-inspiring. In the Euro area alone, reaching sustainability bounds on public debt and repairing household finances will consume ca €2.5-3.5 trillion in cash over the next 5 years – roughly 6-8 times the size of the current European Financial Stabilization Fund.
Worse than that – such a solution also calls for European, US and Japanese leaders abandoning their corporatist model of governance that saw wholesale destruction of the real economies in the name of preserving their clientele – from banks to industrial National Champions and their trade unions.
In summary, then, G7 options currently range between continuing with ineffective policies that will keep their economies spiralling into the depression and administering the medicine that risks destabilizing the prevalent political order of corporatism.
Dr Constantin Gurdgiev is Head of Research with St Columbanus IA and the adjunct lecturer in finance with Trinity College, Dublin.