Friday 26 April 2019

We're in real danger of a double-dip recession

The markets have been badly spooked as policymakers in Europe and the US play catch-up, writes Colm McCarthy

The likelihood of a worldwide double-dip recession has increased markedly, with markets perceiving an absence of firm policy leadership in the US, as well as in Europe. The European leaders' most recent attempt, at the Brussels summit on July 21, to address the eurozone banking and sovereign-debt crises began to unravel through the week. While the turmoil in the Spanish and Italian bond markets grabbed the headlines, the freezing of interbank credit is just as threatening.

European banks are unwilling to lend to one another, uncertain as to where the losses on sovereign debt and credit derivatives are located and unnerved by the collapse in bank share prices. The atmosphere in Europe is eerily reminiscent of the summer of 2008 in the US as the interbank credit famine intensified.

There are several reasons for the sharp deterioration of the last few weeks. First and foremost, the decisions at the Brussels summit have unfortunately proven to be inadequate. While an immediate disorderly default in Greece has been averted, contagion to Spain and Italy has not. Should these two countries find themselves unable to borrow (if one goes under, they both will), the funds needed to rescue them are simply not available to the EU institutions, the International Monetary Fund or both combined.

The lesson is that buying time through half-measures ultimately proves more expensive than biting the bullet with decisive early action. The first European rescue, for Greece in May 2010, was too limited and Europe has been playing catch-up for over a year.

Since the recent Brussels deal the macroeconomic news has been mainly negative and forecasts of economic growth have been revised downwards. Poorer growth prospects mean that governments will find it harder to sustain tax revenues and hence to meet targets for reducing budget deficits. No decisive action was taken at the Brussels summit to support the Spanish and Italian bond markets and both countries now face 10-year borrowing costs over 6 per cent.

Many analysts believe that countries facing low growth and low inflation cannot afford rates as high as 6 per cent and that heavy debt burdens cannot be sustained at these levels.

As a result, these two countries could, it is feared, be forced out of the debt markets to follow Greece, Ireland and Portugal into the arms of the official lenders. Spain and Italy must borrow continuously on the markets to replace maturing debts and to access fresh finance to fund their budget deficits.

Spain struggled to sell shorter-term bonds during the week but does not face another bond auction until September 1. Italy has cancelled bond sales for both August and September. Neither country faces an immediate liquidity crisis but some form of European policy response is required before the next Spanish auction, which means before the end of August.

There is likely to be a meeting of the G7 (the club of the world's seven largest economies) next week and parallels are being drawn with the international response to the 2008 crisis. Central banks around the world cut interest rates in 2008, expanded liquidity to banks and some governments also relaxed fiscal policy.

The economic downturn would have been steeper in the absence of these measures. This time round, central bank interest rates are already low and cannot be cut again, while relaxations of fiscal policy are not really an option either. Putting the credit of sovereigns behind the banking system is not convincing, unless those sovereigns are seen as creditworthy themselves.

In Europe, the extraordinary gabfest between economic decision-makers continues, with public disagreements last week between EU Commission president Barroso and the German government, as well as a spat between the European Central Bank and the Italian government.

The appearance that nobody is in charge reflects accurately the reality that there has been no European policy consensus since the crisis broke three years ago. Prior to the Brussels meeting, there were almost daily attacks from European leaders on the three main ratings agencies, all of which are based in the US and which have been downgrading European government bonds in recent months. They were accused of anti-European bias and there were fatuous calls for the establishment of a European ratings agency to redress the balance.

Now Standard and Poor's has downgraded the US. This is the first time the US has lost its AAA rating as far back as anyone can remember. The hapless agency has been roundly denounced by the US government for this decision and can now claim to be anti-American, as well as anti-European.

The EU rescue fund created to fund eurozone governments unable to borrow in the markets is too small to handle the burden should Spain and Italy go under. The Brussels summit agreed that the fund could in future be deployed more flexibly but the failure to increase the amount committed was the critical failure.

Last week, the ECB resumed its purchases of Irish and Portuguese bonds, a rather pointless exercise since neither is scheduled to re-enter the markets and both are already in rescue programmes. The priority is to prevent Spain and Italy suffering the same fate but there have been no ECB purchases of bonds from these countries.

In a financial crisis which first afflicts banks, there must be some form of liquidity provision to prevent their collapse. This has come from governments, but the system has now short-circuited and several European governments themselves face market distrust.

A common currency area, it would appear, needs also a lender of last resort to governments, a function which the European Central Bank has been unwilling to undertake. This is the key design flaw in the eurozone, a political project embarked upon in the absence of robust crisis resolution mechanisms. The European political leaders are now tasked with retro-fitting the necessary mechanisms under the most unfavourable conditions.

However, it is worth noting that the aggregate budget deficit for the eurozone as a whole is significantly lower than in either the US or the United Kingdom, two countries which have chosen to relax monetary policy while seeking to stabilise the budgetary position. Europe is better placed to move in a similar direction.

Ireland is necessarily a passive bystander as these events unfold. Clearly, it is in everyone's interests that a renewed and more decisive European policy position emerges quickly. This will now most likely take the form of direct purchases of Italian and Spanish debt by either the ECB or a re-vamped European rescue fund. One way or the other, the stand-off will have to be resolved if a disorderly outcome is to be avoided.

Should the principle of enhanced European support for distressed sovereign borrowers be conceded -- as now appears inevitable -- the Irish Government will need to insist on priority access, to reflect the extraordinary share of bank bailout costs shouldered by the Irish Exchequer.

The two main Irish banks, AIB and Bank of Ireland, have now been recapitalised, after stress tests regarded as more realistic than earlier efforts. They should now be a more secure home for deposits. But they need to shrink their balance sheets further and cut costs. They also need to restore public confidence and resume their role as distributors of credit. The reconstruction of a credible banking system is work in progress.

Ireland's budgetary figures for 2011 appear to be more or less on target, at least as far as July, and there is a reasonable prospect that the out-turn for the year will be as planned. The problem is that the planned budget deficit is one of the largest anywhere and re-entry to the markets is unlikely until serious further progress is made.

The most effective action the Government can take over the next few months is an acceleration of the budgetary adjustment. The new Government has not exhausted its welcome but is in danger of failing to exploit it effectively.

Once the news is out, and it most certainly is, that further expenditure cuts and tax increases are on the way, there is a strong case for getting it over with. Intensified focus on getting the deficit down should also help in persuading the European institutions that the Irish rescue deal of last November should be further improved.

October Budget, anyone?

Colm McCarthy lectures in economics at UCD. He headed an expert group examining State assets and chaired the Special Group on Public Service Numbers and Expenditure Programmes, An Bord Snip Nua.

He also authored the report into the semi-state sector from the Review Group on State Assets and Liabilities.

Sunday Independent

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