EuroZone 2.0 Rather than bore you this week with the details of the most recent EU rescue flare, let’s take a look back at the bigger picture. After a 30-year global credit binge, credit is no longer flowing to the irresponsible or over-indebted. Based upon the rules defined in the Maastricht Treaty, entrants into the euro must have a debt-to-GDP ratio below 60 percent and budget deficits below 3 percent of GDP.
Currently across the entire EuroZone, government debt-to-GDP runs 85 percent on average and deficits run 6 percent on average. Granted, we live in unusual times, but the terms in the Maastricht Treaty proved more like guidelines than rules with Germany among the early violators. Without any enforcement mechanisms in place, there are few disincentives for non-compliance. That is the core problem.
So now Germany, as the top EuroZoner, is trying to re-write the Maastricht Treaty to add automatic enforcement mechanisms and/or an oversight board that must approve frugal EuroZone annual budgets. After many hours of politicking, the EuroZoners released a seven-page agreement Friday outlining the new “club” policies. Twenty six of 27 EU members blessed the deal, with Britain the only European Union dissenter. Conjoiners agreed to intercession by the European Court of Justice if budgets fall out of line and violate strict structural (not economic cycle-related) deficit targets.
This amounts to some loss of national sovereignty, I suppose, but so does the law that says I must wear my seatbelt. I might not like that beeping sound my car makes, or the ticket I might receive for not buckling up, but compliance might save my life. Overall, the agreement reached today sets the tone for more accountability and enforceability within the EU.
But … While newfound fiscal discipline is encouraging, old debt levels must recede. In the private sector, when a company’s debts swamp earnings power or assets, they file bankruptcy (see American Airlines). In the public sector, there are other options:
1) Grow your GDP faster than your debt.
2) Default and write the debt off.
3) Inflate the debt away and devalue your currency.
4) Pay savers negative inflation adjusted yields – financial repression.
5) Enter into a depression that deflates labor and goods prices – essentially an economic yard sale.
Typically, governments default, devalue or inflate. Iceland defaulted, the U.K. is inflating, the U.S. is devaluing and repressing. Rarely do governments volunteer for option 5 although Germany seems contemplative. However, when Spanish and Italian yields drift into crisis territory above 7 percent, purchases and proclamations pull them lower. When they drift near 5 percent into “enabler” territory, purchases and proclamations slow.
By keeping the pressure on but the crisis at bay, Germany/ECB maintains the marketplace anxiety necessary for fiscal reforms without inciting mayhem and defaults. It’s a delicate dance. With option No. 5 equating to choosing medicine that kills you and then revives you, we believe the German/ECB bark is worse than its bite. Expect pressure to bring deflationary reforms followed by more traditional inflationary measures.
David Waddell, who is regularly featured in the Wall Street Journal, USA Today and Forbes, as well as on Fox Business News and CNBC, is president and CEO of Memphis-based Waddell & Associates.