Troubles in the Eurozone: Is a Conflict with the U.S. Far Behind?

At its most basic, our economy can be divided up into 3 sectors: there is a private sector that includes both households and firms; there is a government sector that includes both the federal government as well as all levels of state and local governments; and there is a foreign sector that includes imports and exports. As my friend Randy Wray notes: “At the aggregate level, the dollar spending of all three sectors combined must equal the income received by the three sectors combined. Aggregate spending equals aggregate income. But there is no reason why any one sector must spend an amount exactly equal to its income. One sector can run a surplus (spend less than its income) so long as another runs a deficit (spends more than its income). This applies to households, businesses, net saving nations vs. net “dis-saving” nations, and the government sector.”

How does this work in practice? If households attempt to net save by spending less than they are earning, and businesses attempt to net save (reinvesting less than their retained earnings), then nominal incomes and real output are likely to fall. Money incomes and economic activity will tend to contract until private savings preferences are reduced (with essential goods and services taking up a larger share of household income as incomes fall), or until depreciation leaves businesses and households inclined to invest once again in durable assets. Common sense suggests that a drop in private income flows while private debt loads are high is an invitation to debt defaults and widespread insolvencies – that is, unless creditors are generously willing to renegotiate existing debt contracts en masse. Which is why any particular nation in these circumstances must either run an external surplus on its current account, or experience a rising government deficit or some combination of the two.

Of course, given the prevailing levels of government deficit hysteria in the US right now, one can see the political appeal of focusing on export led growth, along Asian lines, since a sufficiently large trade surplus will facilitate the government’s ability to cut spending and run public sector surpluses. The problem of course comes from the fact that it is impossible for all governments (in all nations) to run public surpluses without impairing growth because not all nations can run external surpluses. There has to be another nation willing to become a net importer. For nations running external deficits (the majority), public surpluses have to be associated with private domestic deficits, which is inherently constraining in a way that government deficits are not.

Historically the US private sector has spent less than its income—that is, it has run a surplus, whereas the government has run deficits. From a straight national accounts identity, then, the paradox of private sector thrift is that it is facilitated by public sector profligacy. Or another way of putting it: every time the government runs a deficit and issues a bond, adding to the financial wealth of the private sector.

Of course, the opposite would also be true. Assume we have a balanced foreign sector and that the government runs a surplus—meaning its tax revenues are greater than government spending. By identity this means the private sector is spending more than its income, in other words, it is deficit spending. The deficit spending means it is going into debt, and at the aggregate level it is reducing its net financial wealth. By extension, a country which runs a large trade deficit (as the US has persistently done for the past quarter century), needs an even greater degree of government fiscal expenditure to offset the potential “deficit” spending by the private sector.

Clearly, this financial balances approach is not well understood by most voters. Indeed, a recent poll by Douglas Schoen and Patrick Caddell suggests that the swing voters, who are key to the fate of the Democratic Party, care most about three things: reigniting the economy, reducing the deficit and creating jobs. But the latter two goals are generally incompatible, especially during major recessions. In times of high unemployment, government deficits are required to underwrite growth, given that the private sector shift to non-government surpluses has left a huge spending gap and firms responded to the failing sales by cutting back production. Employment falls and unemployment rises. Then investment growth declines because the pessimism spreads. Before too long you have a recession. Without any discretionary change in fiscal policy (now referred to in the public media as “stimulus packages”) the government balance will head towards and typically into deficit, unless the US miraculously becomes an export powerhouse along emerging Asia lines, and runs persistent current account surpluses, to a degree which allows the governments to run budget surpluses.

This is not going to happen, particularly when the largest current account surplus nations, notably Germany, cling to a mercantilist export led growth model, an inevitable consequence of that country’s aversion to increased government deficit spending. The German government’s reticence to counter any kind of shift in regard to its current account surplus is particularly significant in light of the ongoing and intensifying strains developing in the EMU nations (see here).

Following the inexorable logic of the financial balances approach sketched above, then, I am now more convinced than ever that there is a “Lehman” style event waiting to happen in the euro zone. Last week’s Greek “rescue” is, as we suggested earlier, Europe’s “Bear Stearns event”. The Lehman moment has yet to come. One possible outcome of this could well be significantly larger budget deficits in the US and a substantial increase in America’s external deficit. Let me elaborate below.

In the euro zone, I now see one of two possible outcomes. Scenario 1: the problem of Greece is not contained, and the contagion effect extends to the other “PIIGS” countries, leading to a cascade of defaults and corresponding devaluations as countries exit the EMU. Interestingly enough, the country which could well be affected most adversely in this situation is France, as the country’s industrial base competes largely against countries like Italy and the corresponding competitive devaluation of the Italian currency in the event of a euro zone break-up could well destroy the French economy (by contrast, as a capital goods exporter with few euro zone competitors, Germany’s industrial base will be less adversely affected in our view).

In Scenario 2 (more likely in my opinion) we get some greater fears about other PIIGS nations (discussion is now turning to Spain, Portugal and Ireland). The EMU might well hold together but the corresponding fear of contagion might well provoke capital flight and drive the euro down to parity (or lower) with the dollar. Of course, the euro’s weakness creates other problems: when the euro was strengthening last year due to portfolio shifts out of the dollar, many of those buyers of euro bought euro denominated national government paper (including Greece). The resultant portfolio shifts helped fund the national EMU governments at lower rates during that period. That portfolio shifting has largely come to an end, making national government funding within the euro zone more problematic, as the Greek situation now illustrates.

The weakening euro and rising oil prices raises the risk of ‘inflation’ flooding in through the import and export channels. With a weak economy and national government credit worthiness particularly sensitive to rising interest rates, the ECB may find itself in a bind, as it will tend to favor rate hikes as prices firm, yet recognize rate hikes could cause a financial collapse. And should a government like Greece be allowed to default the next realization could be that Greek depositors will take losses, and, therefore, the entire euro deposit insurance lose credibility, causing depositors to take their funds elsewhere.

It’s all getting very ugly as it all threatens the value of the euro. The only scenario that theoretically helps the value of the euro is a national government default, which does eliminate the euro denominated financial assets of that nation, but of course can trigger a euro wide deflationary debt collapse. The ‘support’ scenarios all weaken the euro as they support the expansion of euro denominated financial assets, to the point of triggering the inflationary ‘race to the bottom’ of accelerating debt expansion.

So timing is very problematic. A rapid decline of the euro would facilitate a competitive advantage in the euro zone’s external sector, but it could also set alarm bells off at the ECB if such a rapid devaluation creates incipient inflationary strains within the euro zone.

What about the US? In the latter scenario, we can envisage a situation in which the combination of panic and corresponding flight to safety to the dollar and US Treasuries, concomitant with the increased accumulation of US financial assets (which arises as the inevitable accounting correlative of increased Euro zone exports) means that America’s external deficits inexorably increase. There will almost certainly be increased protectionist strains, a possible backlash against both Europe and Asia, especially if the deficit hawks begin sounding the alarm on the inexorable rise of the US government deficit (which will almost certainly rise in the scenario we have sketched out).

Assuming that the US does not wish to sustain further job losses, the budget deficit will inevitably deteriorate further, either “virtuously” (via proactive government spending which promotes a full employment policy), or in a bad way , whereby a contracting economy and rising unemployment, produce larger deficits via the automatic stabilisers moving to shore up demand as the economy falters.

How big can these deficits go? Easily to around 10-12% of GDP or higher (versus the current 8% of GDP) should a euro devaluation be of a sufficient magnitude to induce a sharp deterioration of America’s trade deficit.

What will be the response of the Obama Administration? America can sustain economic growth with a private domestic surplus and government surplus if the external surplus is large enough. So a growth strategy can still be consistent with a public surplus, but this becomes virtually impossible if the euro zone’s problems continue, as we suspect that they will.

President Obama, however, has long decried our “out of control” government spending. He clearly gets this nonsense from the manic deficit terrorists who do not understand these accounting relationships that we’ve sketched out. As a result he continues to advocate that the government leads the charge by introducing austerity packages – just when the state of private demand is still stagnant or fragile. By perpetuating these myths, then, the President himself becomes part of the problem. He should be using his position of influence, and his considerable powers of oratory, to change public perceptions and explain why these deficits are not only necessary, but highly desirable in terms of sustaining a full employment economy.

Governments that issue debt in their own currency and do not promise to convert their currency into anything else can always “afford” to run deficits. Indeed, in this context government spending financially helps the private sector by injecting cash flows, providing liquid assets and raising the net worth of some or all private economic agents. In contrast to today’s budget deficit “Chicken Littles”, we maintain that speaking of government budget deficits as far as the eye can see is ludicrous for the simple reason that as the economy recovers, tax revenue rises, the deficit automatically reduces. That’s the whole reason for engaging in deficit spending in the first place. Any projections that show the deficit continuing to climb without limit is misguided–the Pete Peterson projections, for example, will never come to pass. As we near and exceed full employment, inflation will pick-up, which reduces transfer payments and increases tax revenues, automatically pushing the budget toward surpluses. In the 220 year experience of the United States there have only been a few years when we’ve not had deficits and each time the surpluses were immediately followed by a depression or a recession. So the historical evidence here indicates that we can run nearly permanent deficits and that when we do, it’s better for the economy. The challenge for our side of the debate is to expose these voluntary constraints for what they are and explain why the US is not a Weimar Germany waiting to happen.

About Marshall Auerback 37 Articles

Marshall Auerback has 28 years of experience in the investment management business, serving as a global portfolio strategist for RAB Capital Plc, a UK-based fund management group with $2 billion under management, since 2003. He is also co-manager of the RAB Gold Fund. He serves as an economic consultant to PIMCO, the world’s largest bond fund management group, and as a fellow of the Economists for Peace and Security.

From 1983-1987, he was an investment manager at GT Management (Asia) Limited in Hong Kong, where he focused on the markets of Hong Kong, the ASEAN countries (Singapore, Malaysia, the Philippines, Indonesia, and Thailand), New Zealand and Australia. From 1988-91, Mr. Auerback was based in Tokyo, where his Pacific Rim expertise was broadened to include the Japanese stock market. From 1992-95, Mr. Auerback worked in New York for the Tiedemann Investment Group, where he ran an emerging markets hedge fund. From 1996-99, he worked as an international economics strategist for Veneroso Associates, which provided macroeconomic strategy to a number of leading institutional investors. From 1999-2002, he managed the Prudent Global Fixed Income Fund for David W. Tice & Associates, an investment management firm, and assisted with the management of the Prudent Bear Fund.

Mr. Auerback graduated magna cum laude in English and philosophy from Queen’s University in 1981 and received a law degree from Corpus Christi College, Oxford University, in 1983.

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1 Comment on Troubles in the Eurozone: Is a Conflict with the U.S. Far Behind?

  1. “President Obama, however, has long decried our ‘out of control’ government spending” “As a result he continues to advocate that the government leads the charge by introducing austerity packages.”

    …Does anyone know what planet Marshall Auerback lives on?

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