As we muddle through the debt crisis in Europe, the believe in a happy ending is fading away fast…many papers and proposals are published and discussed, but many of them lack a practical approach, are short term solutions, increase moral hazard and lack a comprehensive overview…perhaps because the real and exhaustive solutions are too painful?
Two strategy consultancies have published their highly interesting analyses and come to some different conclusions on what should be done.
McKinsey Global Institute proposes an orderly approach by taking successful Nordic deleveraging in the 90’s as a case example.
David Rhodes and Daniel Stelter of BCG, take into account the reality of political forces and come to a different conclusion for the Eurozone.
Studying Sweden and Finland’s example, McKinsey discerns 2 phases of successful deleveraging:
- following recession, it will take 4-6 yrs to delever private and corporate debt while public debt continues to increase;
- the subsequent 10 yrs fiscal discipline and public debt reduction are needed;
- only after the private-debt reduction the economy will return to its pre-recession levels
Some worrying facts about this comparison:
- The UK and Spain haven’t begun yet to reduce their private debt levels (January 2012) – unfotunately McKinsey merely discusses these two EU countries.
- Therefore, McKinsey estimates, the UK and Spain are still about 10 years (!) away from reducing their private debt levels. Following the graph per above this implies they will take 20 yrs to reduce their total debt to sustainable pre-bubble levels (!)
- Sweden and Finland ran budget surpluses before their crises and joined the EU, stimulating foreign investments and export growth
- Debt reduction alone doesn’t increase competitiveness
6 critical markers of success
McKinsey identified 6 critical markers that policymakers should look for and emphasize in their policies:
- Is the banking sector stable? – It’s undercapitalized at best…
- Is there a credible plan for long-term fiscal sustainability? – Track records of Spain and UK are deficits not surpluses…
- Are structural reforms in place to attract foreign investment? – Are politicians able to loosen labour laws increasing unemployment and social unrest in the short term? I guess Ireland and Portugal are doing a good job, about Greece, Spain, Italy and France I am not so sure…
- Are exports rising? – First Spain, Portugal et al. have to resolve the cost of labour per unit of product (10-30% higher than Germany) and the worldwide economic slump is not helping?
- Is private investment rising? – Are politicians able to restore business confidence, especially in the periphery? I see many investors running for the exit with valuation multiples this low for European stocks and bonds…
- Has the housing market stabilized? Spain still has 1.5 million empty houses…
Can I conclude we are far removed from recovery and a delevered Eurozone economy?The key underlying questions I would like to ask are…do we have the time and patience to pursue McKinsey’s orderly Nordic-style road to recovery and more important...do our politicians have the guts and discipline to lead us through a 10-20-year recovery programme?
David Rhodes and Daniel Stelter of BCG explain, most likely, politicians will eventually be forced into radical action and they outline a painful but much shorter path to debt reduction…
Their analyses starts with sketching why reality will in the end catch up with politicians:
- current crisis is not only a government crisis, but also a competitiveness crisis
- uncompetitiveness dominates in periphery and hinders export growth and trade surplus
- no currency devaluation is possible for Eurozone countries to restore competitiveness
- real devaluation implies pursuing productivity and lower labor costs at the expense of high unemployment and political risk
- Eurozone banks are undercapitalized and can hardly take more losses
- aging of European populations won’t help, increasing health spending, decreasing workers per pensioner etc.
Reducing debt and increasing competitiveness at the same time seems incompatible and will cause serious social unrest
They mention the findings of Cecchetti, Mohanty and Zampolli (Bank of International Settlements) which provide another indication that there cannot be recovery without resolving the debt crisis first:
- debt becomes a drag on economic growth ones private, government or corporate debt moves in the 80-100% of GDP range;
- since 1980 debt to GDP quadrupled in real terms to a 300% to GDP today;
- they urge policymakers to act quick and decisively to prevent a vicious debt cycle spiralling out of control and put a further drag on growth.
Along these lines, Rhodes and Stelter conclude, we’re on the wrong track and that politicians have to eventually implement a real solution: debt restructuring before competitiveness can be restored. Interestingly they also outline how this should be done:
- Set the target: Total debt limit at a sustainable 180% of GDP with enforced limits at 60% private, 60% corporate and 60% government debt of GDP
- Relieve the debtors: write-off all debt above these thresholds (household, corporate and government)
- Secure the financial sector: the EFSF should take the lead to recapitalize banks and guarantee insurers’ payouts to policyholders. Effectively nationalizing the financial sector
- Arrange the funding: all Eurozone savings above a €100k threshold would suffer a ~35% wealth tax to pay for the restructuring operation
- Install structural reform and controls to prevent repetition: embedding the debt ceiling in constitutions, funding of all governments via eurobonds issued by EFSF, control mechanisms for private debt growth and a clear commitment to resolve pressing aging issues (helathcare spending and retirement age)
Unfortunately restructuring doesn’t solve the competitiveness issues, but it makes at least sure that the Eurozone can start fast with becoming more competitive and safeguard long-run prosperity for its population.
And achieving competitiveness? Well this will hurt too…perhaps leading to an eventual break-up of the eurozone. One problem at the time….