The late Professor Wynne Godley of Cambridge University, used to teach that one must be very clear about stocks (amounts of things defined at a point of time) and flows (volumes defined over a period of time, usually a year). His unorthodox macroeconomic framework was good on this and turned out to be a much more useful guide to the way the world worked than conventional macroeconomics.
There is a need to be clear about stocks and flows in the current Euro debt mess. Nouriel Roubini makes an excellent contribution in this respect, in the Financial Times. Italy has a very large stock of debt (nearly everyone now knows it’s €1.9 trillion). It has had a high level of debt for several years but managed to finance it at low interest rates because the annual flow of new debt (the government’s net financial balance) was low. Italy has been running a “primary” surplus for years, meaning that it runs a government budget surplus before paying interest costs. So the underlying stock of debt was not increasing relative to the size of the economy, which is the main test of long term sustainable finance.
The problem now is that the markets have taken fright at the long term ability of Italy to service its debt. So interest rates shot up to 7.5% yesterday, and are currently around 6.9%. There is nothing magical about 7% but it’s clearly too high. At this interest rate the cost of servicing the debt would rise as each old bond is retired and replaced by a new one, until the cost of servicing the stock of debt forced the budget deficit to rise indefinitely. What had been a sustainable stock of debt, relative to GDP, would no longer be so because the annual flow of new debt would be rising.
The rise in interest rates is therefore self-fulfilling. If it persists, Italy will see its debt to GDP ratio increase (from its already very high level of 120%) and nobody will rationally lend to Italy, thus confirming the higher interest rate.
If somehow Italy could write off a chunk of its debt then it would solve the stock problem. But unless the Italian government can permanently improve the outlook for the annual flow of new debt (higher taxes, lower spending) then the debt to GDP ratio will still rise. The new Italian government is indicating it will try credibly to do that. But starting with such a high stock of debt means that it must act quickly and strongly before too much new debt has to be issued at the new higher rates.
Equally, if the ECB were to buy Italian debt without limit it would temporarily solve the flow problem but unless Italy made permanent reforms the debt stock would keep rising and private financing would recede even further out of view.
So one lesson is not to let your debt flow (annual deficit) deteriorate much if your stock is already high, because market confidence can be easily lost and then you’ve got very little room for manoeuvre. The UK has the twin advantages of starting with a lower stock of debt relative to GDP and having a much longer maturity of debt, so it would take years before higher interest rates made their way through the existing stock.
But the underlying problem in the entire Eurozone is divergent economic performance. Italy (like Greece, Portugal and Spain) has lost competitiveness against Germany since the Euro began. Unless it can fix that, there can be little chance of the Euro surviving long term.
Possibly the other interesting point on Italy’s debt is that when it’s yielding at 4 – 5% just 6 months ago, it is still regarded as the sacrocrant of Eurozone. Just a 100 – 200bps moment and now they are having a full blown crisis.
Imagine what a 200bps interest movement would do to Japan / US etc and therefore the Zero Interest Trap seems more than likely to stay on much longer than 2013 as Bernanke has said cos the Govt simply cannot afford to pay more.
Separate questions that I would be keen to learn your perspective: wouldn’t there be a massive ‘circularity’ for any of IFIs or Troika’s rescue? Says for IMF, wouldnt part of funding essentially come from commitment of the rescuee themselves which in Europe case could be quite sizable? Technically, do these funding commitment get cancelled out?
It’s quite right that if Eurozone governments provide new funding to the IMF and the Fund then lends that back to Eurozone sovereigns, then all that happened is that the IMF has been used to launder the money. The IMF has fare more credibility as a lender and enforcer than the European governments or the European Commission so there is some marginal benefit in this. But unless it increases the net flow of funding from low debt to high debt countries, it doesn’t get us very far. The IMF was not designed to bail out heavily indebted mature economies and has nowhere near enough funding to do so. Nor should it, in the view of lower income economies such as China, which would be asked to contribute to new IMF funding. China might go along in exchange for a large shift in voting rights away from Europeans such as the UK, France and Germany, which should happen anyway.