Liquidity, Solvency, and Competitiveness

Kantoos considers whether it is obvious that the eurozone debt crisis is, at least with respect to Spain and Italy, merely a liquidity crisis and not an issue of fundamental insolvency:

The problem is how to distinguish a multiple-equilibria situation from cases of genuine one-equilibrium insolvency – especially for countries as the future capacity to repay is not based on assets in a narrow sense but on the expectation of future economic growth.

...For Italy and Spain, there is a reasonable chance that it is in fact a self-fulfilling liquidity problem, but – and that was my main point – it is by no means certain. A backward-looking remark about Italy having a primary surplus is just not enough to make your case and Henry’s analysis is not encouraging.

A few points. First, take a look at the following chart that shows the debt/GDP ratios for a number of major European economies. See if you can tell which country is Spain. (All data is from Eurostat.)


If the markets believed that Spain (the blue line) is fundamentally insolvent -- or even at risk of becoming fundamentally insolvent in the foreseeable future -- then wouldn't such solvency concerns have also hit the debt of Germany, France, and the UK? (Those are the other three lines in the chart.) Given this, it seems overwhelmingly likely to me that the market's nervousness about Spanish debt is of the nature of a self-fulfilling "illiquid-but-solvent" crisis.

And what about Italy? Italy's debt/GDP ratio is indeed high -- over 100%. But that ratio has been over 100 percent for the past 20 years, so that's nothing new. And in recent years, Italy's budget deficit has been relatively small, as seen below.

Again, it seems far from obvious from this why market participants would have become worried about Italy's insolvency but not that of France or the UK.

There are two factors that Spain and Italy do have in common, however, that sharply distinguish them from France, Germany, and the UK. The first is that they do not have a central bank to provide unlimited liquidity to the government if necessary. The UK clearly does, by contrast, and I think most people would expect that the ECB would also perform that function for Germany if necessary. France is in a bit of a grey area there, which is exactly why the markets have inserted some additional risk premium into French government bond yields in recent months.

The second factor is the long run issue that Kantoos draws attention to: the competitiveness problem. The UK has no such problem, because its flexible exchange rate will automatically adjust its competitiveness to match the amount of financing it is able to attract; if investors become less willing to finance the UK's debt, the pound will lose value and the UK will start to gain competitiveness. Germany has no such problem, because it has undergone a steady improvement in its relative competitiveness ever since the adoption of the euro. And France is much closer to Germany than to Italy as far as competitiveness goes.

But where I would disagree with Kantoos is his assessment that Germany's improvement in competitiveness during the euro period was policy-driven, and that Italy and Spain's competitiveness problems are the result of their unwillingness to tackle the problem.

The changes in competitiveness in each of the eurozone countries during the years leading up to this crisis were driven by capital flows within the eurozone. Countries that received large capital inflows saw their prices rise in relative terms and their competitiveness worsen, which in turn helped to bring about the current account deficits that are the counterpart to those capital inflows. Conversely, countries that sent capital abroad saw their relative prices fall and competitiveness improve, for the same reason. Policy had little to do with competitiveness changes; they were a macroeconomic necessity entailed by the flow of capital from capital-rich countries like Germany to capital-poor countries like Spain.

The following table ranks the major eurozone countries in order of their current account balances between the adoption of the euro in 1999 and the onset of the financial crisis in 2008. Using total changes in the price level to provide a quick-and-dirty estimate of changes in competitiveness, it's clear that the relationship between the two is very strong -- countries that experienced capital inflows saw their price levels rise and their competitiveness worsen. The implication is that in the absence of policies to stem the inflow of capital, there was probably nothing they could have done to prevent that.


To summarize: Spain and Italy seem quite clearly to be the victims of a self-fulfilling illiquid-not-insolvent sort of crisis. They are in this situation because the markets have doubts about the willingness of a central bank to provide unlimited liquidity, unlike the case with Germany or the UK. And in addition they face a competitiveness gap with Germany that has arisen not out of any specific policies in Germany, Spain, or Italy, but that instead is the direct result of the massive capital flows from the northern eurozone to the southern eurozone that took place during the 2000s.

The eurozone therefore faces both a short run problem (the self-fulfilling liquidity crisis) and a long run problem (the competitiveness issue). There are fairly clear policy prescriptions for both. The primary question at this point is whether Europe's policy-makers will act on them.