The recent debacle in Cyprus has essentially been shrugged off by the markets. The European Central Bank vigorously asserts the crisis in the Euro zone is over. So why is there continued unease about the financial viability of countries such as Spain and Portugal, a morass into which even the French are now being dragged?
Economic theory helps us understand a bit more about why this is the case. One thing which the last few years in Europe have shown very starkly is the massive difference between debt which is denominated in nominal terms and that which is in real terms. Nobel Laureate Chris Sims makes the point clearly in his recently published Presidential Address to the American Economic Association.
As Sims puts it, real sovereign debt promises future payments of something the government may not have available—gold, under the gold standard, Euros for individual country members of the EMU, and dollars for developing countries that borrow mainly in foreign currency. Nominal sovereign debt promises only future payments of government paper, which is always available. In other words, money can always be printed. Sims notes almost in passing that ‘obviously, outright default on nominal debt is much less likely than on real debt’.
In order to be able to repay any given level of debt, a country must be capable of generating in the future what are called in the jargon ‘primary surpluses’. These are simply a surplus of government revenue over expenditures, taking interest payments out of the picture. For a country with its own currency, as long as it is capable of generating any primary surpluses at all, it need not default. In accounting terms, the present value of its debt is simply the discounted value of future surpluses. It might not be worth much, but its debt has some value. In contrast, if the debt is in real terms – in Euros for the Italians and Spanish – the country needs to be able to generate primary surpluses which cover its debt commitments in real terms, an altogether more challenging task.
There is a definite risk of the Southern European countries becoming trapped in a real debt spiral, from which the only escape is either – or possibly both – default on debt or exit from the Euro in order to be able to denominate their debt in nominal rather than real terms. France is now looking uncomfortably close to this group.
The experience of the 1930s suggests that exiting the Euro may be far from being a disaster. Once the taboo on leaving the gold standard was lifted, those countries which exited early revived earlier than those which chose to prolong the agony. One reason was that the financial position of the state was once again judged to be viable. The UK quit in 1931, and the very next year our GDP had exceeded the pre-crash peak in 1929. France waited until 1936, and even by 1938 its output was lower than in 1929.
As published in City Am on Wednesday 10th April 2013