It’s Italy for America and Japan for Europe


MUNICH — The American business model has collapsed. During recent years, the United States borrowed gigantic sums of money from the rest of the world. Net capital imports exceeded $800 billion in 2008 alone. The money came largely from selling mortgage-backed securities and collateralized debt obligations, claims against American homeowners (or to be precise, only against the homes themselves, as the owners were protected by the nonrecourse nature of loans).

The market for such securities has now vanished. While the volume of new issues in 2006 was $1.9 trillion, the likely volume in 2009 will be just $50 billion, according to the most recent International Monetary Fund estimates. The market declined by 97 percent. No number reveals the true catastrophe of the American financial system more than this one.

As the flow of funds from the world to U.S. homeowners was disrupted, house prices collapsed by 30 percent, and construction of new homes by more than 70 percent. The recession was inevitable.

Laid-off construction workers tightened their belts, as did homeowners. Some did so because they felt poorer. Others did so because the banks, shocked by the collapse of the securitization business, stopped giving them home-equity loans for consumption purposes.

In the last years before the crisis, the flow of new mortgages had been 60 percent higher than the value of residential construction. Now it is 150 percent lower.

The first 11 months of the recession that followed were as severe as the first 11 months of the Great Depression that started in 1929. But gigantic Keynesian recovery packages worth more than $1.4 trillion worldwide, together with bank rescue packages worth about $8 trillion, have had their effect. They stopped the decline in the spring and early summer of this year, bringing the recession to what one hopes is more than a temporary halt.

Underutilization of capacity, however, remains huge. It will take years for the world economy to return to trend, in particular as the growth outlook is not very promising and unemployment continues to rise in the U.S. and Europe.

The medicine that has helped, and that remains necessary for the time being, is government debt. Governments absorb the excess of private savings over private investment and re-inject it into the global economy, thereby stabilizing aggregate demand and the financial system.

As a result, public deficits are shooting up everywhere.

Nearly all European Union countries will violate the Stability and Growth Pact’s 3 percent-of-GDP cap on fiscal deficits in 2009, and some of them will have deficits at or above 10 percent of GDP, notably Spain (10 percent), the United Kingdom (14 percent) and Ireland (16 percent).

The U.S., the epicenter of the crisis, is in particular trouble. By the end of this year, America’s debt-to-GDP ratio will have climbed to 87 percent from 73 percent in 2008, and, with next year’s deficit set to reach 11 percent of GDP, it is certain that the ratio will surpass 100 percent during 2011. The country that used to be the symbol of capitalist stability and strength now shows frightening similarities to the developing countries that suffered from the world debt crisis in the early 1980s.

Although countries can become insolvent, they have many ways to reduce their sovereign debt before this happens. The U.S. is considering the possibility of imposing a bequest tax on foreign holdings of U.S. securities, and many people believe that it will try to play “the Italian card”: inflating away its public debt and devaluing the currency in order to maintain international competitiveness.

To be sure, inflation is difficult to bring about when short-term interest rates are near zero — and thus cannot be reduced any further without inducing massive hoarding of cash. Nevertheless, investors around the world currently fear such a scenario, and this may create a self-fulfilling prophecy, because it helps to drive down the dollar, boost export demand and make U.S. imports more expensive.

Ironically, flexible exchange rates help the very country that caused the crisis. There is no justice in economic mechanisms.

The opposite is true in Europe. There the European Central Bank has also used up its gunpowder and cannot create inflation even if it wished to do so (which it cannot, because the Maastricht Treaty defines preservation of price stability as the ECB’s only goal.)

But the strengthening euro reduces both import prices and export demand, which, in itself, causes prices to fall. In all likelihood, therefore, Europe will not be playing the Italian card; instead, it will face substantial difficulties in freeing itself from its current stagnation. The risk for Europe is that it goes down the Japanese, rather than the Italian, path.

After its banking crisis of 1989, Japan experienced two decades of stagnation and deflation with skyrocketing government debt. Preventing a repetition of this is the main challenge for European policymakers in the coming years.

Hans-Werner Sinn is a professor of economics and public finance at the University of Munich and president of the Ifo Institute. © 2009 Project Syndicate