The euro's paradox of thrift

Readers of my alter ego might have spotted that I’m not David Cameron’s greatest admirer. However, I fear he might be right to say “‘I don’t think we're anywhere near half way through [the euro crisis]”. Today’s figures from the ECB show one reason for this.

They show that in the last two months the private sector in the euro area has been a net repayer of bank debt. This suggests that the sector is trying to increase its net lending – the gap between savings and investment; whether this is because banks’ reluctance to lend is forcing some firms to become savers, or whether people don’t want to borrow anyway is not terribly important for our purposes.

And here we have a problem. Governments also are trying to increase their net lending, or at least reduce their net borrowing. But the two aims are not compatible. Across the whole economy, net lending (and the changes therein) must be zero; for every euro someone borrows, someone else must lend a euro.

What happens, then, if both governments and the private sector try to become net lenders?

One possibility is that the third sector of the economy – overseas people – will take up the slack. Governments and domestic private citizens and firms can be net lenders if foreigners are net borrowers. This, though, requires the euro area’s current account surplus to increase – which means the rest of the world must run an increasing deficit. Remember, the current account balance, by definition, is the difference between domestic saving and investment.

This would happen in a nice way if the world outside the euro area were borrowing heavily and buying euro area goods. But this is not happening, and nor is it likely to in the near-term: although Asian economies are growing well relative to the west, they are still high net savers.

This means that there is only one way for the euro area to increase its current account surplus - for its GDP to fall so that imports decline; this is just what happened in Q4. To put this in more familiar terms, as governments, households and businesses cut spending in an effort to raise savings, GDP falls and so do imports.

But of course, falling GDP also reduces tax revenues and increases welfare bills, which tends to increase government borrowing. The efforts of both governments and private sectors to increase net lending might therefore merely cause one (or both) to be frustrated in those attempts. As Larry Summers says in the FT: “Austerity measures at the national level are likely to be counterproductive in terms of creditworthiness. Fiscal contraction reduces incomes, limiting the capacity to repay debts. It achieves only very limited reductions in deficits once the adverse effects of contraction on tax revenues and benefit payments are taken into account.”

Euro zone governments, therefore, will be slapped in the face by the paradox of thrift. The debt crisis cannot be solved by fiscal austerity alone.

I‘ll concede that this could change. If the private sector were to want to borrow more, invest more and save less, then fiscal austerity and growth could go together. This is what happened in periods of expansionary fiscal contraction. But there is little sign of the private sector doing this – quite the opposite.

If the private isn’t going to change its plans, then governments must. At best, this will be a long process. Which is why I fear Mr Cameron is right.

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