Who’s Nexit?

BY DANIEL ALTMAN

JULY 30, 2015

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As many as five other eurozone countries are flirting with trouble. Could one of them be the first to leave the common currency?

Which will be the next eurozone domino to fall? With Greece enjoying a temporary lull in its apparently permanent crisis, we can take a moment to look around its neighborhood at other candidates for trouble. There are several — and the euro’s future looks far from bright.

Greece ran into trouble mainly because it should never have been in the eurozone in the first place. Its governments couldn’t balance their budgets, and its economic cycle was far out of sync with those of the eurozone’s leading lights. When Germany grew, Greece shrank, and vice versa. Using the same monetary policy in both countries made no sense at all.

The more proximate cause of the Greek crisis was its inability to service its debts on time. In the midst of a deep depression, taxes and other government revenue started to slip away, eventually falling 15 percent between 2007 and 2014. Without control of the currency, the government couldn’t print money to stimulate the economy and devalue its debts. It had to choose between repaying its lenders and doing everything else: paying pensions, providing public services, protecting its citizens, etc.

What other countries in the eurozone might soon face this choice? To hear the credit-rating agencies tell it, the first in line are Portugal, whose government bonds are rated as junk by Standard & Poor’s, and Italy, which receives the lowest investment-grade rating of BBB-. Each country’s government is carrying a debt bigger than its GDP, something the IMF doesn’t expect to change any time in the next five years. Spain, whose debt-to-GDP ratio is below 70 percent but may rise in the coming years, is rated BBB.

Not far behind are Ireland, whose debt burden of 86 percent of GDP is supposed to decline rapidly now that economic growth has resumed, and France, at 89 percent, where growth rates may struggle to crack 2 percent in the coming years. Both of them receive reasonable grades from Standard & Poor’s — AA for France and A+ for Ireland, with AAA being the safest of all.

But it’s important to take these ratings with a grain of salt. After all, Standard & Poor’s gave Greece’s debt a grade of A- until December 2009, when the fiscal writing was already on the wall. Partly because of the rating, Greece had no trouble borrowing at reasonable interest rates as late as November of that year, just as Portugal can today. Yet at the end of 2009, all of the countries above except France were once again being called by their pejorative acronym: the PIIGS.

Going forward, the primary risks for these countries are dips in government revenue (mostly likely stemming from disappointing economic growth) and the buildup of other fiscal obligations. Either one could force a decision like the one that faced Greece: to pay or not to pay.

Government revenue in France and Italy has trended gently upward ever since the introduction of the euro in 1999, with few fluctuations along the way. By contrast, revenue in Ireland and Spain spiked dramatically just before the global financial crisis, suggesting that their governments relied more on volatile sources like corporate income taxes. (Because companies pay taxes only when they’re profitable — as opposed to households, which pay them when they have revenue — collections from corporate income taxes tend to be much more correlated with the ups and downs of the economic cycle.) Portugal landed somewhere in between:

Of course, collecting revenue is one thing; what a government chooses to do with it is another. During those heady high-revenue years from 2005 through 2007, Ireland paid down almost 30 percent of its debt, but Spain shrank its liabilities by only about 13 percent. Yet Portugal took the brass ring for most profligate fiscal policy, with its debt load rising sharply every year — despite a growing economy and rising tax revenue — for a total increase of 36 percent. If any of these events reflects long-term tendencies, then Portugal is one to watch.

Another risk for these countries is the possibility that their economic cycles will fall out of sync with the rest of the eurozone or, more pertinently, with Germany. The PIIGS and France rely much more on tourism, for instance, than Germany; as a result, trends in their exports may depend on demand from wealthy households in China, Japan, South Korea, and the United States more than on industrial activity in the eurozone.

If the countries at risk fall out of sync, then the European Central Bank (ECB) will be raising interest rates when they’re already in recession or lowering rates when the countries are growing apace. In this situation, monetary policy will have the opposite of its intended purpose; it will only serve to amplify the countries’ booms and busts.

As the chart below shows, the rates of economic growth in these five countries were most similar to Germany’s during the worst years of the global financial crisis. Then, in the past few years, all five fell behind Germany. As Germany recovered more quickly, driving the ECB toward a more hawkish stance on inflation, the other countries were left without the monetary support they needed to escape recession. And most recently, Irish growth has exceeded German growth by more than 2 percentage points; Ireland may eventually need higher interest rates to avoid overheating, but the ECB is unlikely to provide them anytime soon.

When the next recession hits the eurozone, the laggards will again come under threat. And there’s no reason to believe that some of them will be any more capable of snapping back. Italy, Portugal, and Spain have enormous baby-boom generations a decade or two from retirement, whereas France has a more stable population profile and Ireland has young reinforcements on the way. For the first three countries, the costs of pensions and medical care will loom large for at least the next two economic cycles.

These costs will imply hard choices like the one that caused Greece to falter. Its government ended up in the worst of both worlds, making deep cuts to the very jobs, benefits, and services that it chose to fund in lieu of repaying its debts. Given the staggering cost Greece has already paid to stay in the euro, the next country engulfed by crisis might choose a third option: leave the eurozone sooner rather than later.