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Caught Out by Reality in Europe

By Claus Vistesen

The rumour mill is grinding particularly fast at the moment. Germany and France seem to be working on the famous nuclear solution, Spain plays tough on outsiders, the IMF is rumoured to be preparing an aid package for Italy not to mention Hungary and Austria (just like Belgium) has entered the rating agencies’ cross hair.

So, what to believe?

I don’t know, but it is interesting that Reuters are now reporting France and Germany to be in an agreement on a fast track move towards fiscal union as well as allowing the ECB to aid sovereigns more forcefully (i.e. unsterilised intervention).

I want to see this before I believe it. Germany is certainly sending conflicting signals. Yet, this may be because they are truly unsure how long they can play this game of chicken with the rest of Europe. Clearly, Merkel has a point in refusing to issue euro bonds and/or letting the ECB step in since the periphery needs to put their house in order or at least show a credible plan to balance the budget. This is essentially quid pro quo as Merkel knows that Germany needs to pay in the end.

But there is a rub. One issue is surely the fact that public finances across the eurozone are unsustainable but another is how these economies are going to achieve anything near the growth needed not to collapse (default) anyway.

We keep on coming back to two main points.

1) It was clear for all that pain was coming in the periphery already in 07/08 and that this would be a substantial period of negative growth/deleveraging consolidation.

2) But the question was always whether such pain could be administered from within the euro zone. We are steadily coming to the conclusion that this is not possible and Germany knows this. But the solution is not clear since jettisoning the euro would have grave implications for the EU too and therefore there is a very strong lock-in mechanism here which it is difficult to get out of.

Finally, there is always the risk that one or many of the Southern European economies will simply "get" enough and make some quick and devastating decisions. It is important to understand my point on this.

I am sure it would be catastrophic for Greece or another country to leave by their own accord and do a messy default, but at some point the rest of Europe and the market will simply corner whatever government that might be in place and they will start taking their own independent decisions.

I note that there are calls for the new government in Spain to play "hardball" with Germany. In this situation, Germany has a distinct interest in just letting the market squeeze the periphery, but of course the rest of the "core" is getting dragged down too and the whole banking system is now at risk of a major liquidity/solvency crisis. In this sense, I only agree conditionally with Felix Salmon:

El-Erian is very good at explaining the problem which needs solving:

"Europe must still stabilize its sovereign debt situation. But this is now far from sufficient. Policymakers must also move quickly to contain banking sector frailties, and do so using a more coherent approach to the trio of capital, asset quality and liquidity."

It seems to me, though, that sequencing matters here. Liquidity is — always — more important than capital/solvency. Give an insolvent bank enough liquidity, and it can live indefinitely. Remove liquidity from a bank, and it dies immediately, no matter how solvent it might be or how high its capital ratios are. And as for asset quality, we’re pretty much talking a zero-sum game here: when the banks’ dubious assets are the sovereign’s liabilities, the real solution is inflation, not nationalization.

I agree that liquidity is a key issue at the moment in the euro zone banking system, but let us not kid ourselves. Europe has not had a functioning interbank market since 2008 and we are just now seeing the accumulated effect of this.

I just read a big and very detailed BC report on deleveraging among EZ banks and I am extremely concerned. It is clear to me that not only sovereigns are battling with solvency issues but so are many banks and the extent to which they are fighting it means that they will have to cut lending and asset growth substantially. As such, I am afraid that the problems in the euro zone are beginning to resemble a widespread solvency problem both amongst banks and sovereigns, a combination which, to boot, will feed off each other. Especially Eastern Europe are going to have big problems in 2012. They are going to see an almost complete stop of credit flows through the banking system due to parents cutting cross border lending.

I think  that we will see a wholesale and government driven process of bank nationalisations and restructuring in the next 6 months in the euro zone. I also think that most southern European economies are ultimately facing both public and private insolvency issues which will need balance sheet write-offs to get solved. It seems to me that, as so many times before, euro zone politicians are once again getting caught out by reality.

Claus Vistesen

About 

Claus Vistesen is a Danish economist who specialises in macroeconomics. His primary research interests include demographics, macroeconomics and international finance.