This is a continuation of my thoughts from two weeks ago on Europe. Rather than continue using the new Credit Writedowns Post Framework, I want to to use the news flow to bring this one together.
I have a slew of European articles for the links that I will use here instead to tie together the overarching themes dominating the European landscape. The dominant theme is that the economy of Europe is in tatters and this is causing a re-think of the policy course. In my view, the political space for the re-think is limited and will ultimately entail some tacked-on growth policies and relaxed deficit target timetables. However, the prevailing economic paradigm will remain the same, fiscal consolidation to prevent sovereign default.
As fiscal consolidation is a deflationary policy, I expect European growth to be weak. On the bank and sovereign debt front, some leeway is available but crisis is never far away. However, fiscal consolidation is negative for periphery corporate bonds in particular as I will detail below.
Note, I have separate articles prepared for Spain and Cyprus, this one will focus on the European-wide policy level as well as on Germany.
This piece picks up where the last three I have written on fiscal austerity leave off: nothing in Europe has changed because of the debunking of the public debt position taken by Reinhard-Rogoff. Ample evidence now exists to demonstrate this is so.
In November of 2011, during the Italian crisis, I outlined what European policymakers call the ‘complete strategy’ . The existing European crisis paradigm is a three-legged stool: sustainable public finances and structural reform for growth, stabilization mechanisms and banking system recapitalization and reformation.
The first leg of the stool is what we have all been focused on and the key here is the sustainable public finances part. That is what is driving most of the political debate and dictating the economic course right now. The growth from structural reform part was tacked on when it was clear that the austerity path was not going well. But notice that the ‘pro-growth’ thinking here is about structural reform and not about stimulus. What has happened in the year and a half since then is that pro-growth has come to also mean some stimulus as well.
The second leg of the European paradigm is bailouts. That’s what stabilization mechanisms mean – liquidity in order to help governments deal with negative reactions to market-adverse data which could ordinarily lead to crisis. The key here is that Germany wants these measures to be seen as liquidity – loans and guarantees – only. The concept that any German taxpayer money has gone to the periphery must be eliminated. And this is extremely important to Merkel with elections coming up. It dominates her thinking about how bailouts can be structured.
The third leg of the economic crisis response is bank recaps. Initially, the thinking here was that the recaps would proceed by getting private investors to chip in after the stress test rounds revealed the capital shortfall. And in worst case scenarios, the government would have to make up the difference. This policy has been a disaster. In Spain, the government did make up the difference last year, but there was almost no private sector funding available. So the entire recap funding fell on government and it triggered a crisis – one in which Spain was forced to go cap in hand to the Troika to help bail out its banking system. Therefore, at the same time, the worst case scenario has moved from just having government cough up the funds to bailing in bank creditors. And again, the rationale here is first and foremost about making sure that there are no ‘bailouts’ in the strictest sense of the word.
That’s the European approach. And I am arguing here that it has always been the three-pronged approach. The policy mix changes but the overarching goals remain the same. As to the evidence that demonstrate this is so, here is a sampling.
First, just after the Reinhart-Rogoff scandal hit the media, I saw a Belgian article which got an immediate reaction from EU officials. This article quotes an EC spokesperson as saying, “the strategy remains the same: a reduction of government debt and deficits, coupled with structural reforms in order to stimulate the economy.” (article links at the end of this post).So this initial statement says Europe will stay the course.
Later statements do as well. For example, in his famous denunciation of austerity, a careful read parsing of the text shows that EC head Jose Manuel Barroso never actually repudiates austerity. He just says it is untenable given the social and political constraints. This is clearly a call to modify the approach to meet the facts on the ground, not a call for a radical re-think.
I saw something strange last week that I should point out in this context. European policy makers took to the New York Times, an American newspaper, to defend how Europe has handled the crisis. They wrote that “Europe is Responding” and they went into detail as to how Europe was meeting the need to engage in fiscal consolidation to meet public debt sustainability yet still deal with growth concerns via the EIB and other means. The piece also went out in print for the International Herald Tribune. As I tweeted at the time, this is clearly an EU statement as it comes from the four most relevant EU level institutions.
The interesting bit was who signed the document. It read as follows:
“Jeroen Dijsselbloem is president of the Eurogroup. Olli Rehn is vice president of the European Commission, responsible for economic and monetary affairs and the euro. Jörg Asmussen is executive board member of the European Central Bank. Klaus Regling is managing director of the European Stability Mechanism. Werner Hoyer is president of the European Investment Bank.”
Notice that Dijsselbloem and Hoyer are presidents of their respective organizations and Rehn and Asmussen are not? The obvious question is why Olli Rehn and Jörg Asmussen are signing the document and Jose Manuel Barroso and Mario Draghi, the presidents of their respective organzations, are not. I took that question to Twitter. No one had a good answer. I postulated three potential options: Barros and Draghi have fallen out of favour with other leading policy makers. That’s option one. Option two is that Barroso and Draghi disagree with the wording of this text – something that is specific to this situation but not mutually exclusive with the first possibility. And the third possibility is that the Op-Ed was meant to be a statement by the core countries and they selected leaders from those countries from the main EU institutions for that reason. Ultimately, I think a combination of options number two and three is most likely. And given Barroso’s comments subsequently that, “we haven’t done everything right,” it stands to reason that Barroso wasn’t fully onboard.
I want to flag this ‘Europe is Responding’ Op-Ed as a significant event in terms of what it says about EU policy. It shows a lack of cohesion. And at the same time, it shows a desire by leading policy makers to stay the course.
When you listen to what is coming out of Germany, you almost get the sense that the Germans don’t want to go as far as Barroso. Merkel is out saying that “prosperity due to debt isn’t going to work any more” and she is now visibly annoyed that people are using the term austerity to describe the prevailing EU policy framework when she sees this as living within one’s means. The finance ministry continues to adhere to the line of “growth-friendly consolidation,” rejecting outright that austerity is inherently contractionary. And all of this plays well in the German media. After all, the German people have seen a serious erosion of their social safety net under Schröder and Merkel has continued this policy. Moreover, wage restraint is commonly seen as an integral part of Germany’s export prowess and economic success despite the weak domestic demand and burgeoning resistance to yet more wage restraint. There is no way, bailouts for the periphery are going to be accepted in this context.
The problem is that expansionary fiscal consolidation is a preposterous concept when the only real economy effect of fiscal consolidation is to suck money out of the economy, reduce demand in the aggregate. And what’s more, the goal of reducing government deficits implicitly means reducing private savings since the financial sectors must balance. When private debts are high and recession has already reduced private income, the cut in public net deficits will mean a loss of income in the private sector that can only be solved via defaults or concomitant private sector cuts. This is exactly why the fiscal multiplier is much greater than one in the wake of a private sector debt crisis. Interestingly, a University of Chicago Professor Amir Sufi took to Twitter today to point out that the private sector debt drag on growth was the real takeaway from Reinhart-Rogoff. He believes the focus on public debt has been detrimental. I agree. This is something I have always said. The crisis is about private debt. In any event, the only way around this interplay between the public and private sector is via movements toward or further into net surplus in the current account.
Bundesbank head Jens Weidmann has recognized this and gave a speech to the Bank of International Settlements last year on rebalancing Europe (pdf here). The gist of his speech is that adjustments must be driven by the south, not by any adjustment in the north. In the short-term, this will lead to an improving external balance that can only be reduced over time as the net debtor states in the euro zone regain competitiveness vis-a-vis the net surplus countries. Otherwise, Weidemann is saying that the EU would be moving to a net current account surplus position, which invariably means a move toward net deficits outside of the euro zone, something people like Paul Krugman decry as beggar thy neighbour policy.
The long and short of it is that Europe is caught up in a deflationary – even debt-deflationary – economic paradigm. The only way out of this policy cul-de-sac is via improved external competitiveness after grinding internal devaluation in the periphery that explodes private and public sector debt ratios as the economy contracts. This is very dangerous policy. An even the German economy is succumbing to it now. The German economy only grew 0.7% last year. And the projection from leading private economists this year is for 0.8%, marginally better. Even in 2014, the prediction is for 1.9% real GDP growth, a weak figure that the US already exceeded most of last year.
Let’s think about the result of all of this in four ways:
- Government Debt: First, the weak growth and contraction in some countries will mean that government debt to GDP ratios cannot decline. Likely they will rise everywhere. Even in Germany, where GDP growth was positive in 2012, government debt to GDP increased. This is a key factor limiting support for bailouts. And while the Germans will likely attack this problem by cutting, doing so will ensure weak domestic demand that can only be made up for via export growth. In the periphery, this will mean renewed crisis because even relaxed targets could be overly optimistic. And if and when crisis does hit, the question must be what deviation from the existing policy paradigm is acceptable to maintain European cohesion.
- Banks. Second, the bank – sovereign nexus is the most important one in transmitting economic shocks. We live in a monetary system that is dominated by the credit creation of private sector financial institutions. The health of those institutions is critical then to the availability of credit and the pace of economic growth. The European crisis has to date seen a perverse symbiosis between sovereign governments and the banks in their realm; when the banks get sick, so too does the sovereign and vice versa. Slovenia is the most recent example of this. As I pointed out two years ago when the German-language press started worrying about Slovenia, there is no comparison between the Slovenes and the Greeks. A better comparison would be Latvia. But that doesn’t matter because, the problem is the implicit guarantee a sick banking sector has from government and the degree to which taking on the sector’s liabilities makes sovereign default possible. My sense here is that the EU will allow deviation from the policy paradigm to save Spain, Ireland, Italy or Slovenia from sovereign default via the OMT program. Portugal and Greece cannot make this grade. But in all respects, bail-ins will be the way forward. Bank bondholders are going to be very much at risk. An some uninsured depositors could be at risk as well.
- Business Debt: Third, in the private sector, we all know that households are struggling with debt. But, the IMF believes that 20% of periphery business has an unsustainable debt burden as well. I believe the contractionary policy in Europe will negatively impact European corporate credit profiles and cause defaults. Sovereign debt enjoys a partial and implicit backstop from the ECB now as a quid pro quo for austerity. Bank bonds, while at risk, do enjoy a partial and implicit backstop from sovereigns. So, these two sectors have some breathing space because of these guarantees. Other private business debtors are completely on their own. And this is where I would look for increasing default risk. Equities are another story. While their appreciation is capped because multiples will not expand while the economy is in recession, interest rates are coming down right now and that means discount rates are as well. That is supportive of equities in Europe as are the already low multiples on a relative value basis.
- Nationalism: We are going to see more political chaos due to the economic situation in Europe. In Greece, the case is being made for World War 2 reparations against Germany as I write this. In Germany, the eurosceptic Alternative für Deutschland is now over the 5% hurdle in some opinion polls. Expect that number to increase if Germany’s domestic economy under-performs – and weak business confidence numbers say it will. This nationalism will make things more volatile and unpredictable. We cannot be surewhat kind of cohesion there will be. The Cyprus crisis saw the government consider a euro zone exit – something I will write about soon. So, we should expect future crisis events to be equalyy laden with euro breakup risk, especially because bail-ins will be an integral part of the policy response.
The crisis in Europe is far from over. And I do not believe there has been any paradigm shift in policy response. We will continue down the path of bailouts in exchange for austerity that began three years ago with the first bailout for Greece. But now two factors have been added to the mix. Austerity will be leavened by actual stimulus to create jobs and capital investment, not just structural reform policy. Spain and Portugal both are presenting budgets with this in mind, measures which will cause their targets to be pushed back. I believe these policies will be approved at the EU level too, marking the only real break in the austerity paradigm.
On the bailout side, bail-ins will take center stage. There is no fiscal space or political appetite for more bailouts, even of the loan and guarantee variety. Every single crisis flashpoint from here on out will be met with private sector losses. The only question now is where crisis crops up next. While I had been tipping for Spain early in the year, I believe Slovenia is where crisis is headed next. And given the country’s small size, it will be interesting to see, how far policy European policy makers are willing to deviate from previous policy positions to deal with this crisis. This is only months, if not weeks away. Stay tuned.
This Belgian article points out that the IMF believes that the debt of at least 20% of non-financial business in the periphery is unsustainable. Again, this gets at the huge private debt problem. But this article demonstrates there should be concern over periphery debt must be business as well as household debt. The problem is only exacerbated by government cuts and austerity. Bond holders should take note.
This Belgian article was the first that I saw just after the Reinhart and Rogoff debate exploded. It quotes an EC official as saying, “the strategy remains the same”. And indeed all indications since this scandal has erupted lead me to believe this quote represents reality.
Leading economy researchers in Germany believe that economic growth this year will be a slow 0.8%. This comes after an equally slow 0.7% in 2012. Faster growth is not expected until 2014 at 1.9% and even then this is sub 2.0%. Clearly you can’t whack government debt to GDP ratios at this rate unless you hold the line on spending and taxes.
Merkel will continue the course. Her main argument is that “prosperity based on debt doesn’t work any more.” That’s the title of this article and gets at the heart of Merkel’s argument in favour of the present policy path. Good article on defining her economic point of view.
“In 1816, the net public debt of the UK reached 240 per cent of gross domestic product. This was the fiscal legacy of 125 years of war against France. What economic disaster followed this crushing burden of debt? The industrial revolution.
Yet Carmen Reinhart and Kenneth Rogoff of Harvard university argued, in a famous paper, that growth slows sharply when the ratio of public debt to GDP exceeds 90 per cent.”
“Greece had a primary budget surplus of 520 million euros in the first quarter of 2013, the Finance Ministry said on Monday.
This compares to a deficit of 334 million euros in the first three months of 2012.”
“Mr Noonan was speaking after comments from EU Commission president Jose Manuel Barroso, who said austerity has reached its limits.
But, on his way in this morning’s Cabinet meeting, Mr Noonan said: “We have laid out a programme for correction and we should stick to the programme and stick to the targets in the programme.”
He left open the possibility of investing in the economy to boost jobs and growth, but warned against a “spending spree” which would achieve little”.
“If there is spare cash around, we should use that money for investment purposes to grow the economy and get people back to work,” Mr Noonan added.
“We shouldn’t, you know, just because we are making progress, go on some kind of spending spree now which would have no effect expect to spend the money available.”
“A strike which has grounded Lufthansa planes is the latest in a wave of industrial unrest over pay in Germany, threatening to end a decade of wage restraint in Europe’s biggest economy.”
“German business confidence fell in April for the second consecutive month, according to a closely-watched survey.
The Ifo think tank said its business climate index, based on a survey of about 7,000 firms, fell to 104.4 in April, down from 106.7 in March.
The survey sent the euro to its lowest against the dollar in nearly three weeks on worries about the strength of Europe’s largest economy”
“Portugal unveiled an ambitious stimulus program on Tuesday to resuscitate its economy despite new concerns about some public companies that could hit the government’s budget plans.
Economy Minister Álvaro Santos Pereira said the government will aim to cut the corporate tax rate, provide incentives for foreign companies to move to Portugal, tackle a highly bureaucratic system that hurts investments and offer financing for small- and medium-size enterprises at attractive terms.”
“The European Central Bank is closer to lowering interest rates than at any time since it last cut them in July 2012 and is likely to shave a quarter-point off at its policy meeting next week.
Senior sources involved in the deliberations say momentum is building for action to help a euro zone economy which has slipped back into recession, a move that some policymakers wanted to take earlier this year.
Inflation sliding well below target gives the bank scope to act and a senior ECB official said even Bundesbank chief Jens Weidmann, the most hawkish member of the 23-man Governing Council, had an open mind.”
“German voters have never loved the euro, but most don’t want it to fall apart. A collapse could cause both economic disruption and the breakdown of the wider project of European integration. That project has helped Germany to achieve historic security, trade and neighborly relations.
“If the euro fails, then Europe fails,” Ms. Merkel has repeatedly said.”
Hans-Werner Sinn: “Soros does not recognise that the ongoing eurozone crisis is merely a symptom of the south’s loss of competitiveness”
“”I won’t negotiate with you,” Ms. Merkel replied. “You need to talk to the troika”—the International Monetary Fund, European Commission and European Central Bank.
It was a typical Merkel move: trying to play down Germany’s dominant role in reshaping Europe’s currency union. Few in Europe believe it.
However lightly Ms. Merkel treads, German strength in Europe is raising tensions. Many Greeks and Spaniards blame Berlin’s austerity diktat for turning their countries’ financial crises into economic depressions.”
“”Through continuing our policies of growth-friendly consolidation we are systematically building up the trust of international investors lost in the crisis,” the finance ministry said.
The ministry said it has been “clear from the beginning that only comprehensive reforms and consolidation can provide the basis for sustainable public finances and growth,” and added that the overhauls don’t impact the jobs market from one day to the next.
While pressure from European peers and Germany’s center-left opposition to loosen its focus on austerity is growing, the government of German Chancellor Angela Merkel shows no signs of caving.”
“Greece is planning to pursue a long-dormant claim for reparations from Germany over World War Two, a further strain on relations with Berlin, which foots most of the bill for its 240-billion euro rescue.
The Finance Ministry has compiled a report that takes stock of all relating available documents spanning more than six decades, Greek Foreign Minister Dimitris Avramopoulos told parliament on Wednesday.
It will be submitted to Greece’s legal advisers and then Athens will decide how to officially press its claim, he said.
Avramopoulos did not say how much would be sought.”