Some thoughts on Europe, most of them positive

In the past two weeks, a lot has happened in Europe. I would say the general tenor of the news flow has been downbeat. Nevertheless, I am mostly positive on Europe. I don’t see an imminent eurozone breakup, nor do I see a further dip into depression. Instead I see economic improvement and political will to keep Europe intact. In a few paragraphs below, I will explain why I remain upbeat despite the news flow.

Europe as a US counterweight

Let me go right into the political here and start with the NSA scandal. One facet of the spying that the U.S. has done that I believe is under-appreciated is the degree to which it affects the political situation in Europe.

A few months ago, I was reminded of why the European Union and the Euro exists due to a joint interview with former French President Valéry Giscard D’Estaing and Former German Chancellor Helmut Schmidt. Here’s the article link. I recommend it. Now these two initiated the European Monetary System which later became the euro. So their commentary is important in understanding the animus for the Euro and European cohesion. Let me put a few quotes forward and then describe the tenor of their message.

• Giscard: “We are the victims of a smear campaign that has its origins in the American banking system. We are in the middle of a communication battle that is fueling speculation.”
• Schmidt: “When the Maastricht Treaty was signed in 1992, the EU had 12 member states. And these 12 made the mistake of inviting everyone in Europe to join, and even to become a member of the monetary union. The currency wasn’t actually born until 10 years later. Now, the EU has grown to 27 members, the majority of whom decided to adopt the euro.”
• Giscard: “To be perfectly frank, it was a mistake to accept Greece. Greece simply wasn’t ready. Greece is basically an Oriental country. Helmut, I recall that you expressed skepticism before Greece was accepted into the European Community in 1981. You were wiser than me. The Euro Group cannot be allowed to expand endlessly.”
• Giscard: “Of course, one needs institutions — how else can the fiscal and economic policy coordination be expected to work? When the Euro Group meets under Juncker’s chairmanship, there is not even a secretary general, not even a written record of the meeting. That is absurd. The Euro Group council needs its own structures, independent of the large European Council.”

I see these quotes as generally very pro-European integration, supportive of further support for the European Project with some caveats, those being that not all euro members should belong. If I had to characterize the animus here however, it is the first quote from Giscard about the “smear campaign” in the American banking system that stands out. What is wholly unsaid here is how much the EU is meant to be not just a project to prevent European nationalism and conflict but also one to act as a counterweight to US aggression and global domination. Giscard is much more focused on this. Spiegel asked about whether Europe will be a global power. Giscard says “Yes. It has what it takes. And we should give it an opportunity to become one.” On the other hand, Schmidt, cognizant of the Nazi legacy, says, “I would be somewhat more cautious here. The European Union will hardly coalesce to become a genuine global power. And Europe doesn’t have to be a global power.” So what you have here is the nuanced views of the French-German alliance on why the EU exists and what kind of power it should project.

In this context, we need to see the NSA scandal as something very important. Now I know from being on the inside that spying goes on on a broad scale that is not discussed openly, both of governments and for industrial espionage. This has always been so. So it would be naive to think the US is not spying on its so-called European partners and vice versa. On the other hand, the way this spying has been done, the brazenness and disregard of consideration by the US to appear collegial will be very damaging in terms of the likely reaction from the European political elite. What is likely is that Europe will circle the wagons – the UK’s allegiance to the US being a complicating factor. And that means greater desire for more Europe, more cohesion, a larger European IT sector and less reliance on the US in all matters. As far as the euro goes, the NSA spying scandal makes European elites more desirous of saving the single currency by any means necessary. Europe now has every reason to keep the euro together, if only to further the sentiments expressed by Giscard.

So that is the political setting here. The EU, the Euro, and European integration has always had a degree of competitive animus behind it. Europe as a counterweight to America was always a background motivation. But now that we know the lengths to which the U.S. will go to spy on governments, companies and citizens globally, it is clear that Europe must not disintegrate if it is to maintain that economic counterweight.

The sovereign debt crisis is not over

From an economic perspective, Europe’s ability to maintain cohesion is being severely challenged. The sovereign debt crisis is not some sort of scam perpetrated on Europe by the Americans as Giscard asserts. It is due to the inappropriate institutional structure of the eurozone. Look at the contrast between Greece, Italy or Portugal and Japan. In the one case, you have crisis after crisis while in the other, Japan has been borrowing at the lowest interest rates in the world for years. This speaks to the leeway currency sovereignty has given the Japanese and the lack of policy space in the eurozone.

Earlier today, Greece released its inflation figures. And the figures showed a 0.4% decline in inflation on a year-over-year basis. So, right now, Greece’s economy is contracting, the debt pile is growing and the real burden of debt is growing as deflation takes hold. That is an extremely toxic mix for a country without a government lender of last resort. In Japan, the country has the central bank. In Greece, default is the likely (eventual) outcome.

And so the question here is what this means for European cohesion in the context of a hegemonic United States. I think it means that Greece will receive a free pass for as long as it is possible. Every trick will be turned to kick the can down the road and give Greece breathing space until the EU runs out of options. And I believe that gives Europe at least another year or two.

The same is true for all of the periphery, Spain, Italy, Portugal, and Ireland as well as Greece. In this sense, I am positive about Europe because I believe the political will to stay the course has only become more intense. The question is what the economic/debt outlook is as well as what institutional structures will develop to support the end of crisis.

Monetizing debt

Three years ago, I set out the terms. There are three options for the euro zone: monetisation, default, or break-up . Now more than ever, the monetisation option will be the preferred way of dealing with the crisis. And so this puts the ECB in the driver’s seat from a policy perspective. The ECB started its monetization approach with a half-hearted backstop during the Italian crisis late in 2011. But this unraveled and when Spain hit the wall last year, the ECB was forced to ratchet up its rhetoric with the “everything it takes” approach that led to the OMT program. The OMT backstop has been very effective in keeping things in stasis for the past year. However, last month things started to unravel in Portugal and Greece in particular.

My view here is that the OMT threat is not enough. Eventually one country or another will need to actually enter an OMT program. I had seen Spain and Ireland doing so this year. But as yet, this has not occurred. What has happened however is that the ECB has gone one step further in supporting sovereigns. The ECB’s forward guidance to match the Fed is not just about keeping euro banks happy. It is also about keeping sovereign yields as low as possible. I see it as a form of debt monetization in the same way that the Fed’s forward guidance is.

What the ECB has effectively done is anchor interest rates for the next 12-24 months, preventing any rise in sovereign yields outside of redenomination or default risk. Effectively, the only reason sovereign yields in the eurozone will be high from here on out is because of redenomination or default risk – both of which can be mitigated or eliminated by a formal OMT program application. For Spain, Ireland or Italy, that effectively means their bonds have almost the same level of risk as for Austria, Belgium or France. Any backup in yields will be met by an OMT program.

For Portugal and Greece, you do have a problem because they are not really eligible for the OMT. Portugal was trying to get there. And in May I marvelled at their ability to move in that direction as I had written earlier this year that the OMT was out for Portugal. At this point then, the best that Portugal and Greece can hope for is a miraculous turnaround in their economies to help reduce default or redenomination risk.

Economic Turnaround

And indeed the numbers do look better for Europe. All of the economic numbers show a smaller pace of contraction i.e. a sustained improvement in the 2nd derivative – change in the change – numbers. But increases in 2nd derivatives is not growth and it is definitely not sustained or robust growth. We have a long way to go. And that means you get an increase in the debt burden and worse macro statistics for at least the next 3-6 months in both Portugal and Greece. 

In sum, I have a constructive view of the European economy. I believe we will see recovery later this year. But I do not believe this recovery will be robust or necessarily sustained. And that makes it especially difficult for Greece and Portugal in terms of debt sustainability and political and social unrest. The likely outcome here is one of recovery in Europe toward the end of 2013, with recovery coming to Greece and Portugal later. This will be followed by weak growth and political and social frustration with the pace of improvement, making the outcome unpredictable. At some point, I anticipate a flaring of yields again, testing the political will of the policy elite. And of course, I eventually expect Greece to exit the eurozone due to this outcome.

So, Europe’s fortunes are better but the institutional structures just aren’t there yet. And the economic outlook is not enough to overcome this. In this context, Greek bond outperformance is likely over. 

Much more to come.