Thursday, October 20, 2011

Europe - Update

A big and indecisive day in Europe today. These are pictures in Athens in the second day of the 48 hour General Strike, shortly before the Greek Parliament approved another tough round of austerity measures. This weekend was supposed to be decisive, with a Sunday meeting to declare and present the Grand Plan. But France and Germany cannot come to agreement on the Plan; so the meeting will be held, but the Summit where all things will be decided and revealed is moved to Wednesday.

It's a mess. A Big Mess. Strangely enough, our markets are still listening to the refrains of optimism. The S&P was up a tick today, although Europe was slightly down. No one knows what will come down; for now, optimism can still make its case.

If, for the moment, we leave out the fundamentals, the crisis has three parts that a Grand Plan must address: recasting the July deal on Greece, where bondholders agreed to a 21% haircut voluntarily (thus avoiding a CDS triggering credit event); recapitalizing European banks (estimates range from $80 billion to $400 billion); and finding a way to leverage the 440 billion euro European Financial Stability Facility (EFSF) to support Greece, the bank recap, and prevent sovereign defaults by supporting sovereign bond issues.

Lots to do. No real mechanism to do it. And disagreement among the principals. Will this all work out, if only at the last minute, like the painful, yet successful debt ceiling deal in the US? Possibly. Possibly not. If I had to bet, I would bet yes, but add that the likely "solution" will only be a bandaid, and the same crisis will shortly reemerge.

What are Sarkozy and Merkel (and other leaders) not dealing with? Three things:

     1. Austerity won't work.

The Troika (IMF, EU, ECB) reported in today. Greece is in trouble again. Their growth is slower and their deficits larger than forecasted just a short while ago. The other Europe South countries, who have been forced onto austerity diets, are likewise beginning to miss targets. Britain has more than a year showing us in glorious detail just how clearly austerity does not work to unleash the theoretically shy and anxious private business energy into the world. When government pulls spending out of the economy by committing to disciplined and austere budgeting, it simply does not cause the private sector to spend more, and the economy to step up its growth. As one pundit wrote, try to change the thinking of the "teutonic granite that is the Bundesbank." 

The IMF, surprisingly, has just changed its tune a bit, calling European leaders to caution with their fierce austerity push, warning it might bring recession. Europe needs growth. Germany in particular is committed to budget cutting austerity, to bring country deficits "into line". It won't work. Irving Fisher wrote about this in 1933, The Debt-Deflation Theory of Great Depressions. You simply cannot cut your way out of a deep recession. Doing this when there are high levels of debt will lead to Depression.

Europe/Germany will not, I am afraid, let up on this. The results, even if we get through the immediate crisis, will not be pretty.

     2. Only the European Central Bank (ECB) has the financial firepower to deal with the crisis, but Germany is unwilling to use the ECB's money creating capacity to underwrite sovereign debt and thus quiet the markets.

This crisis would be over almost immediately if the ECB would make the same kind of commitment to provide liquidity to banks and sovereigns that our Fed did in 2008-2009. France wants to move in this direction. Germany is adamant that this road is not to be taken. The ECB is, the Germans argue, forbidden by the original Maastricht Treaty from monetizing debt, interfering in fiscal policy, or providing any financial facility directly to a sovereign. The old inflation fear is too deep in the German heart; this is the straight path out of the hole, and they will not take it.

     3. Germany cannot maintain its large export surpluses to Southern Europe without providing an ongoing mechanism to recycle the surpluses back into the import GIIPS countries. They cannot continue to require these countries to deficit spend and finance their import deficits with bond financing.

This is the biggest structural issue: Germany, and to a lesser extent the Netherlands and Austria, have a significant (30%) competitive cost advantage over Europe South. As a result, these countries run trade surpluses, while the GIIPS run trade deficits. And if you do a sectoral balances analysis of the GIIPS, you will see that their public budget deficits are mostly sourced by their trade imbalance. Private deficits (trade balance, private household savings, and business investment) must be matched by public budget deficits. Take a look at this chart provided by Martin Wolf at the Financial Times:

It is not too far off the mark to say the GIIPS are being hammered by the Troika and Germany simply as a result of buying so much from Germany, and Austria. Their indebtedness is almost completely sourced by their trade imbalances (which seriously supports the German economy); and this indebtedness has led to a steep rise in sovereign bond yields, which brought us to the crisis, and where we are today. Germany cannot have it both ways: great export markets and then fury when credit markets turn sour and your trade customers are in  trouble. So far, Germany seems to want it both ways. If they do, this crisis will continue, until it boils over. Not a pleasant thought.

No comments:

Post a Comment