Champagne is popping in Brussels, Strasbourg and other EU-bureaucracy cities this weekend, following a major decision by euro-area governments to address the prolonged euro-area sovereign funding crises with a dramatic expansion in cross-border financial support, including both fiscal transfers and guarantees. While no doubt a short-term political success, does this qualify as an economic one? Does it in any way address the fundamental economic problems which brought about the crises in the first place? No. The euro-area periphery still lacks the productive capacity to service its vast accumulated debt. And it is unrealistic to believe that, over the coming year or two, Germany is going to be both able and willing to make up the difference. The can has been kicked down the road yet again. What politicians have missed, however, is that the road ahead is quickly becoming more treacherous to navigate. Another funding crisis probably lurks in the near future.
We have written about the evolving euro sovereign debt crises on multiple occasions. Our first missive on the topic, The Real Lesson of the Greek Debt Crisis, March 2010, concluded that, notwithstanding the glaring economic problems of Greece and certain other peripheral euro-area sovereigns, the euro-area as a whole has a smaller debt servicing problem than the US and, importantly, the onset of austerity measures on the European side of the Atlantic, when juxtaposed with the accelerating, even breathtaking fiscal profligacy of the US, implied that that the euro currency was likely to rise in the medium-term relative to the dollar.
Here is a relevant excerpt from that report:
In the drama of the Greek debt crisis we are seeing a classic example of financial markets doing precisely what they are supposed to do. To mix our metaphors, on the gun pointed at Greece—and previously at Ireland—we see not only the fingerprints of bond market vigilantes but also those of Adam Smith’s invisible hand. And when we gaze into the future, we see either reformed, sustainable euro-area fiscal policies across the board or a smaller but more competitive euro-area economy. The real lesson of the Greek debt crisis is that it illustrates that, for all its flaws, the euro-area is structured in a way that imposes a greater degree of market-based fiscal discipline on sovereign members than is the case in the US, the UK, Japan, and probably many other countries. By implication, the euro should provide a superior store of value than either the dollar or sterling in the coming years, as indeed it has done for the better part of a decade.
Back then the euro was trading at a mere 1.20 to the dollar. Today, notwithstanding a series of sovereign debt crises, it is near 1.45, some 20% stronger. That is no mean feat. But in our view it is entirely justified. Market forces are working their magic on the euro-area, forcing unsustainable government policies to be sharply curtailed, if not abandoned.
In our second look at the euro crises, Is the German Eagle a Grey Swan? from August 2010, we pondered the possibility that, at some point in future, Germany would lose patience with the more profligate euro-area governments and would either seek to withdraw from EMU (European Monetary Union) unilaterally, reinstating the Deutsche mark in the process, or it would seek to retain a core group within EMU, most probably including France, Austria, the Benelux countries, and possibly Finland, while leaving the rest to default, devalue and/or withdraw from EMU. As we put things at the time:
The German economy is now beginning to weaken. It is early days yet, but the signs are there. Exports are slowing as the global economy runs out of all the stimulus thrown at it in 2008 and 2009. Extrapolate current trends out a year or so and what you have is a German economy that has slowed by enough to push up the unemployment rate slightly. Amidst a continuing debate as to whether Germans should be continuing to provide open-ended bailout funds to others, rising unemployment could well shift the political balance slightly. The risk of Germany reneging on current, tenuous, arguably unconstitutional (ie Treaty-violating) bailout arrangements is going to be higher a year from now that it is today.
Now, who wants to be holding that Greek debt, or shares of European banks exposed to Greece, if that shift occurs? That’s right. No one will touch it. It will be game over. The question then becomes, how large a haircut (loss of capital) will bondholders face in a restructuring? And how will this impact European bank balance sheets and earnings? Well, it won’t be pretty. Now repeat with Ireland. With Portugal. With Spain. With even Italy perhaps.
This outcome remains possible, in our view, although it is probably unlikely until 2012, by which time the core euro-area economy is likely to have entered a significant economic downturn. (More on that later.)
Our third take on the crisis was The Rising Sea of Debt, November 2010. Here we considered the possibility that the Irish, among other euro members in crisis, would simply choose to default rather than face the prolonged agony of servicing an unserviceable debt for a decade or more, prior to defaulting someday anyway. As we wrote:
Recent polls show that the Irish don’t WANT this “bailout”. They would PREFER TO DEFAULT. Just as a homeowner can make a perfectly rational economic decision to walk away from a mortgage which exceeds the value of their home, so the Irish can make a perfectly rational decision that, rather than spending the rest of their and their children’s lives servicing a colossal debt, they can JUST SAY “NO!” by defaulting, walking away and starting over.
The doomsayers respond to this by pointing out that the Irish government will find it difficult to access the debt markets again following a default and would do so only at far higher borrowing costs. Yes, that’s right, but ISN’T THAT THE POINT!? Just as the Irish may not want to eternally service a debt that was foolishly run up by well-compensated bank executives, they don’t want their government to ever have the option of assuming such a grotesque amount of debt ever again. “What’s that you say Mr Politician? Can’t access the capital markets to save a failing bank? OK, let ‘em fail. Can’t raise debt to pay for bloated, unsustainable welfare programmes? OK, end the programmes. Can’t finance some pet project in a representative’s district to help him get re-elected? Cancel it. Now let’s move on and get back to the business of working for a living, providing for our families and paying a reasonable, modest amount in taxes for essential services as we go along, rather than piss our hard-earned incomes away on debt that we can’t realistically service; on mismanaged private enterprises that have gone bankrupt; on welfare programmes that we can’t afford; and on political pork that serves no purpose other than to keep incompetent, corrupt politicians in power. Oh and by the way, we Irish fully understand that what we owe in debt, we owe largely to the English, who occupied our country for centuries, occasionally with brute military force. Well take this John Bull: WE DEFAULT!”
Irish politics has clearly been moving in this direction although it remains too early, in our view, to expect such a radical break with the past. As with Germany, however, the mood may have shifted somewhat further by 2012 and, in our view, an Irish default may very much be on the table at some point in future.
Why our continuing pessimism? Why now, that European leaders appear to have closed ranks against the bond market vigilantes, laying the groundwork for massive cross-border fiscal transfers and debt guarantees, do we still believe that, in the end, they are fighting a losing battle?
The answer is simple really: Nothing that the Eurocrats have done to date addresses the fundamental economic problems of the weaker euro area sovereign countries. Yes, they have passed various austerity measures. Yes, on paper at least, these are going to reduce government deficits going forward. But no, these measures are not, in fact, going to make it any more feasible to service the already colossal debt built up over the past decade. And why is that? Because while they do (in theory at least) reduce government expenditures, they do not provide incentives for private businesses to invest and expand. Without that, tax revenues cannot increase. Unless they do, the debt, even as restructured under this past week’s agreement, is simply not serviceable at its present, real face value. And that which is not serviceable will be either devalued or defaulted on.
As per the new agreement, Germany, France, and other relatively healthy euro-area economies are supposed to be on the hook in the event that an imminent peripheral sovereign default looms again in future. But are they really? No, of course not. The Germans, the French, or the Finns for that matter, can pull the plug anytime. So can the recipients of the bailout money, which is only forthcoming if they continue to make good on hugely unpopular austerity programmes.
The financial markets know this. German public opinion is already overwhelmingly against the bailout just agreed. Chancellor Merkel is acting in unambiguously undemocratic fashion. Her party, the Christian Democrats, are aghast. The opposition Social Democrats smell blood. Younger Germans, well educated yet lacking any palpable sense of cultural guilt for the bloody twentieth century, can’t believe that they are being asked to underwrite the unserviceable debts of their southern neighbours. Well, in the end, they won’t. Politics will not triumph over economics, not when those who are being asked to open their wallets feel little if any sense of obligation to do so.
But perhaps it will not be the Germans who pull the plug in the end. Perhaps it will be the Irish, who remain opposed to the bailout arrangements agreed to date by their supposed government representatives. We don’t know. What we do know is that the risks are only going to keep growing on all sides of this fragile, undemocratic, multilateral agreement.
Why? Consider: Whereas the German and French economies have been doing rather well of late, they are, in fact, beginning to weaken, just as we anticipated last fall. By late this year or next, they are likely to be growing below trend, with unemployment gradually rising.
Why are we so certain? First, the relative strength of the core euro-area economies is derived largely from exports to emerging markets, in particular the BRICs, which have contributed the bulk of global GDP growth since the 2008-09 credit crisis. All indications are that these economies have been slowing gradually for some months now as interest rates have risen in response to sharply higher domestic inflation rates. This trend shows no sign of abating.
Second, there are now initial indications that this BRIC-led slowdown is arriving in Europe. The German Ifo index, a widely followed leading indicator, peaked in February at 115.4 and has subsequently declined to 112.9. The German and French PMI indices, comparable to the US ISM index, peaked in the spring and have now declined to just over 50, on the edge of indicating an outright contraction of industrial activity, if not economic activity generally.
Other factors equal, if the core euro-area economies continue to weaken, this is going to be a net negative for the peripheral economies, including of course their ancitipated tax revenues and ability to service debt, inviting yet another speculative attack by the euro bond market vigilantes. Should that occur in a context of rising unemployment in the core, should we be confident that the hugely unpopular bailout just agreed is, in fact, going to be implemented? On the contrary, as discussed above, there will be growing domestic political pressure in Germany and possibly also in France and other core countries to either renegotiate terms or just renege altogether on their guarantees for peripheral debt.
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While we understand why the Eurocrats are celebrating, we doubt they will be for long. Undemocratic decisions are unpopular for good reason. When they are shown by events to have been poor decisions, they are more unpopular still. In the current instance, there may be some number of months to wait for the next round in the euro-area sovereign funding crisis. But when it arrives, those who have been celebrating will find that they have been overtaken, yet again, by economic realities, and they will have a rather nasty political hangover with which to contend.
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