Europe is moving closer to the endgame
This is probably one of the most upbeat posts I have written on Europe in quite a while. Originally, I intended to write this post as a short blurb discussing Angela Merkel’s recent European proposals but there are a few loose threads I should tie in to what Merkel is saying to give a more complete analysis. The title says it all. What I see in the rhetoric and decision-making of European politicians is support for policy moves that will be difficult to reverse. That makes me believe we are reaching the end phase of the European debt crisis, with the workout lasting years beyond this.
First, just as a prelude to the recent spate of European policy initiatives was the ECB’s outright monetary transactions program. This is what is commonly known as monetisation. And given the unlimited support that the ECB has given member states, it is clear that it will work in stabilising bond prices. The real economy is another story since the quid pro quo is austerity. Nonetheless, I believe European politicians are pragmatic enough to throw off the austerity yoke just enough when it counts to prevent the euro zone from disintegrating.
In that vein, it was interesting to see what Christine Lagarde has been saying about easing austerity in Greece while her Lieutenants are praising more austerity in Portugal. The FT noted the following comment from Abebe Selassie who is overseeing the program in Portugal:
Mr Selassie, who represents the IMF in the so-called “troika” of Portugal’s international lenders – officials from the European Commission, the IMF and the European Central Bank – said he was issuing the statement in response to media queries on the IMF’s position.
He said that countries like Portugal “need to undertake fiscal adjustment, paying heed as much as possible to the impact on growth and other macroeconomic variables”.
Mr Selassie added that individual “country circumstances” are important, citing recent comments by Christine Lagarde, the IMF’s managing director, that “a fiscal adjustment programme over a period of time cannot be one size fits all. It has to be adjusted based on the parameters of each country”.
What Selassie is saying is that the IMF, at least, is willing to relax austerity in individual cases like Greece where it has led to a serious depression. But they are still committed to austerity as a necessary component of restructuring. And in Portugal’s case, draconian measures enacted by the Portuguese government are fully supported by the IMF.
What does this mean? For me it means that the Troika are not going to allow the euro to collapse due to an austerity-laden ugly deleveraging. Rather, the Troika’s goal is to enforce enough austerity to make a country’s debt burden sustainable without the country defaulting on loans to creditors. The IMF, as always, wants creditors to be paid back in full, if possible. Meanwhile the ECB and the European Stability Mechanism will do their best to stabilise yields on debt as this is ongoing.
In sum, the message is just enough austerity to pay creditors back in full offset by monetisation by the ECB and ESM.
Meanwhile, the Europeans are moving forward with long-term plans on banking union according to press reports. That speaks to a mutualisation of risk that would be hard to undo. Once the banking union is set in stone, it would be yet another factor tying euro zone countries together that would be hard to undo.
Angela Merkel is also talking about setting up a solidarity fund, presumably funded by a financial transaction tax. The solidarity fund is supposed to be a way of giving nations in economic downturns a countercyclical push that is not available through current euro zone mechanisms. The overtones here are similar to what I called a European Harmonisation Fund almost three ago as the sovereign debt crisis was in its infancy.
Merkel is also calling for “fiscal union” along the terms I identified as Germany’s preferred fiscal union setup late last year where the EC can take control when a country is an egregious violator of the Maastricht Treaty budgetary rules. I said then that “I continue to predict that the move will be toward temporary ECB intervention followed by tighter fiscal integration and explicit mechanisms for euro zone exit.” This seems to be how things are proceeding (though Merkel has not joined members of her coalition in pushing for euro zone expulsion mechanisms). Also notice that three years later, the structure now taking place is almost identical to what I was calling for in 2010 with my European Harmonisation Fund, an IMF-led oversight regime assauged by a countercyclical funding mechanism. I wrote then:
“I suggest a two-stage approach. In the short-term, we would need a trust-but-verify approach that only the IMF could institute. Greece would continue as planned with the budget measures they have already enacted. However, the Greeks could, therefore, be assured that – should it face liquidity problems – the IMF would intercede and ensure the Greeks stick to their budgetary plan. From a political perspective this takes the heat off Germany and supports their austerity agenda. For the Greek government, it gets cover domestically: ‘we didn’t create this mess; the former government did. And we’re not forcing the cuts; the IMF is. The key, of course, is that the IMF funds be available as a loan for temporary fiscal stimulus to support liquidity over the medium-term in exchange for concrete promises on longer-term budget issues. This would attenuate any economic pressure.
“Over the long-term, the proposed European Monetary Fund makes sense. However, first and foremost, let’s call it a European Harmonisation Fund because this is the purpose – harmonisation.
“For example, within the United States, I imagine there are substantial interstate capital account imbalances between individual states. Florida might have a substantial capital account surplus because of all of the retirees moving there. While New York could have a capital account deficit because of the financial sector wealth. (I don’t know if this is true. The example is just illustrative). But you wouldn’t hear New Yorkers screaming bloody murder about the profligacy of Florida. Nor would you hear the Floridians yelling about New York’s enormous current account surplus.
“The point is the United States has more well-harmonised internal market because of the free movement of labour and capital, a common language and federal automatic stabilisers. This is what the Eurozone lacks. And this is why we can change the unbelievable EMF – and its inflammatory expulsion clause into the more believable EHF.”
My sense is that it has taken us so long to get here – to what I identified as a reasonable and politically feasible policy choice in March 2010 – because politicians are anchored to previous policy choices and are therefore loathe to stray too far from those positions too quickly. Inch by inch we are getting there.
One final note, the ECB monetisation scheme is proceeding as I believed it would, with yields falling – even before the ECB has intervened. Spain and Italy won’t fail. And the ECB will not need to spend a lot of capital supporting Spain and Italy if it plays its cards right. I would have preferred to see an explicit spread target and less austerity in Spain. Nonetheless, what we are seeing will work over the long-term as long as the EU is willing to relax its deflationary policy response when things get too critical.
As an investor, this makes Italian sovereign debt look good. Italy is not in the dire straits that Spain is in and so the downside is more limited there. Moreover, it is now clear that the EU is putting processes and institutions in place that will make the euro zone even harder to leave in a panic. The euro zone will break up only as a result of universal agreement and using an explicit pre-designed mechanism for expulsion. I still believe, however, that Greece will use this mechanism down the line. But there will not be an imminent euro zone departure now. Nor is it likely that any other countries will exit. I know we have a long way to go. And the economy in Europe still stinks. But I see the light at the end of the tunnel because of all of the policy choices now being made. All of this is cause for optimism.