How is the eurozone periphery doing?
Summary: With Spain posting its first gains in GDP in over two years, every media outlet I have seen is trumpeting this as the end of the eurozone recession. I called it early, yes. However, one quarter’s GDP growth does not make recovery. Let’s look at how Europe’s periphery is actually doing.
Before I get started, I have to flag gold as a topic that I have been meaning to discuss for the past week. I had been bearish on gold since the beginning of 2012 after being a longtime bull. However, I believe the bear market in precious metals may end soon and am watching inflation and interest rates for the signs that the pre-conditions are right for another surge upward in the price of precious metals.
Meanwhile, despite the upswing in the European economy, the prospect of deflation, and specifically debt-deflation, has not gone away. Read Ambrose Evans-Pritchard’s latest piece on this for further pointers. Ambrose is his usual hyperbolic self – and for good reason. As a student of economic history, his points on debt deflation are valid and must be considered as the backdrop to the situation in Europe. That is not yet a situation which favours gold.
The public and private debt levels throughout Europe are high and within the euro zone this presents a particular problem because governments lack a sovereign currency. This forces both public and private sectors into simultaneous deleveraging, which adds a debt deflationary impulse to the economy, something I correctly predicted three years ago would be the origins of the next crisis. The ECB is really the only agent that can overcome these forces and it has played its part.
The OMT maneuver by the ECB last year ended the spectre of imminent sovereign default outside of Greece. And the liquidity for the banking sector that the European Central Bank has provided has also been helpful in providing liquidity that supports credit growth. These actions and the move to backloading austerity have given Europe a reprieve. This is why I am relatively upbeat about Europe. However, right across Europe the policy mix is still not that reflationary. Austerity is still the prevailing fiscal paradigm and the ECB is nowhere near as accommodative as the Fed, though it has become more so with its move to forward guidance. Thus, debt deflation continues to loom in the background.
Spain. Spain is an important country in terms of future EU policy for a number of reasons. As a large economy, it matters in terms of the periphery. Only Italy is more important. Spain’s basic problem is private debt as it had low public debt levels pre-crisis. But a housing bubble has created a debt deflationary spiral which has resulted in large public debt levels. This is important to remember in terms of EU policy response, which, given the lack of currency sovereignty, has been focused on cutting public debt levels in order to avoid a sovereign bailout or default. Because Spain was so close to the edge and because it was so important, the EU began the OMT program and began back-loading austerity, essentially pushing deficit reduction targets out. The result is finally here as Spain’s economy grew 0.1% in Q3. But note that GDP is still 1.2% lower than a year ago. And unemployment remains at extremely elevated levels, though unemployment has begun to recede (link in Spanish). In short, this is no robust recovery yet by any means. It may not even be a recovery at all. We will have to wait to see how long the upswing lasts.
Italy. If Spain is important, Italy is even more so given the size of its economy. I believe Italy holds the key to the euro zone because were it to leave, the euro would cease to exist. In most senses of the word, Italy is thus a core country in Europe. Even in terms of demographics, with its aging population, Italy is closer to Germany than it is to Spain or Ireland. Italy is considered on the periphery only because its public debt profile with government debt to GDP of 133% is loser to peripheral countries than to core countries as was its pre-euro currency management. Italy is the weak link in the periphery because of its core European-like profile of an aging society combined with high public debt levels and an unstable political environment, make growth weak and public debt problematic. Austerity in this environment creates debt deflation and carries weakness over into the banking sector where bad debt is building (link in German). Look at the recent bailout of the Italian airline Alitalia in that light. If it were not bailed out, not only would Italy’s only major airline cease to exist, tens of thousands would go unemployed, and credit writedowns in the financial sector would be massive with potential knock-on effects. I see the Alitalia bailout as analogous to the GM and Chrysler bailouts in the US.
Three anecdotes tell you how bad the banking problem is. First, the oldest bank in Italy Monte Paschi di Siena is receiving a massive state-funded bailout. Second, the largest bank in Italy Unicredito is talking openly about selling its stake in German-based HVB in order to deleverage and increase capital. Third, credit to small business and households is collapsing due to the capital shortfall at banks. Despite high house ownership, mortgage lending in Italy fell by half last year. And now the banks are looking to import American GSE-style federally-endorsed mortgage methods into Italy, shunting risk off onto the state. In the U.S. this led to disaster as Fannie and Freddie were rescued after they collapsed from massive losses on mortgages. The situation is dire and it is only because of the toxic mix of built-in slow growth due to demographics, worsened by austerity economics that has ended in debt deflation. Protests continue.
The Italian government has decided to take a leadership role in calling for a more expansionary economic policy that focuses on infrastructure spending as a quid pro quo for structural reform. But it is unclear still how quickly the Italians will gain traction on this because the Bundesbank is warning the German government against just this kind of fiscal loosening. And Italy has joined France and Spain in demanding the ESM European bailout fund be used to help banks as well as governments. Germany wants to limit the fund to governments and only sees the Spanish bailout as a one-off to prevent a Spanish sovereign bailout, something that the Germans do not wish to repeat.
The bottom line here is that Italy’s economy, banking system, employment market and political institutions are all weak. And given Italy’s importance, this cannot continue without severe repercussions that lead to renewed crisis.
Greece. In Greece, the population is now 40% poorer than it was in 2008 (link in Spanish). This is exactly why Greece has any chance of a statistical economic ‘recovery’. It is much easier to grow from an economic base once it has been reduced by 40%. If an economy grows another 50% over a decade from there, it is still 10% below its pre-recession base. And note, the latest figures on industrial production show a fall of 7.2% year on year. Household disposable income in Greece is still falling. It was 9.3% below year ago levels as of Q2 due mainly to a 14% reduction in wages and a 12% fall in benefits. Unemployment is over 27%. and could reach 34% by 2016.That’s how bad things are in Greece. So we need to put the recovery there in that context.
With that backdrop, the government has reduced the deficit considerably. A primary surplus before interest costs is likely for 2013. The government debt situation can be helped further if Greece is able to privatize assets. But the current economic environment makes any asset sale more of a fire sale. And so privatization is being questioned. Note that Greece is still selling 3-month paper at 4% and that the government debt burden ballooned from 160% of GDP to 169% in Q2. And Greece is still missing its targets.
Let’s not kid ourselves; Greece is going to need another restructuring. The debt burden is unsustainable. Moreover, the reason it has become so unsustainable is because the policy mix in Europe reduces GDP so much that you need Herculean levels of budget cuts to reduce debt. Meanwhile the debt load increases while the economy contracts, ballooning the debt to GDP metric. IMF economists have told us this in the past. And now even EU economists are saying the same thing. Right now, tourism is driving Greece’s economy. That won’t cut it; a restructuring is going to happen despite denials from Germany and the EU.
Portugal. My contention earlier in the year on Portugal was that it could not possibly get out of its bailout and move to an OMT style one. After the Cyprus deposit grab, however, sovereign yields in Europe plummeted and I looked to be wrong. Since then, however, things have gone a bit pear-shaped as yields have climbed. Portugal is still looking to make the grade though. The fact that the country had the highest increase in industrial production in the eurozone according to the most recent figures makes one think they can pull this off. I remain sceptical. The country is still missing targets despite the sign-off on their efforts at the EU level (link in German). Let’s wait and see.
Ireland. We do have a positive example in the periphery though because Ireland will probably make the grade and leave its bailout program because it now has full market access. The Irish economy was already growing in Q2, a quarter in which it grew 0.4%. And house prices are rising again in Ireland, helping to end debt deflation. In Dublin, for example, prices are up 10.6% in the past year. The Irish Prime Minister Enda Kenny has said he expects the country to exit its bailout program on December 15 and he is now working with EU officials to see whether he can get a 10 billion euro OMT-style backstop from the ECB. In anticipation of a positive outcome, the Irish are going ahead and presenting yet another austerity budget for the coming year as a sign of good faith.
All is not well, however. Public debt now stands at 125.7% of GDP. And 90% of commercial property transactions and 50% of residential property deals are cash-only deals. In Germany, the coalition talks are hitting a snag on the Irish business tax issue. The SPD believes corporate taxes are too low and are making raising Irish taxes a key issue in its coalition talks with Angela Merkel’s winning CDU/CSU. It is possible that Germany could make further support for Ireland contingent on movement on taxation issues. We’ll have to wait and see.
General comments. Meanwhile, the latest figures out of Germany show a very weak, even backsliding recovery. The composite PMI for October was 52.6 versus 53.2 last month. This tells you that domestic demand in Germany is weak despite the booming housing market. And to the degree the German government heeds the Bundesbank’s warning for fiscal restraint, Germany will add a further dampening impulse to an already weak economic situation in Europe. The bottom line here is that recovery is not assured. I believe it has come and will continue, but it is a weak recovery. Debt deflation is still a threat in the periphery, particularly in Italy. And any exogenous shock could tip the region back into economic contraction. The periphery is doing better, yes. But we have a long way to go.