European cohesion, austerity, Grexit, and eurozone expulsion

Daily commentary

With Ireland and Spain poised to leave Europe’s bailout mechanism, Europe appears to have weathered a very big storm. Yet, the Eurozone is still wracked with joblessness and economic growth remains elusive. And the spectre of deflation looms. What’s more, Europe’s institutional framework will not make a robust recovery easy. This virtually guarantees political and social tension for some time to come despite today’s apparent successes, which will eventually lead to a departure from the eurozone.

Stepping back from the brink

As things stand today, we should applaud Europe’s success in overcoming crisis. If we look back to early in the year when Cyprus’ banking system collapsed, Europe faced a crisis on multiple fronts. The immediate issue, Cyprus, saw a eurozone country’s largest banks declared insolvent, with depositors forced to bail them out. Capital controls were imposed within the eurozone for the first time. Five countries within the eurozone were in official Troika bailout programs. And the whole eurozone was wracked by recession. Talk of a collapse of the single currency was rampant.

In February, I wrote about Europe’s economic data, “Looking at the overall figures, the 0.6% contraction in the fourth quarter in the euro zone is the worst economic contraction in Europe since the beginning of 2009. And so it marks an acceleration of economic decline that should signal to European policymakers that their economic policies are not working. That said, I don’t anticipate this will be the message the data send European leaders.”

But, you know what? Europe did hear the message. And lo and behold we got a policy shift. In fact, we got two shifts.

On the bailout front, Cyprus represented a major shift with private sector participation being key in order to minimize sovereign debt burdens. As onerous as the deposit tax was, there were few choices given the unwillingness of the Germans to commit bailout funds in an election year and given the widespread concerns amongst Cyrpus’ rescuers about their own sovereign debt sustainability. Rather than being simply the least worst solution, the Cyprus bailout represented a laboratory for future EU bailouts. And the final agreement was very much along the lines of what I had been recommending.

On the economic policy front, in the immediate aftermath of Cyprus, there was a wholesale shift as well. The way I framed the problem was this:

“The European Union is an existential crisis because its crowning achievement, the single currency, has come under assault from all sides. The continued existence of the Euro has even been called into question as country after country within the euro zone has been forced into bailouts and austerity. The heart of the problem, as elsewhere in the industrialized world, stems from the unseemly growth in private credit that preceded the financial crisis in 2008 and the private debt overhang that accompanied that credit growth, even in the aftermath of extensive asset price deflation. Put simply, many private sector households and businesses across the industrialized world are upside down, in negative equity, bust by common definitions of balance sheet solvency. And the result has been and continues to be crisis.

“The only legitimate question in this crisis is who is going to take the losses. That’s it. That is what this crisis is about and all of the crisis summit proclamations, restructurings, private sector involvement, bail-ins and defaults are just different ways of  carving up the losses.  

“The problem is that, in the euro area, the toxic combination of high private debt and imploding asset prices is especially pernicious because of the limited policy space the euro affords countries with these problems. There is no money tree; the European central bank is not permitted to fund national governments. What’s more, national governments themselves are really not supposed to fund private sector losses either. The 3/60 deficit and debt hurdles of the Maastricht Treaty prevent this. So the tried and true method of deficit spending to reflate the economies is not on the agenda.  This leaves euro area countries with limited options, which certainly include bank nationalization. However, given the lack of central bank support these governments have, we now see this loss socialization route to reducing private indebtedness is pernicious indeed.

“As I argued two years ago, the attempt by governments to maintain the excess credit by socializing the private debt problem onto government instead of writing down the losses would be the origins of the next crisis. And so it is. The euro zone is particularly vulnerable here because of the policy space limitations. And this is why we have a euro crisis, one that will continue for some time.”

And while Europe’s institutional architecture tied governments’ hands and the central bank’s too, Europe did jury-rig a solution together. They floated trial balloons about backloading austerity in April. By May, it was a done deal, with IMF Chief Economist Blanchard giving the intellectual cover for the shift in policy. Days later, I was talking about recovery. And indeed that recovery has now come.

That is the history here. Europe went to the brink, looked over the edge and stepped back. That’s where we are now.

Slow growth will be difficult

But let’s not fool ourselves here. Lots of pain lies ahead. It’s not like austerity has been defeated as a policy response. Just today, the EU warned Italy and Spain that they needed to re-double austerity efforts.

It’s interesting. Paul Krugman looked at the economic success of Europe in a macro context and he was able to construct the following chart:

What does that tell you about where Europe is headed – given continued demand loss from public sector cuts, credit contraction due to weak bank balance sheets, and a currency that debuted in the 1.10’s, sunk as low as the 0.80’s, but is now trading in the 1.30’s to the US dollar? It tells me that growth is going to be remarkably slow in Europe, and that all of the social and political turmoil associated with slow growth is going to be a big problem. This crisis isn’t over.

Below are some thoughts on what to expect going forward.

We have the figures for Q3 in Euroland and growth has slowed from 0.3% to 0.1%. The European Commission is predicting 1.1% growth for next year in the face of low to declining inflation. That tells you nominal GDP growth in the eurozone is going to have a 1 or at tops a 2 handle next year, which means sovereign debt burdens will grow.

Slow growth therefore has limited and will continue to limit what Europe can do. I believe that European policy makers in the main – whether they are Greek, German, Dutch, Spanish or what have you – are committed to the Euro. All of the palaver about euroscepticism and this country or that country wanting to get out of the euro is overblown. European policy makers maintain a fervent commitment to the euro, if only because they must. But I believe most policy makers in Europe are genuinely committed to European cohesion and see the euro as adding to that cohesion if the right institutional architecture can be developed.

Therefore, I have contended in the past that Europe would do effectively “whatever it takes” – to use Mario Draghi’s phrase – in order to keep the euro together. At this juncture, almost all of my medium-term predictions for Europe from last May during the Spanish crisis have been realized.  We have seen the ECB intervene and threaten monetisation via the OMT program, we saw EU-level bank bailouts, and we have seen austerity move from front- to back-loaded. The only solution the Europeans have not embarked upon aggressively is the growth pact. The Italians are pressing for one but it has yet to be implemented. I think we will see a full-fledged growth pact eventually and the recent youth unemployment initiative is a move in that direction. But a real growth pact is still not in the offing. Moreover, I have to note that the EU level budget has been cut for 2014, which tells me that European policy makers are still more concerned about sovereign debt sustainability than growth.

This is simply not going to be enough then to prevent crisis from re-occurring. But that is a long-term problem.

Over the medium-term, the question is in Greece and Portugal; Cyprus is a special case that doesn’t bear any eurozone-wide implications now that eurozone exit is off the table. Greece and Portugal are still in bailout programs with Greece in the worst shape. I don’t think either can leave the Troika program and that Greece will actually need another restructuring.

None of this means we are going to get a crisis out of this. Crisis in Europe has to do with the domino effect of bank and sovereign weaknesses across member states. Just because the Portuguese government or Cypriot banks are weak doesn’t mean there is a general crisis in Europe. We will have a crisis because these factors spill over into other markets due to intra-European interconnectedness. And on this score I am now relatively optimistic about Europe over the short- to medium-term.

Ireland and Spain are now both ready to swim naked and re-join the core. Neither is exiting the Troika program with an OMT-style bailout as I had predicted early in the year. That’s a huge win for Europe I think. And while the real economy in Italy and France remains a concern, those countries are enjoying record low interest rates. Bottom line: Greece, Portugal and Cyprus are now the only official periphery countries, with Slovenia possibly joining them.

For me, the ECB’s rate cut and the comments by ECB Chief Economist Peter Praet on quantitative easing change the calculus about likely policy responses and market reactions. Basically, we are in the middle of a weak recovery, actively bolstered by ultra-aggressive monetary policy. The ECB is now more dovish than the Fed. So that tells you the likely policy response in the event of a hiccup in the real economy will be aggressive. And I believe this will prevent crisis as long as real economy conditions do not deteriorate significantly.

The policy mix will eventually be intolerable for some

You can’t have upwards of 20% unemployment for years and years without some sort of social and political meltdown. And while Europe has made shifts in policy, frankly I don’t see the willingness by Europe to move enough toward growth where social and political unrest don’t eventually become a problem that results in crisis.

I have already written on my views about Grexit. As I put it in May on Greece’s eventual exit from the eurozone, “I believe the institutional structure of the eurozone is such a straitjacket that it’s hard to find a solution to the euro zone’s economic problems within the existing framework without years of pain. Europe would need to make huge constitutional and operating changes and create even more significant dodges to existing law to prevent another decade of malaise.” So, it’s not that the Germans don’t want the euro to work. Rather, it is that the Germans (and the Dutch, the Austrians, the Slovaks, the Finns, and the Latvians) do not want to move the institutional architecture of Europe as drastically as they would have to in order to make Greece work as a eurozone country.

Everywhere we can see hints of pushback on these architectural adjustments. For example, during the Spanish crisis, I thought we would get a EuroTARP. Spain thought so too, since they were the one’s who needed it and were pushing for it. But Rajoy was hoodwinked; we didn’t get that at all. And the Spanish bank bailout we did get was only taken as a last resort. German policy makers across the political spectrum are now saying that this kind of bailout is unacceptable. And the talks between left/right coalition partners show agreement on this score. Moreover, despite the ECB’s pushing for an EU-level banking supervisor, the Germans are having none of this.

Where I think this is headed is a Greek expulsion. Here’s the logic. During the Italian crisis, we heard rumours that Germany was preparing for a Greek exit from the eurozone, which suggested to me that not only were the Germans making contingency plans, but they were also only willing to move so far in terms of policy responses to the crisis. As I thought about longer-term implications, it was clear then that policy space would remain limited in the eurozone, which in turn meant continued depression in Greece.

Last year, both the Austrian and German foreign ministers backed explicit euro expulsion mechanisms. I believe the thinking here is that a new Europe needs to be a hard core Europe and that all of the euro members can get there with considerable pain… except Greece. And as a result, the eurozone needs to set up a mechanism to expel Greece and any other country that is not willing to move along toward the new hard core Europe. Yesterday, German magazine Der Spiegel wrote that German Chancellor Angela Merkel’s Bavarian sister party CSU now also wants to set up this eurozone expulsion clause because they are afraid of losing support to the new eurosceptic AfD party in Germany. So, the support for eurozone expulsion is gathering support in Germany and Austria. And I believe it will eventually make its way into EU treaty language.

But of course you can’t have expulsion without the risk of contagion. This is why I believe we will also see Eurobonds. Even Jürgen Stark, the ECB member who resigned in a huff because he felt the ECB was monetizing periphery debt, thinks Eurobonds will eventually come. People are not reading the tea leaves correctly if they don’t understand this point. The Germans are saying we want Europe, but we want Europe on our terms. That means we will acquiesce to a banking union, Eurobonds, and the whole nine yards. But it also means a souped up stability and growth, with penalties for abusers and expulsion for serial abusers.

The Germans are willing to do ‘whatever it takes’ to keep Europe together but only under these terms. And they are slowly inching Europe in this direction. Countries that cannot or are unwilling to toe the line will be expelled.