Predicting Europe’s endgame policy response
This morning I made the argument that the global economy is growing across the breadth of developed and developing economies. I still have a problem with Europe though as I believe the risk is to the downside. Basically, the policy response is deflationary, just as the U.S. Treasury has written. I didn’t write enough though because while I pointed to the likely outcome from America’s asset bubbles, I failed to talk about likely outcomes in Europe.
I really want to review what I have said in the past in the context of the new information that presents itself.
Let’s start in December 2011 when the Italian crisis was at its apogee. This was a crisis that resulted in the ECB’s starting its vaunted LTRO program. And let’s remember that this intervention was not enough as the ECB had to start the OMT just eight months later when Spain blew up too.
What I wrote in December 2011 on what I think will happen in Europe was the following:
“Merkel’s push for treaty changes is going to be about transforming the stability and growth pact into something that has teeth, something that allows for euro area oversight, penalises fiscal profligacy and even creates a path for expulsion. In some ways the mechanics are less relevant because they are in flux. For example, Merkel is pushing to avoid the Schengen route to agreement as an intermediate step because it would mean a two-tier euro zone. Let’s see what happens here.
“What is really relevant is the vision; and that vision is a for a bailout followed by a hard currency United Europe which practices fiscal discipline.
“Getting from here to there is going to be a struggle given what we already know about the economic situation in the periphery. More than that, Nicolas Sarkozy is talking about balanced budgets in the euro area by 2016. And we know that an adjustment to balanced budgets throughout the euro zone would require either an exactly equivalent offset in private sector savings down and/or in the export sector up. This is never going to happen in countries like Greece. Sarkozy also promises no eurozone member will default too.
“What does that mean for policy choices?:
- It means ECB intervention to bring down rates.
- It means moving to the hard currency United Europe which practices fiscal discipline that I have outlined.
- It means severe adjustments in the periphery toward fiscal consolidation and internal devaluation aka wage and price cuts.
- It means an implicit desire for offsetting adjustment in the euro currency down to create export competitiveness and/or equivalent private sector dissaving.”
What we have seen thus far is ECB intervention to prevent a eurozone sovereign default in Italy and Spain – against the counsel of the German Bundesbank. That takes care of point #1. We have also seen a continuation of the fiscal consolidation straitjacket despite the move to backloading this consolidation. That takes care of point #2. Moreover, this fiscal consolidation has indeed caused the periphery’s overall external account to shift toward balance. That takes care of point #3.
But point #4 is not working. The implicit desire for an offsetting adjustment in the euro down to more easily effect the wage and price cuts in the periphery is not being realized. In fact, the euro is near two year highs, as the real interest rates in Europe from Europe’s deflationary macro policies make it difficult to expect any exchange rate help in the face of greater monetary easing outside of Europe. I don’t think the periphery can get to internal devaluation wage and price cut nirvana without another crisis.
If we fast forward to May 2012 as the Spanish crisis was deepening, my sense was that the European Endgame was within sight. And by that I meant that the outlines of the decisive European approach were coming into view. My conclusion was this:
“over the medium term, we are likely to see
- Monetisation via the ECB’s Securities Market Program but this will be a stop-gap only as the Europeans are not ready to give the ECB authority for backstopping sovereign debt.
- EuroTARP either for Spain in isolation or Europe-wide. Clearly the Irish and others will want equal treatment to the Spanish. Moreover, a political backlash against bank bailouts will ensue. Therefore making this Europe-wide and tethering it to the Basel III reforms makes sense.
- Growth pact via the EIB that will invest in infrastructure projects in return for medium-term fiscal consolidation and ‘growth-oriented’ market reforms.
- Target relaxation because that will be a major compromise in order to deal with the Spanish and Italian situations and to assuage French concerns about front-loaded cuts and tax increases.
- ECB backstop will come as well. Even Juergen Stark has intimated that ECB liquidity could be on offer under the right circumstances i.e. “only when important steps toward political union are made can we have common bonds,” the ECB would get a green light after the bilateral agreements to provide unlimited liquidity until Eurobonds are issued.
“Over the long-term, we are likely to see more permanent structural remedies like
- Grexit as the euro zone will lose Greece as a member. It could happen over the medium-term too if the European situation is not stabilised. Portugal could also exit.
- But the rest will become more integrated as the Lisbon treaty is amended to add greater fiscal integration and penalties. The big question marks are Italy and Spain.
- Defaults in Greece and elsewhere. Portugal seems most likely, followed by Ireland.
- Eurobonds will eventually have to occur in order to keep sovereign debt from being a problem. Clearly, the fiscal compact and the penalties will have to have teeth for Eurobonds to be palatable. In practice, you could have sovereigns conduct a ‘sovereign debt swap’ whereby the ECB buys an agreed-upon portion of the existing debt from the sovereigns and then uses these funds to back the supranational debt.”
In terms of the medium term predictions, Europe undertook all of my predicted policy actions within three months of my writing that post except for the growth pact – something that Italian Prime Minister Enrico Letta is still calling for. For me, this is telling – because it means that Europe’s response is as expected if only less expansionary.
What about the longer-term? As I wrote two weeks ago, Greece is still on an unsustainable trajectory. A Grexit is going to occur during the long stagnation period that lies ahead. And notice that Greece – despite having had the worst economic outcome from Europe’s depression – was one of only two nations in the last round of PMIs to show continued contraction. It is remarkable that Greece has stuck it out this long. But I think there is little chance it can do so for the long time. Policy makers are merely buying enough time to shore up Spain and Italy before they let Greece go. For Greece, this will be a bitter pill after a 40% deflation in the economy. But I believe this is where things are headed.
As for defaults, again Greece is a foregone conclusion. Portugal still seems likely. Ireland and Spain are out of the woods. Italy is a non-starter due to its economic importance. And Italy is where Eurobonds begin. You cannot continue to let crisis fester in Italy as it has done. Eventually this will blow the eurozone apart and require more drastic action. My sense is that the Germans will not allow any more strain on their public balance sheet via bailouts and will have to look toward other approaches to deal with Italy. The OMT is certainly an option that is already on the table were Italy to run into trouble. But eventually Eurobonds are going to be necessary if Italy’s interest rates are going to recede to levels that both allow the country to have some economic growth and reduce the country’s debt burden. Given Italy’s over 130% debt to GDP, the country needs really low interest rates in order to deal with the interest costs from the mountain of existing debt. And Italy needs growth in order to chip away at this mountain. That de facto means Eurobonds in my view. OMT might get us there, but this is only a stop gap and a longer-term solution for Italy must involve Eurobonds.