Today’s Commentary
Summary: Yesterday the European Central Bank cut the interest rate on its main refinancing operations by 25 basis points to a record low 0.25%. It also cut the rate on the marginal lending facility by 25 basis points to 0.75%. The news was unexpected but welcome given the economic outlook in the periphery and the spectre of deflation. However, in Germany, the news was received with fear about bubbles in housing and the stock market.
For me, this dichotomy in reactions is emblematic of the whole problem with the euro. Two newspaper headlines crystallize this conundrum.
First, in Greece, the economy is still shrinking and unemployment is over 27%. Earlier in the week, there was a general strike to protest austerity. I expect Greek sovereign debt to be restructured in 2014. This morning after the ECB rate cut, the headline read “Greek October consumer prices mark biggest deflation in 50 yrs”. The Reuters article told us that, “Greece posted its biggest deflation since 1962 on Friday, as consumer prices fell 2.0 percent on an annual basis, data from the statistics service showed on Friday. The EU-harmonised inflation reading fell 1.9 percent from 1.0 percent in September. The October reading was below a forecast of -1.5 percent. A combination of deep recession, wage cuts and substantial spare capacity in the economy have pulled prices down, prompting internal devaluation that could render the Greek economy more competitive.”
The conclusion of the article is that, in Greece, where the economy has already shrunk by 40% and is still shrinking, deflation is a good thing because it could “render the Greek economy more competitive”. Seriously. See the link above; I am not making this up.
Then, there’s Germany. The German private economy expanded for the sixth month running in October, as euro zone demand boosted German manufacturing. As a result, this morning Germany reported a record trade surplus. Unemployment is at a post-reunification low and the housing sector and stock market are booming. After the ECB rate cuts hit, the German headlines were “ECB monetary policy: interest rates fuelling fears of price bubbles” and “Low interest rates: savers fear expropriation by the ECB”.
Do you see the problem?
Frankly, the euro doesn’t work. As the late British economist Wynne Godley put it twenty-odd years ago, the euro’s conception and institutional framework “as they stand are seriously defective”. The only convergence we have seen in Europe since the Euro was introduced was the one in interest rates before the sovereign debt crisis. And this produced a spectacular boom and bust that created the situation we are in today. Economically speaking, the gulf between Greece and Germany is as wide as it ever was.
Let me refer back to Godley here. This is what he wrote prophetically in 1992:
“Although I support the move towards political integration in Europe, I think that the Maastricht proposals as they stand are seriously defective, and also that public discussion of them has been curiously impoverished…
[…]
“It needs to be emphasised at the start that the establishment of a single currency in the EC would indeed bring to an end the sovereignty of its component nations and their power to take independent action on major issues. As Mr Tim Congdon has argued very cogently, the power to issue its own money, to make drafts on its own central bank, is the main thing which defines national independence. If a country gives up or loses this power, it acquires the status of a local authority or colony. Local authorities and regions obviously cannot devalue. But they also lose the power to finance deficits through money creation while other methods of raising finance are subject to central regulation. Nor can they change interest rates. As local authorities possess none of the instruments of macro-economic policy, their political choice is confined to relatively minor matters of emphasis – a bit more education here, a bit less infrastructure there…
[…]
“…It should be frankly recognised that if the depression really were to take a serious turn for the worse – for instance, if the unemployment rate went back permanently to the 20-25 per cent characteristic of the Thirties – individual countries would sooner or later exercise their sovereign right to declare the entire movement towards integration a disaster and resort to exchange controls and protection – a siege economy if you will. This would amount to a re-run of the inter-war period.”
I agree with these sentiments. And we should look to Greece as the country which “would sooner or later exercise their sovereign right to declare the entire movement towards integration a disaster and resort to exchange controls and protection.”
If you recall, during the pre-crisis period, Germany was in a sort of soft depression due to the weight of problems emanating from how its reunification was executed. Labour in the east was uncompetitive because productivity levels were low given that the one for one Ostmark – Deutschemark conversion overvalued the East German currency. That meant depression, high unemployment, and increasing neo-Nazi nationalism in East Germany. The ECB kept rates low in this period and it greatly aided Germany as it sorted through its problems.
In Spain and Ireland, on the other hand, interest rates were negative in real terms. And a speculative frenzy ensued, aided and abetted by capital flowing in from Germany, the Netherlands and elsewhere. Public finances in Spain and Ireland were just fine, much better in fact, than in Germany, which was persistently in breach of the excessive debt and deficit rules. The financial crisis brought the good times to an end. The result was large deficits and a collapsed financial sector whose debts were socialized onto the sovereigns’ books. Ireland is just now exiting its bailout due to these socialized losses.
This is the historical context leading up to the rate cut in post-crisis Europe. The pre-crisis situation has entirely reversed. It is Germany were the boom times have gone and Portugal, Ireland, Italy, Greece, Spain, and France are mired in recession or outright depression – with more pain expected due to the austerity policies used throughout the periphery. Note that France’s sovereign debt downgrade by S&P today should be seen as a sign that France is indeed semi-peripheral in terms of its economy.
A 25 basis point cut in this context seems rather minor. And given the ECB’s inability to finance the spending of its member sovereign states, the ECB is almost out of ammunition. In my view, this makes downside risk from deflation and debt-deflation higher than it is in the U.S.
The Italians not only begged for a cut, but also are begging for some sort of EU-level fiscal support. I think this will happen, especially once the German grand coalition kicks into high gear. But again, in context it is not enough. Italy’s sovereign debt burden has jumped, in hockey-stick fashion from 105% of GDP when the crisis began to well over 130% and rising. With sovereign interest rates climbing 150 basis points since 2010, the problem is more acute.
The fact is Europe’s policy mix is deflationary. And the institutional framework, which is not designed for large scale countercyclical transfers or quantitative easing – cannot cope with the magnitude of this downturn. Given the size of the economy and the sovereign debt load, Italy is where this will matter most. Italy’s Central Bank can’t just print euros. The sovereign’s debt sustainability will start to be questioned. And an Italian default is a worst case Armageddon scenario which the euro zone fears most. It was the impetus for the LTRO program, the ECB’s shift away from German monetary orthodoxy, and the cause for resignation of the two German ECB members Weber and Stark.
Europe cannot withstand an Italian default. And so I expect an OMT-style event to eventually take place. More than that, I expect Eurobonds because OMT will not be enough to hold the euro together given the policy constraints and the economic trajectory.
Let’s remember that not only is Italian GDP growth weak, but the Italian banks are weak as well. The IMF estimates that 30% of debt in Italy is owed by firms with an interest coverage ratio below 1.0, meaning they cannot cover interest charges out of pre-tax earnings. Banks must roll over existing lending facilities or the firms will face default. This is commonly known as extend and pretend and only works if economic growth picks up. Bank capital shortfalls have caused credit availability to implode, especially for SMBs and households. For example, mortgage lending in Italy fell by half last year.
Despite Europe’s claims to have decoupled the problems at banks and with sovereigns, the two are still inextricably linked, no more than in Italy. I explained during the Italian crisis in late 2011 why Investors will buy Italian bonds after ECB monetisation. The simple fact is they can get a yield pickup that compensates them for the risk that the ECB really doesn’t stand at the ready. And indeed Italian banks have loaded up on government debt since the ECB was forced into the LTRO program. In 2007, Italian government debt only comprised 5.5% of Italian bank balance sheets. By the end of 2012, this figure had risen to 14%. In August, Italian banks held a near record 397 billion euros of government bonds on their books, double the amount at the end of 2011 when the LTRO began.
But Italian banks are near the saturation point on government debt. LTRO loans must be repaid early in 2015 and the stress tests for European banks are looming. Morgan Stanley believes this combination will ‘nudge’ banks into drawing down government bonds assets, something that will leave the Italian government with fewer bidders for its debt. That means that yields may rise, subjecting the Italian banks to capital losses on a mark-to-market basis. In a worst case scenario, yields would rise enough to call the sustainability of Italy’s debt trajecory into question and re-ignite a crisis that would mandate an OMT-style intervention.
The bottom line in all of this is that Italy is a key member state in Euroland and its problems highlight the dichotomies within the common currency’s economic realm. The one size fits all ECB interest rate policy cannot be effective given the lack of EU-level fiscal transfers. Europe’s institutional framework is fatally flawed. More problems in Europe are sure to come.