Why the Eurozone Bomb Has Not Been Disarmed Yet

Wolfgang Munchau in the Financial Times gives a good recap as to why the recent spell of good cheer regarding the Eurozone is overdone.

His central observation is that the Eurozone, like the US, patched things up with duct tape and bailing wire, and the hope was that the resumption of peppy growth would reduce sovereign debt burdens. But as studies by Reihnart and Rogoff, both Reinharts, and the IMF have shown, serious financial crises produce protracted periods of high unemployment and subpar growth. As Munchau notes:

After Lehman’s collapse, Europe’s establishment adopted a dual strategy – if you want to call it that. In the short term, it threw money at the problem, through loan guarantees and generous liquidity provisions, culminating in a huge bailout facility for sovereign states. The long-term strategy was a prayer for a strong V-shaped recovery.

As long as you make sufficiently optimistic assumptions about future income growth, you can pay off any amount of debt. If you assume a post-reform Greece will miraculously turn into a Aegean tiger, or that Ireland will generate another housing price bubble, the present rate of indebtedness will be no big deal. It all rests on your assumptions about growth. In the summer, it looked as though the strategy might work, as the economic data came in better than expected. That was then.

As we saw last week, this strategy came badly unstuck in Ireland. The Irish government massively underestimated the scale of the problem in its banking sector. On my own back-of-the-envelope calculations, the cost of a financial sector bailout may exceed 30 per cent of Irish gross domestic product, if you make realistic assumptions about bad debt write-offs and apply a conservative trajectory for future economic growth…..

You need not make gloomy growth forecasts to reach a pessimistic assessment of underlying solvency. The eurozone will probably not have a double-dip recession. Even so, a sustained global economic slowdown, the start of which we may have just witnessed, is all it would take to derail the do-nothing strategy. In the absence of strong growth, the European banking sector will not be able to generate the excess profits needed to write off the bad assets.

Yves here. Recall also that earlier this year, European leaders were visibly at loggerheads, and managed to stitch together deals onlyafter nervous-making wrangling. We are likely to see continued less than stellar management of the process as the Eurozone faces continued stresses, particularly on the bank front.

Marshall Auerback in July pointed out that the ECB has moved into a bit of a power vacuum, which appeared to be alleviating pressure short term but was not a long term solution due to the political pushback it is likely to generate:

With little fanfare, the ECB has been responding to the EMU’s solvency mess by conducting large-scale bond purchases in the secondary market (which, unlike direct purchases of government debt, is not contrary to the Treaty of Maastricht rules) for the debt of the EMU nations. As Bill Mitchell has noted, it is remarkable how little press coverage this has generated, but despite saying there would be neither be bailouts, nor unsterilized bond purchases, the ECB is now buying huge amounts of PIIGS debt to ensure the funding crisis in the EMU is contained. Given that this substantially reduces the insolvency risk, this is probably a wise policy, although it does little to address the underlying design flaws in the system which we have discussed before…..

The reality, then, is that the ECB has become the political arbiter for fiscal decisions made by each of the euro zone national governments. If the ECB determines that any member nation is not complying to their liking, they will start threatening to stop buying their debt, thereby isolating them from the ECB credit umbrella, while allowing the remaining nations to remain solvent. And soon the bureaucrats who run the ECB will realise that the non-sterlisation of the bonds doesn’t create inflationary pressures and they will keep doing it, as they will find it to be a very powerful tool to keep national government spending plans which they don’t like in check. ECB spending on anything is not (operationally) revenue constrained as the member nations are, so this policy is nominally sustainable, even if fundamentally undemocratic…

But the actions of the ECB are neither politically desirable, nor sustainable over the longer term. The conflict will remain the money interests in Europe who put currency strength as a priority, versus the exporters who favor currency weakness. The consensus will be that unions and wages in general must be controlled, which will create ongoing social turmoil. That’s not a great environment, especially in the “new normal” of subpar returns on financial assets.

As austerity measures bite deeper, citizens of the periphery countries are likely to perceive (correctly) that their sacrifices amount to a transfer to foreign banks. Recall that it was demonstrations in Greece in May that heightened concerns about Eurozone arrangements. But if the ECB continues its stealth intervention, it may take some time before market-rattling Eurozone broadcasts reach a TV near you.

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  1. Diego Méndez

    Münchau is not speaking about a bomb on Eurozone’s periphery. He’s just saying the whole European banking system is insolvent unless growth is stellar.

    “Germany in particular is still under the illusion it can generate a strong and sustainable growth over a long period. (…)”

    “The German state is in no danger in terms of solvency. But the health of the country’s banking sector is sensitive to various growth assumptions. I would consider the German banking system, taken as a whole, to be insolvent if you apply the strictest definition of capital – equity capital and retained earnings.”

    He’s saying the European banking system is undercapitalised. Banks should be nationalized in some cases and injected capital, wiping out bondholders.

    This has nothing to do with the euro or Europe’s periphery, and you’d be well advised to apply the same analysis to the US.

    The US is in a credit crunch as of today (credit falling 15% yoy). That’s because the US banking system is undercapitalised. Funny that you cannot see it reported in the English-speaking press/blogsphere.

  2. sean

    I think this is an accurate reading of some of the problems here in Europe.
    Germany is happy for now the ECB is mopping up peripheral country sovereign bonds from countries like Ireland(where I live) while it maintains a favourable euro exchange rate for its exports.If the euro broke apart now a new German currency would appreciate much faster and its export sector would come under pressure.
    Its possible that German strategy recognises the current situation is unsustainable and is planning for an exit from the euro in a couple of years and possibly setting up a north European ‘euro’ comprising the Netherlands,Austria and possibly France.
    The common problem which the above countries face is the negative effect on their banks should Greece,Ireland etc exit the euro and default on debt held by German banks etc.

    A possible straw in the wind for this strategy is the fact that Siemens ,one of Germanys largest exporting companies recently got a licence to set up its own bank.Clearly they are planning for the possibility that German investment banks might not be able to fund their debt in the coming years.
    If this process develops then German exporters will not be reliant on the ECB and the euro.It may even keep a new ‘Deutch Mark’ lower in exchange rates than it otherwise would be.

    Socially ,Europe is starting to unravel.Sarkozy of France is deporting thousands of Roma gypsies while indegenous populations are becoming more unsettled by the high numbers of immigrants in their respective countries.
    Anomolies point to policy failures such as dysfunctional labour mobility as recently reported in the FT by Wolfgang Munchau.In Ireland ,for example our unemployment rate has been significantly higher than Polands for several years,our GDP is in freefall while Polands is rising.Yet large Polish immigration into Ireland continues whilst there is almost zero movement the other way by Irish people.

    Politically ,at least here in Ireland ,an earthquake is in the making .There is no way to predict how things will evolve ,whether change will be managed well or if conflict will ensue.
    What is apparent is that many people in Ireland are reeacting similarly to the accounts of germans in the 1920’s to the turmoil brought on by war reparations and money printing.Some politicians are now using that language,describing the the transfer of bank debt to the Sovereign as reparations imposed on the Irish people.

  3. petros

    a great part of the reason is illustrated by the hereunder; which at the end of the day shows how corrupt the eu is
    E-MAIL Details
    To :eurofreedom@yahoogroups.com
    CC : –
    Received:Mon, 13 Sep 2010 12:03:37 -0000
    Subject :[eurofreedom] REIFICATION OF THE ZERO!
    A vulgar variant of concept stealing, prevalent among kleptocrats, avowed mystics, and irrationalists, is a fallacy I call the Reification of the Zero. It consists of regarding nothing as a thing, as a special, different kind of existent. This fallacy breeds such symptoms as the notion that presence and absence, or being and non-being, are metaphysical forces of equal power, and that being is the absence of non-being. E.g., Nothingness is prior to being. (Sartre) — Human finitude is the presence of the not in the being of man. (William Barrett)— Nothing is more real than nothing. (Samuel Beckett) — Das Nichts nichtet or Nothing noughts. (Heidegger). Consciousness, then, is not a stuff, but a negation. The subject is not a thing, but a non-thing. The subject carves its own world out of Being by means of negative determinations. Sartre describes consciousness as a noughting nought (neant neantisant). It is a form of being other than its own: a mode which has yet to be what it is, that is to say, which is what it is, that is to say, which is what it is not and which is not what it is.

    Since Nea Democratia and Pasok have become dirty words, Neodemocrats call themselves Antipasokers, and Pasokers call themselves Antineodemocrats! In reality Pasok and Nea Democratia are exactly the same thing, Pasoneodemocratia! Basil Venitis, twitter.com/Venitis, points out that for 35 years since dictatorship, Pasokleptocrats and Neodemokleptocrats who took turns in running Greece, the most corrupt country on Earth, borrowed as if there were no tomorrow, and they received 200 billion euros in kickbacks from Siemens, JPMorgan, Goldman Sachs, MAN, Daimler, Deutsche Bahn, Ferrostaal, Krauss-Maffei Wegmann, antitrust, military purchases, monasteries, and many more. Through mismanagement, robbery, kickbacks, and nepotism, they drove the cradle of democracy to the brink of bankruptcy with a public debt of 350 billion euros. Reification of the Zero!

    Venitis points out two roommates of Amherst College of Massachusetts, Anthony Samaras and George Papandreou, lead the two most corrupt political mafias on Earth, Nea Democratia and Pasok. Papandreou is the premier of Greece, and Samaras is the leader of opposition. Papandreou participated in the kleptocratic government of Simitis, and Samaras participated in the kleptocratic government of Caramanlis. They are very good friends, but in public it’s their job to accuse each other. Love in private, hate in public, and omerta galore! Reification of the Zero!

    Venitis muses that Greek Ministry of Economy is George Orwells’ Ministry of Plenty or Miniplenty in Newspeak. Miniplenty imposes heavy taxation, especially VAT, overregualtion, heavy antitrust, and controls prices, salaries, and domestic production. Miniplenty publishes false claims of having raised the standard of living in dystopia, when it has, in fact, reduced production and increased misery. Miniplenty’s concocted-statistics are Trojan horses sent to Brussels, in order to get bailouts and avoid penalties. Reification of the Zero!

    Venitis muses the Greek Ministry of Defense is George Orwell’s Ministry of Peace or Minipax in Newspeak, whose only purpose is to generate military kickbacks and bewilder hoi polloi. Minipax revolves around the principle of perpetual war. Since Greeks have a well-defined enemy, terrorist Turkey, they know whom they hate, and constant government propaganda helps to convince Greeks to vent all their unconscious rage for their own country against terrorist Turkey. Since that means the balance of the country rests in Turcophobia, Minipax is in charge of fighting Turcoterrorists, but making sure to never tip the scales, in case the fight should become one-sided. Reification of the Zero!

    The German euphemism for kickbacks is nuetzliche aufwendungen(NA), useful payments. Corruption scandals at Siemens, MAN, Daimler, and Ferrostaal show that German companies owe some of their success abroad to NA. Germany is the world champion in bribery! NA has transformed Greece to the dumping place of Germany. German companies sell their defective equipment to Greece at double prices of their perfect equipment! Yes, at double prices Greece buys submarines that bend, airplanes that cannot balance, helicopters that fall down, security systems that do not work at all, and useless machines rusting in warehouses! Yes, Greece pays gold for garbage, thanks to NA! Reification of the Zero!

    After months of haggling over its involvement in the unprecedented Fourth Reich(EU) bailout to save Greece from defaulting, Germany finds itself at the center of another financial tangle with Graecokleptocrats; this time involving defense contracts Greece could ill afford and the shadowy deals behind them. At the same time Merkel’s cabinet was approving a quarter of a trillion euros in aid to Greece, prosecutors in Germany began investigating whether defense contractors had paid billions of euros in bribes to Graecokleptocrats in connection with the sale of heavy military equipment, including submarines. Reification of the Zero!

  4. Ldfarfadets

    To Sean

    “Some politicians are now using that language,describing the the transfer of bank debt to the Sovereign as reparations imposed on the Irish people.”

    They’re right. This is a kind of “traité de Versailles” for the irish people, but the bill come from Irish banks, not UK-France.

    To Diego :
    “Münchau is not speaking about a bomb on Eurozone’s periphery. He’s just saying the whole European banking system is insolvent unless growth is stellar.”.
    That’s F.. true, but the ECB balance sheet remains anyway three times less than the Fed’s, the problem is only politic

    Could WM tell us a bit about English Bansters’ss ? German or French ones are ewes compared to English’s.
    More generally, could the FT be a very little objective some times or is the FT only working for the Americano-British banking industry ? I’m no proud of my French Pravda-newspaper but I’m startled with the FT-WSJ.

  5. Noémie

    To Sean:

    “Socially ,Europe is starting to unravel.Sarkozy of France is deporting thousands of Roma gypsies while indegenous populations are becoming more unsettled by the high numbers of immigrants in their respective countries.”

    There is a contradiction here. Is-it a social problem or an immigration problem that begins to unravel? What would be economically sound for you? Letting an unlimited number of immigrants live in France? How can any country stay economically sound if it doesn’t even control it’s borders? (I have to point out that Roma people live for centuries in Europe and France and are indegenous to Europe).

  6. Opinionated Bloviator

    The euro is not sustainable long term, as a result it will cease to exist. The only question is when this will happen.

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