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.