Cross-posted from Credit Writedowns
Today is the big European summit. Expectations are low because European politics have become messy. At the beginning of September I wrote about European political dysfunction:
Clearly, [Former ECB Chief Economist Juergen] Stark sees the monetisation path the ECB is on as not at all compatible with the ECB’s mandate.
Separately, the noises coming out of the German governing coalition show exasperation with the progress in Greece. Edward Hugh writes that “a Greek euro exit is no longer the unthinkable taboo topic”. This is especially true after the beating Angela Merkel’s party took in elections in her home state of Mecklenburg-Vorpommern this past weekend.
Fiscal consolidation is not expansionary. Moreover, it increases deficits due to the increase in spending on fiscal stabilisers and the decrease in tax receipts – that is unless the cuts are extremely large. There is zero chance that Greece will make its targets. I don’t expect Portugal, Italy, Ireland or Spain to meet their targets either, especially given the incipient double dip we are witnessing.
As the Germans are likely to see their fiscal trajectory deteriorate markedly in this environment due to the anaemic domestic demand and dependence on exports, their willingness to fund bailouts will evaporate. The political calculus may turn to topping up capital at underfunded German banks. Greece, at a minimum, will default. Indeed, without the ECB’s assistance Italy would default – that’s the real Armageddon scenario because no amount of recapitalisation would prevent a deep depression. Stark’s resignation increases the chances that just this will occur.
The euro zone is coming apart at the seams. Right now the economic outlook looks bleak. If you are a euro zone investor, the policy outlook is extremely volatile. That means avoiding the periphery and piling into German and Dutch bonds and/or gold because we are about to see how limited the ECB’s bond purchases are.
This is an update of sorts.
On the first topic from above, many at the ECB still see monetisation as not at all compatible with its mandate. I don’t care what Silvio Berlusconi says about the need for a lender of last resort. Italy will dangle in the wind until they make structural reforms. Only then – or if spreads shoot to the moon – will we see whether the ECB backstops Italian debt.
Topic number two: Greece. The talk now is of 50-60% haircuts as we predicted a couple of weeks ago. Back then, there were comically weak denials. Now everyone has admitted the default and hard restructuring in Greece is upon us. German institutions are preparing for the event. Both Deutsche Bank and Münchener Rück have marked down their books for example. What about the French? That is still a question.
The third topic I discussed above, the anti-growth nature of fiscal consolidation has now been confirmed by the Troika in Greece via a leaked document we posted a few days ago. Clearly, it is this reality which has caused the troika to move to a hard restructuring. Spain has already acknowledged it won’t make its fiscal targets. I don’t expect Ireland or Portugal to do either because Europe is going into a recession due to an anti-growth fiscal policy and the ill effects of the sovereign debt crisis. Ireland looks good now. But recession will create problems.
I said in August:
I think the ECB will eventually step in here. They have already gone in the market for Ireland and Portugal. The ECB increased liquidity for banks, offering up unlimited funds for six months. These are nice measures. But they don’t go nearly far enough. They will have to act as lender of last resort for the entire euro zone and eventually they will accede to this.
The problem is what happens between now and then. You saw the interview with Elga Bartsch of Morgan Stanley. She was saying the ECB can step in at any time if need be, meaning there is no rush. And that is certainly the way the ECB has acted. However, I think this kind of panic we are witnessing right now, this kind of market meltdown, will have grave consequences for a European and American economy already at stall speed.
The consequences are recession all around. The ECB’s stance has led to crisis in sovereign debt and the banking sector. All indications are that Europe is already in a double-dip recession. The latest data reinforce this. Look at these charts from Global Macro Monitor from yesterday’s Eurozone Flash PMI. The composite index is below 50 at 47.2, it’s lowest in over two years. That means recession. And if you look at core Europe, you can see that France and Germany are catching up to the rest of Europe on the downside.
On the fourth topic of Germany having its fill of bailouts and moving to recapitalisation, that is definitely what is happening here. But Italy is the real problem for the Germans. Politically, there is no appetite to bail out the Italians. As I said above, “without the ECB’s assistance Italy would default – that’s the real Armageddon scenario because no amount of recapitalisation would prevent a deep depression.” The ECB is going to have to monetise Italian debt or a deep Depression is coming. There is no other choice. Silvio Berlusconi recognizes this and said as much yesterday. However, the ECB needs movement on the reform front first. The question is whether the reforms happen before the bank sector implodes and sovereign yields in Italy and Belgium spike. If they don’t, there will be contagion into the real economy and the recession in the euro zone will deepen.
Yes, I still think the euro zone is coming apart at the seams. The dust-up between Merkel, Sarkozy and Berlusconi is quite ugly, especially ahead of a critical summit. Moreover, the economic outlook looks bleak. As I have written increasingly, nationalism and populism will become ever more powerful issues as this difficult economic period continues.
Ray Dalio puts it well:
This growing populism will have important implications for monetary, fiscal and trade policies and will significantly increase risks of a markets downturn and a global depression.
I wrote two years ago that:
this kind of volatility will induce a wave of populist sentiment, leading to an unpredictable and violent geopolitical climate and the likelihood of more muscular forms of government.
We are now entering that period.