The Euro : moving on or just staying in a death spiral

This week saw a number of developments in the ongoing Eurozone crisis, none of them particularly good news for the currency. The published opinion piece was sent to the Irish Examiner before the coordinated Merkel-Sarkozy announcements on the need for fiscal union, but that is such a large issue as to deserve a post of its own. This post appeared as

First, and quite startling, we saw the emergence of negative yield rates on german short-term bonds. This in effect means that investors will now pay to hold (sure and safe) german bonds rather than lend to other risky assets. This says something not terribly good about how investors see the prospect of the eurozone. There has indeed been a generalized and widespread flight to safety with yields being bid down on swedish, UK and Swiss bonds also.

We saw the Italian yield curve invert, where investors seek a higher rate on short-term loans to Italy than they seek for longer term loans. Such an inversion preceded the bailouts of the existing programme countries, and is generally taken as being a fairly decent predictor of an economic slump looming. More generally as discussed in this short but excellent Seeking Alpha piece it is a general feature of distressed credit that short end yields will be greater than longer end, due to the same discount (haircut) being applied across the maturity spectrum and as a consequence the measured yield on the short end rising.

Third, we saw a coordinated can kicking, whereby the central banks of the world, persisting in the assumption that this is a liquidity as opposed to a solvency issue, injected massive amounts of cheap money into the world economy. Of course, the money is cheap dollar finance, as opposed to euro finance, but as the advert states ‘every little helps’. It is true that italy, spain and france all are still raising small amounts on the bond markets, albeit at increased costs. This perhaps reflects less a desire by markets to lend to them and more a demand from banks for assets, relatively cheap (recall that as interest rates rise the value of bonds falls) compared to german assets, to swap or repo at the ECB for liquidity.  This in turn gave rise to (so far unsubstantiated) rumors that a large (french) bank was in liquidity problems.  The ever reliable FT Alphaville has a series of posts on this issue which are well worth a read : see here, here and especially here where El Arian, the CIO of PIMCO and the man who in most ways personifies the bond markets, gives a cautious, muted and less than glowing analysis of this..

Finally we saw the publication of an exceptionally gloomy outlook from the ESRI and an even gloomier one from the OECD. In passing it is quite extraordinary that the ESRI charge several hundred euro for their Quarterly Economic Commentary. Why on earth that is the case beats me….

The approach taken by the central banks is treating a symptom. The drying up of liquidity in the markets is a symptom of real concerns about the longer-term prospects of these countries repaying their debts. European banks, sovereigns, companies and consumers are heavily indebted. Banks have to ‘deleverage’, shrink their balance sheets, and in doing so are, even if this is something the Bank of England doesnt want to see,  forcing the deleveraging of nonfinancial companies and individuals.  Similarity states need to reduce their debt levels.

Italy has a debt/gdp ratio of 118% , france 83%, spain  a lowly 62% and even Germany is at 84%. Recall that the oft-noted Reinhardt-Rogoff threshold for distress is 80% and we see that even in the core of Europe we have problems.  Italy is already paying over 5% of GDP in interest payments, Greece over 6% and Ireland close to 4%. Europe as a whole is extremely indebted and this will inhibit growth hugely

These burdens will continue to grow. In the ESRI analysis the sustainability of the debt burden, its stabilization, depends crucially on the economy achieving growth of between 2.5% and 4.5% in the 2012-5 period, set against projected flat lining for this year and next. And yet, growth in Europe in general and Ireland in particular is predicated on sustained export growth. While it is clear that we have been spared the trade and protectionism wars of the 1930’s it is also evident that any export growth will involve exports to Asia and BRICS, nations where we have at best muted penetration. An excellent presentation on this was made by Kevin O’Rourke, one of the highest profile economists in the world, a world leader in his field who left at the start of this academic year to move from TCD to Oxford.

Europe is in many ways like a heroin addict. We have become addicted to cheap, easy credit. Credit is an absolute essential part of the modern economy, as are natural opiates an essential part of the body. Overreliance however causes problems. The really hard task for European politicians is how to wean the sectors off cheap easy credit without a collapse. In that context liquidity is similar to methadone – it can act as bridging element while a longer term solution is generated. The longer solution must involve three elements: growth, which is especially important for Iberian countries with their dangerously high levels of youth unemployment; modern administration which means in the case of Greece and Italy that tax compliance is enforced; a proper fiscal union which is not simply ceding to an unelected and unresponsive central power the ability to raise debt and disburse but which involves automatic stabilizers.

In the USA a major automatic stabilizer is internal migration. If there is a recession in Kansas people move elsewhere. Ireland has experience of this, via mass migration, and it is neither a likely nor desirable nor feasible solution for Europe as a whole. Thus any fiscal union needs to be culturally bounded by the diverse political cultures of Europe, be democratically controlled, and be effective. It is very debatable if that can be created by 9th December this month’s final final drop dead deadline.

What will not work is a hodgepodge of measures designed to remove the immediate liquidity crisis without dealing with the longterm solvency; a series of measures that move democracy even further at a remove from the technocratic governments we have seen installed; a one (german) size fits all policy on fiscal austerity; nor a policy that treats symptoms not causes. Europe needs to move from credit led to economic led growth, and any policy that does not deliver same will not work. More to the point, discipline for its own sake is simply masochistic.

Europe is, as Goldmans put in this excellent graphic in a ‘death spiral’. Someone needs to break it and soon.  Pouring more cash into the system will not work.