Eurozone Faltering – Again


2013-03-15 By Harald Malmgren

ECB President Mario Draghi dramatically declared last year “the ECB would do whatever it takes” to stabilize Eurozone bond markets. It would purchase sovereign debt of troubled Euro member governments on condition that such governments would permit a European Union or Eurozone body to oversee and assert final authority on their national budgets.

At the time of this bold declaration, markets assumed that at least Spain and Portugal, and probably Italy, would yield sovereignty and accept fiscal discipline dictated by a European body made up of officials of other Euro nations. In other words, accept imposition of budget authority by officials not elected by the citizens of a troubled nation, and who most likely would be citizens of other nations.

Markets then waited interminably for the Spanish government to request relief and negotiate conditions that would be administered by non-Spaniards.

Politically, it should not be surprising that Prime Minister Rajoy demurred and from time to time reassured markets that Spain would not need to request relief. It would likely have been an act of political suicide if he had turned over Spain’s spending and tax policies and enforcement to what would likely be a German-dominated body composed of citizens of other countries. Moreover, Rajoy is simultaneously confronted with a serious threat of secession by Catalonia, based upon regional unhappiness with the consequences of fiscal austerity and bank crackdowns imposed by Madrid and the EU.

The February elections in Italy in recent days resulted in a “hung Parliament.” No party secured sufficient seats to assert a majority or be positioned to lead a coalition government. Instead, at least initially, it became clear that the key parties were unwilling to cooperate with each other and yield leadership to their rivals.  Moreover, voters had rejected the leadership of Mario Monti as a puppet of Berlin.

This posed a new challenge in interpreting the ECB’s willingness to “do whatever it takes.”

If a government was not able to decide on any Eurozone-established conditionality would the ECB’s demand that such a government accept conditionality be relevant?

Furthermore, it became evident that a substantial share of the newly elected Parliament was determined to end all EU fiscal austerity measures and revert to economic growth stimulus, making the various decisions of EU and Eurozone leaders over the last couple of years no longer applicable to Italy.

Political calls for abandoning the Euro were heard again. Yields on Italian debt abruptly began to rise and CDS spreads grew larger than Spanish CDS.

All of this happened in parallel with new official data revealing that the Eurozone had fallen into recession, with even the German economy looking likely to weaken in coming months. European stock markets began to be beaten down, and the Euro fell from recent peaks.

The Draghi declaration of new “OMT” sovereign debt purchases should never have been considered as meaningful, as it was never politically likely that any troubled government would surrender national sovereignty and subject itself to non-elected decision makers under German leadership.  How would that sell to voters?  Eurozone investor complacency was not warranted because the terms of Draghi’s pledge to “do whatever it takes” was never likely to be politically acceptable.

It also became evident that the Berlin government and its Frankfurt Bundesbank would simply not tolerate large scale bond buying of any of the troubled “peripheral” Euro members, especially during this year of German national elections, regardless of conditions that might have been negotiated on Euro governments that requested help.

Looking deeper into the underlying problems, all of the Eurozone governments are facing rising unemployment and deepening recession.

Even the “core economy” of France looked to be tumbling downwards, with its national fiscal deficit growing day by day, rapidly transforming France into another Spain or Italy.

Nonetheless, in spite of the negatives in Spain, Italy, and France, financial markets remained complacent as the Draghi declaration still seemed to convince investors that there is no longer need for extraordinary yields on sovereign debt of troubled economies, because the ECB is ready to “do whatever it takes.”

As we have reminded on several occasions in the past, the Continental European economies have long been heavily dependent on bank lending and investment in sovereign debt. European banks, confronted with deterioration of their capital and especially the value of their sovereign debt holdings, and in many cases suffering deposit flight, were pressed by regulators to reduce their ratio of assets to capital.

As it was very difficult to secure additional capital from investors in this troubled political and economic context, it was decided both by bankers and regulators that dramatic cuts in asset size were necessary. This not only meant splitting off worldwide lines of business but also reduction of intra-Eurozone lending and holdings of debt of fellow Euro member governments.

The potential of realization of a new European banking union was also an emerging dark cloud for many banks. Even more threatening has been the pressure of European bank regulators to adopt Basel III capital standards, which would require gathering far more capital and/or reduction in lending, to achieve less risky asset to capital ratios.

European banks had long been the primary providers of trade finance around the world, but this scaling down process within the banks has recently resulted in large-scale withdrawal of European banks from global lending, especially to emerging market economies.

This has been taking place at the same time that world trade growth has been slowing down dramatically.

As the Eurozone economies are highly dependent on export demand as drivers of domestic economic growth, the combination of recession within Europe and global economic slowdown and stagnation of world trade is adding to the downward pressures on European national economies.

While European politicians and the European Commission continue to forecast end to recession and early recovery, the outlook in our view is that the European recession will most likely deepen and extend well into next year and possibly beyond.

The probability of bad “hung Parliament” elections in other countries besides Italy is growing alongside rising unemployment, especially youth unemployment.

Holding the membership of the Eurozone intact will be increasingly subjected to local and regional political pressures for growth policies and freedom from the tyranny of non-elected, non-national Eurocrats.

The fragmentation of politics in Italy is a precursor of greater political unrest in other European Union economies – including a serious UK “rethink” about its membership in the European Union.

As Europe experiences aging demographics, faltering national social support programs including pensions and health care will likely add to the misery of fiscal austerity.

Spending on the military will dwindle to a trickle, leaving Continental Europe with a hollow shell of “security.” 

The European financial crises of the last couple of years are far from over, both in economic and political terms.

And it is looking increasingly likely that NATO will end up as a conference center for the very few Europeans still in uniform.