Europe is groping its way toward economic sanity. Most critics of eurozone policies want to make Europe over in some image of their own. But Continental Europe will be itself. It will be different from the U.S., it will be different from Britain, and it will be different from anywhere else. Several Continental nations made a mess of their finances by utilizing the apparent strength that they had gained from joining the euro to borrow in order to pay for social safety net expenditures that they had committed to over a number of years. Those borrowings were unsustainable, and when the markets realized that, the markets rationally required high premiums in the form of higher interest rates.
Countries such as Italy and Spain then were faced with the conundrum of what to do about being over-leveraged in the eyes of the marketplace. They could not make the marketplace go away. They had few alternatives: Default on their debts; get bailed out by some other country or set of countries who would, in effect, pay off some of their debts; or raise taxes and reduce spending in an effort to require less borrowing in the future. The choice of business as usual was not offered by the marketplace. Under business as usual, the marketplace was not going to buy the debt at all.
Ireland, Portugal and Greece -- other countries that had suffered the same fate, though for somewhat different reasons in the case of Ireland -- sought and obtained bailouts by other countries (in the form of the eurozone and the IMF). The bailouts put the bailing entities in the position of the marketplace lenders that they replaced. Quite naturally, the bailing entities reacted the same as the marketplace lenders. That is, they were not going to fund business as usual. They required higher taxes, lower spending, and restructuring of labor and capital markets in ways designed to make the debtor countries more competitive. The lenders knew quite well that this formula would impose hardships on the people of the debtor countries. But in the long run, the bailout lenders believed, restoring the competitiveness of the borrower nations was the only way that they (the lender countries) might get repaid. The imposition of austerity was not a morality play; it was a business decision made by lenders of last resort.
Not surprisingly, GDP goes down when you reduce government spending. One of the elements of GDP is government spending. So when you reduce government spending, unless some other part of GDP goes up, GDP goes down. Duh, as they say in the cartoons.
The more important issue is employment. Employment naturally goes down as well when you reduce government spending because the government lays off workers in order to reduce spending. No mystery there, either. And reducing government spending also may reduce private employment because government may reduce spending by buying fewer widgets. Higher taxation also might reduce employment because people who pay higher taxes have less money to spend, which reduces final demand, which reduces private sector employment, as the day follows the night. So why the devil do the creditors think lower government spending and higher taxes is going to help a country to repay its debts in the long run?
This has to do with how the country got into the fiscal mess in the first place. Most European countries, especially southern ones such as Greece, Portugal, Italy and Spain, have had parts of their populations that have fallen behind economically and stayed behind economically for generations. The natural question is what they should do about that. The answer has been to have the state provide a liberal safety net to prevent dire privation, while at the same time protecting those with jobs -- who have to pay for it in the long run -- by making it difficult for workers to be fired, difficult for companies to break unions, and easy for guild-type organizations like taxi drivers to use the political system to fix prices and protect their own from competition by outsiders who would charge lower prices. It was a bargain that looked good to most of the participants. The only real problem was that it depended on the governments being able to borrow to fund the economic mess that the bargain created.
When the borrowing to pay for this economic system had to stop, there was no easy way to get from there to economic growth and sanity. The pain in Spain, the unease in Italy, and the tragedy in Greece are natural consequences. I wish they were not. But the Good Fairy's magic wand was lost a long time ago.
How long will all that pain go on? I wish I knew. It could get worse if a country's political system does not stay the course. That is, a rollback of the harsh measures in mid-course will merely retard the possibility of future progress. And with elections in Italy in February, for example, almost anything could happen.
France's economy already is getting worse, in part due to contagion, and in part because the Socialist government has to act Socialist, even if President Francois Hollande ought to know better. I believe that France's finances will continue to weaken for the next year or two. Then the Hollande government will remember to act like the Socialist Mitterand government of a generation ago and abandon its socialist stance to make mid-course corrections. My fear is that the debt of France is so much greater than it was a generation ago that the shift will not come in time.
Enter The ECB
This sounds, so far, like a forecast of doom and gloom. What about the European Central Bank (ECB) and its president Mario Draghi's pledge to do "whatever it takes" to preserve the euro?
Even Mr. Draghi knows that the ECB has not rediscovered the Good Fairy's magic wand. But the ECB can use its powers to give breathing room for an economic recovery to take place if the countries involved will stay the course toward economic market reforms.
I have been writing about Mr. Draghi since he came to office in November 2011. I have depicted him as an economic hero, and I have no reason to change my tune after a year of significant accomplishments. Without him, I believe that Europe would be in much sorrier shape than it is in now. But the accomplishments have slowed in the last few months, and getting the support from the major European nations that further progress requires is bound to be difficult.
In his first press conference after taking office, Mr. Draghi signaled a fresh start for the bank he heads. At the time (November 9, 2012), I wrote that:
The ECB cannot solve the euro's basic problems. But the ECB's vigorous action to "do whatever it takes" could buy enough time for the political process to make fundamental changes in a less heated atmosphere. That is an optimistic view. But unwinding the euro seems sufficiently fraught that I am optimistic that the Europeans will find a way to avoid it. Vigorous ECB action is likely to be a necessary first step, and based on his press conference, I expect Mr. Draghi to be a proponent of "whatever it takes" when the time comes, although he will have to couch the action in terms that avoid the restriction the treaty places on loans directly to the countries of the zone.
Many writers who commented on Mr. Draghi's first news conference were misled by his apparent parroting of the need to operate within the ECB's mandate. They failed to see that he described the mandate in "centralbankspeak," a language unknown to most of the world and often misunderstood within central banking circles as well. In actions taken in August and September 2012, he used the same "cenrtalbankspeak" words to explain why the ECB's program to buy short-term sovereign debt in the open markets in unlimited amounts was within the ECB's mandate. Mr. Draghi is a very canny man who sees several moves down the chessboard of time.
In December 2011, at Mr. Draghi's second meeting of the Governing Council, the ECB enacted the first of its blockbuster programs to ease liquidity in the eurozone: the Long Term Refinancing Operations (LTRO). In two tranches -- December and February -- the ECB offered three-year funding to banks at 1% per annum, significantly below the rates that banks would have had to pay in the marketplace. The banks borrowed about one trillion euros under this program, thereby boosting their liquidity and their ability to make loans, as well, potentially, as their profitability. For solvent banks in the eurozone, this more or less assured them survival over the medium term.
Despite the LTRO, banks continued to fail. LTRO could assist liquidity, but it could not address balance sheet insolvency, and banks that were balance sheet insolvent could not attract deposits and could not be allowed to continue in business as they were. Balance sheet insolvencies were especially prevalent among the second tier of banks in Spain. The biggest of these insolvent banks, Bankia, was a gaggle of smaller insolvent banks that the government had smashed together a year or so earlier. For some reason, ordinary people think that putting a bunch of insolvent banks together will make them solvent. I have seen it tried over and over again in many places on the globe, and it never works because the big new bank still has fewer assets than it has liabilities. Spain could not, however, bail out its insolvent banks because that would violate its agreements with lenders. So it asked the rest of Europe to pitch in. (The idea that shareholders should be wiped out and creditors bear the rest of the burden of recapitalization is un-European. In addition, the Spanish government had a little publicity problem in that it had participated in encouraging retail depositors to take subordinate positions in the earlier, failed recapitalizations. Apparently, no one in authority in Spain ever had studied bank failures and the many ways to botch their recapitalizations.)
The ESF has come forward with up to 100 billion euros for the Spanish banks, and it looks like about 50 billion of that will be used. Spain has gotten away with very light requirements to get this sum of money. I guess it is no longer a large sum.
Nevertheless, the market interest rates that Spain was having to pay to refinance its maturing debts were trending upward again -- after falling somewhat after LTRO. It was at that point that Mario Draghi publicly stated that the ECB would "do whatever it takes" to preserve the euro. And in the August meeting of the Governing Council, the Council approved his assertion and outlined a program to support national sovereign debt markets.
OMT - Doing Whatever It Takes
The program outlined at the August meeting would permit the ECB to buy unlimited amounts of short-term debt of a eurozone nation, provided that the nation received EFSF/ESM approval and agreed to abide by whatever conditionality the EFSF/ESM imposed.
Such EFSF/ESM actions would, in theory, provide the ECB with the cover it needs to for an ambitious program to resuscitate the cross-border short-term money markets in Europe. I found Mr. Draghi's answers to reporters' questions after the August meeting most interesting. He said the predicate for ECB action is that the money markets have become increasingly national rather than integrated throughout the zone. This fragmentation has made the transmission of monetary policy ineffective. Examples of fragmentation are the gradual reduction in cross-border deposits and money market loans in the last two years, as well as the reduction in cross-border collateral being offered to the ECB. The consequences of such fragmentation, which has contributed to the significant interest rate differentials among the nations at the short end of the yield curve, are serious for the exercise of monetary policy, which is the ECB's mandate. Therefore the ECB's program, a program that had been approved in principle by the Governing Council, will be, if implemented, to make open market purchases of specified countries' bonds at the short end of the yield curve. I wrote about this right after the meeting in August.
In September, the ECB's governing council approved the Outright Monetary Transactions program (OMT), incorporating the basic ideas approved in August. A country could become eligible to have the ECB buy its short-term (up to three years maturity) bonds if the country made application to the EFSF/ESM and agreed to abide by whatever conditions that entity imposed.
Market Reactions to OMT
It was widely believed that Spain -- and perhaps Italy -- would apply for this form of assistance in order to drive down the costs of its borrowings. The Spanish government was, however, lukewarm to the idea, talking about lost sovereignty and, undoubtedly, worried about internal political consequences, especially in light of the Catalan separatist movement. Then a funny thing happened: Without anyone lifting a finger, the market reacted to the ECB's words and actions without the ECB having to buy a single bond. The rates on Spanish, Italian, and even Greek bonds tumbled. Spain, of course, backed off asking for help, as did Italy. And Mario Draghi is now talking about "positive contagion."
The following graph from The Economist December 22, 2012 issue traces the trend of sovereign debt effective interest rates for Italy, Spain, and three assisted countries. As the chart shows, even without any country applying for assistance from the ESF/ECB under the OMT, the markets reacted:
It remains to be seen whether the markets will permit Spain and Italy to have the benefits of OMT without having to apply to the ESF and comply with such conditions as might be imposed. I have suggested that the conditions are likely not to be onerous -- that is, they are likely to be basically to adhere to the programs that both governments already have adopted. But accepting European conditionality is seen in both nations as imposing a loss of sovereignty.
On the last business day of 2012, Italy sold six billion euros of bonds at reasonable interest rates, despite political uncertainty about elections called for in February.
"The treasury sold the maximum €3bn of bonds due in 2022 at 4.48 per cent, slightly higher than the 4.45 per cent it paid last month. It also sold €2.871bn of bonds due in 2017, slightly below its maximum target, at 3.26 per cent, versus 3.23 per cent at the last auction in November." The Financial Times reported.
Spain offered seven billion of10-year bonds on January 22, 2013, and the offering was significantly over-subscribed.
Over the last few weeks, major banks throughout the eurozone have been borrowing at low interest rates, and there is talk that many of them will repay substantial amounts of LTRO. Such signs of bank stability are welcome and, to most people, unanticipated.
The stock markets of Europe also have reacted in bullish fashion, almost from the date that Draghi made his declaration in mid-summer. Many European indexes are pushing secular highs.
Markets At Odds With Economies In Recession
Nevertheless, Spain and Italy remain in severe recessions, France has fallen into recession, and even Germany is not growing briskly. If the economic climate remains bleak, as I think it may for some time, electoral politics may undo the progress toward market reforms that has begun. That would lead to greater uncertainty and, I believe, rising interest rates on sovereign debt. Such events also could adversely affect European equities that have soared off their 2012 lows.
Cam Hui, writing for Seeking Alpha, is bullish on European equities for 2013. I admire Cam. He may be right. But I still think there is a long way for the European economies to go before they are out of the woods. And the run-up of prices since the summer also gives me pause.
On the other hand -- and being a lawyer, you know I have two hands -- by the time the European economies really have turned the corner, the equity markets may well have anticipated it, and all the upside may be gone. Risky game, investing. Whatever happened to the "sure thing"?
On balance, I remain a long-term investor who tries to take advantage of short-term opportunities when they appear to me to have a balance in favor of relative certainty. Last March, I recommended a couple of European bank stocks for the medium term and suggested selling them in September when the medium term came to an end. The investments paid off quite nicely. But at the moment, I do not have any such medium-term thoughts. There are elections in Italy and Germany in February. I am going to be cautious about Europe until after those are decided. I may miss some boats, but I may miss some bad stuff, too.
Europe is, it is my guess, about at the mid-point of its crisis. I expect ups and downs for the next couple of years as it continues to sort out.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.