Eurozone: The Way Out Of The Crisis

 |  Includes: FXE
by: Evariste Lefeuvre

I compiled a few factors that may be a useful to gauge, beyond the recent rebound in economic surveys, the overall improvement of the Eurozone economy and institutions.

1. Internal imbalances: For many investors the overall improvement in current account balances is considered a positive sign. I would restrain our enthusiasm.

  1. There are some exceptions but the adjustment came mostly from a retrenchment in domestic demand. Even if some countries improved their exports (Spain, Portugal and Ireland notably), the supply base is too small to make up for the decline in domestic spending.
  2. In addition, the twin deficits theory does not work in all European countries: for Spain, Portugal and the Netherlands, the improvement in the current account balance came along with wider public deficits.

Click to enlarge

  1. The current account deficit is the sum of the trade balance and the net income balance. While trade imbalances can rapidly be adjusted (strong exports remain yet a structural challenge when specialization is weak or the integration in the global value chain is insufficient), the deficit in net income flows results from years of accumulation of foreign debt, which cannot be dismissed unless the country resorts to default. Unfortunately for Spain, the net income balance is still negative.
  2. It is clearly too early to say if current account improvements are reflecting a sharp improvement in competitiveness or the depth of the recession. I would lean on the recession side. Therefore, the risk in the medium run is a lack of external funding when any tentative recovery drives the trade balance back into negative territory.

2. Financial Fragmentation: Cross border financial flows have collapsed within the Eurozone. According to the European Banking Authority, the outstanding or foreign government bonds held by domestic banks have also fallen. The same pattern is observed for cross-border lending. The combination of stringent capital rules (Basel III where banks don't have to hold capital against their government debt portfolio) and financial repression have given rise to a parallel increase in bank capital and (domestic) sovereign bonds held by banks. This has many implications:

  1. The link between bank and sovereign risk still exists. In addition, the current stability mechanism (European Stability Mechanism) does not completely address the issue since no direct recapitalization will be allowed before the "legacy" (never properly defined) has been written off. It can nevertheless grant loans to countries for recapitalization purpose, which maintain the negative feedback loop between banks and sovereigns. Only when the Single Supervisory Mechanism (see below) is in place in late 2014, the ESM will be able to recapitalize directly banks - under stringent conditions though, as it will clearly be a last resort.
  2. The currency-union trilemma proposed by Maurice Obstfeld is still valid: one cannot simultaneously maintain cross-border financial integration, financial stability, and national fiscal independence.
  3. This is the reason why the insistence is no longer on Eurobonds or fiscal integration (European budget) as they have been deemed politically unacceptable, but rather on the banking union to break the loop.

3. Banking Union: Probably the most urgent step forward. A well designed banking union encompasses a (Single) Supervisory Mechanism, a (Single) Resolution mechanism (default/restructuring) and a deposits insurance scheme. As stressed by many academics, any banking union has a fiscal component in it:

a. Any restructuring based on a purely national fiscal backstop enhances the sovereign/bank negative loop. Pooling European resources (fiscal capacity) to implement a well-designed bank restructuring will be one of the biggest challenges for the next future.

b. The bail-in of private bond holders is a game changer, as the European authorities are trying to limit the risk on taxpayers and depositors. This is clearly a significant step forward brought by the BRRD (Bank Recovery and Resolution Directive).

4. Stabilizing the economy: The "six-pack" and "two-pack" have strengthened the surveillance of the discipline of EMU members. It could pave the way for more fiscal integration as it would reduce the moral hazard associated with the pooling of resources. Yet, it hinders the potential for (counter) cyclical stabilization at the European level. The ESM may help a country when fiscal stabilization comes along with a huge deterioration of its public finance (liquidity or even solvency crisis - where the outcome is a private sector involvement). But the real and sole potential player for cyclical stabilization remains the ECB.

a. The ECB is playing its role of Lender of Last Resort through the potential OMT intervention but has failed to re-open the credit channel of monetary policy - refusing for instance to bundle small business loans.

b. The crisis came along with some significant operational changes at the ECB (collateral rules - Additional Credit Claims, more freedom given to National Central Banks for collateral rules, VLTRO, forward guidance, willingness to publish Minutes) and also institutional changes (the OMT is still under review by German Constitutional Court), but the mandate remains the same: the overall level of inflation, which forbids the ECB from letting inflation ramp up excessively in order to ease deflationary pressures in southern countries (see last sentence here). With overall inflation standing at 1.3% in August, the risk of persistently high real interest rates in southern countries remains.

c. This suggests that the ECB is not ready to go much further than cutting rates and providing liquidity, insisting though that "euro area countries should not unravel their efforts to reduce government budget deficits and … must step up the implementation of the necessary structural reforms so as to foster competitiveness" (Press Conference August 1st).

5. Structural Reforms: There is a huge debate about whether the scant signs of recovery are due to the effectiveness of reforms that have been carried out (supply side), or because of pent-up demand building after several years of collapse in investment and durable good purchases.

a. Car registrations suggest that there is some pent-up demand (but without credit growth, it might remain severely constrained for a while). The limited rebound in the saving rate over the last few months may also help temporarily.

b. Fiscal policies will probably be slightly less contractionary. As can be seen below countries went through a mix of growth killing VAT and Employers' contribution increases.

c. Structural reforms were necessary but may have been taken in a very hasty way. in addition structural reforms have been carried out at a time when public spending was reduced - something that generally reduces its effectiveness. But my main point is that there has been overemphasis on labor market flexibility, instead of on the goods and market competition. The lack of competition in the goods market and some hikes in indirect taxes (VAT) have kept inflation above total compensation growth, reducing de facto consumers' purchasing power.

6. Germanization of the euro economy: Many investors, economists and policy makers have advocated the implementation of German style reforms/economic model. There are many dangers associated with this. The question may not be whether European countries should adopt German style reforms but rather if Germany should change its growth model. The answer is not straightforward.

a. Angela Merkel may have criticized Schroeder for Greece's entry in the EMU, but his reforms are still considered part of the German miracle: wage restraint associated with greater inequality, lower job protection and working poor, fiscal tightening. It has been shown that the contribution to the slow growth of unit labor cost was more linked to wage restraint than outstanding productivity growth. The distortion of the distribution of income toward profit also spurred the industrial sector but the latter also benefited from huge outsourcing in Eastern Europe (the so-called bazaar economy and the increased indirect pressure on German workers through outsourcing threat). Of course there were some positives: better product sophistication, new value-chain organization, company growth, poor worker vs. long-term unemployed tradeoff. But is it a reason to export the model throughout Europe ?

b. Germany has been criticized for exporting its recession in the 2000s, alleviating the domestic pain through exports to southern Europe countries (financed by German banks…). Could we expect a more cooperative Germany with stronger domestic demand? Germany has already increased real wages since the Great Recession while the export performance has disappointed (further proof that Germany is a global/Europe growth accelerator, not motor). What seems more cooperative will not necessarily help southern countries: many of the European countries that imported massively from Germany have a low export market share in Germany. Enhancing domestic demand in Germany may not spur southern Europe countries' exports as much as is often suggested.

c. Furthermore, the cause of the current account surplus is not only linked to the export performance. The other side of the coin is, of course, low wage growth but also excessive saving linked to the aging of society and a growing share of poor workers (precautionary saving), a low level of public and construction investment, and an under-developed service sector. The current account surplus of Germany therefore highlights some economic ills. Solving them would probably enhance domestic demand but the net impact on other EMU members might not be as strong as usually expected (geography of trade flows and stronger demand for mostly non tradable goods like services and construction).

d. The widening current account of many non-core countries before 2008 was clearly a sign of excessive leverage, but also of worsening competitiveness. Endeavors to restore competitiveness are necessary but their combination with fiscal adjustment is economically and socially painful. The German model presents some shortcomings and the Schroeder reforms should rather be seen as a specific historical event than a pattern for reforms given Germany's idiosyncrasies. The alteration of the German model would not necessarily be helpful for non-core countries either, as we have seen above. Indirectly a lower current account in Germany would entice a lower EUR/USD through a dwindling European external account. This is a small positive.

Bottom Line: In recent months, we have seen ongoing institutional and even cyclical improvements. There are still many uncertainties pertaining to the nature of the improvements (temporary or structural). I hope that the grid presented above can help sort out the different issues.

Even though I do not rule out any political blips in the next few months (Germany, Italy…) the biggest challenge will clearly be how Europeans deal with their banking system. I will focus on the expected (and partial) details on the criteria that will be used by the ECB for its Asset Quality Review (announcement expected between October and the end of 2013). The "perfect scenario" for the ECB would be the following:

a. End of the Asset Quality Review (AQR) in February 2014;

b. Start of the stress tests by the European Banking Authority (EBA) in May 2014;

c. Results to be published in October 2014 1.) when the ESM is able to provide a backstop (direct capital injection) 2.) and the bail-in of private investors (BRRD) is ready to be implemented.

If the timeline is respected, the Eurozone will have almost made its way out of the crisis. The only big hurdle will be potential growth with an urgent need to invest.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.