Merkel rightly believes that Europe's problems will take years to solve, but she translates that into meaning that she has time to act. The luxury of time is just not there; if Italy or Spain go from being illiquid to being insolvent, the problems that are manageable today become unmanageable. What is required, or rather desired, is something credible; something decisive; something substantial; something quick; something comprehensive. This was not achieved and so risks remain elevated. Something giving a few months or quarters visibility would help, but we remain in an environment where we watch the story unfold one day at a time.
Nevertheless, there were positives; incremental positives are always welcome and equity markets rallied, but bond markets displayed skepticism as yields continued to rise.
Step 1 of the European Promise
The plan for several countries to include balanced budget requirements in their constitutions.
Target deficit 0.5% maximum; automatic adjustments and sanctions if deficits are over 3%.
Automatic adjustments and sanctions can be waived by 75% majority.
Why Is This Important
Fiscal and political congruence are essential ingredients for any monetary system. And an expression of commitment to long term balanced budgets goes a long way in reducing perceived credit risk.
As of now, these are statements of intent. The proper adoption and implementation remain risks.
It is an expression of commitment to fiscal discipline which should in theory provide comfort to lenders that they will be re-paid and thus drive credit risk and yields lower.
There is scope for cyclically adjusted deficits, because deficits can rise to 3% and even over with the blessing of 75% of the members.
Generally a target for a balance budget is a plus during a period where an economy has low unemployment and low spare capacity. However, during periods of high unemployment accompanied by spare capacity, it will lead to deterioration in fiscal condition as economies continue a deflationary contraction resulting in falling fiscal revenues and spending; a deflationary cycle is difficult to break out off.
It is hoped that ultimately, with falling real wages, the economy becomes globally competitive and unemployment will reduce and spare capacity get utilized through exports and the creation of a trade surplus. This exit strategy in itself is weak; an economy should thrive mainly on domestic consumption with a balanced external trade account objective. In addition, if all member nations adopt austerity and balanced budgets during a period of economic distress, there are limited markets to which the deflating nations can export to create trade surpluses.
There is also a problem in that even with fiscal congruence, political congruence is lacking. Europe lacks elected leadership; Germany is filling the gap, but they are not elected representatives of Europe. Ultimately, a trade, labor, monetary and fiscal union also needs political union; a German must be capable of seeing himself as "first European & then German"; he must be willing to sacrifice albeit grudgingly for the benefit for Europe, even if the problems are in Italy or Spain. And since this is unlikely to happen, an elected European leader is necessary to impose the right policy for Europe without bias. Barak Obama, an elected leader, acted to save banks because it was in the best interests of America even while people despise Wall Street; he could do it because he is an elected leader of a nation.
Fiscal congruence together with enough flexibility to permit cyclically adjusted fiscal targets is a positive. This is a step in the right direction, provided that member nations which are solvent adopt stimulus driven by small fiscal deficits to create markets for insolvent members.
Some solvent members, such as Italy and Spain, are facing a liquidity crisis due to dramatically rising yields; this can drive these nations to insolvency, unless they have access to debt markets. This brings us to the second part of the European promise.
Step 2 of the European Promise
We now have the EFSF which has a lending capacity of euro 440 billion, of which euro 190 billion has been committed, leaving euro 250 billion in lending capacity. We also have the start of ESM being accelerated to July 2012; this will have euro 500 billion. And finally we have commitments from National Central Banks for euro 150 billion, with a further euro 50 billion from other EU states, which will be made available to IMF for European rescue operations. So in total there is euro 950 billion available.
Overall, it is hoped that this will provide nations access to debt markets when private markets will not participate as a result of dramatic credit risks.
For a block which constitutes about 30% of global GDP Euro 950 billion is not near enough. At present, the ESM is not intended as a leveraged vehicle, which can borrow to expand its lending capacity. However, this together with the size and scale of ESM will continue to be evaluated. Additionally, the euro 200 billion loan from National Central Banks to IMF may be seen as sending a very, very negative signal. On the one hand Europe says they are taking steps which will save Europe. On the other hand they are not willing to put their money where their mouth is – by lending to IMF, the debt of National Central Banks is senior; NCB's are demanding that IMF takes credit risk. If Europe believed the credit risk were truly lower, channeling of funds via IMF would be unnecessary.
In my view, ESM should be allowed to leverage and it should also be capable of issuing stability bonds for funding illiquid but solvent members. Part of the ESM corpus must of course be reserved for funding insolvent recovering members who have no access to private debt markets until they return to solvency.
It would be far better to have a huge fund lending capability, with much of the capability unutilized but available, and with actual lending used only to fund insolvents. For countries like Italy and Spain, this fund should serve more as a backstop to reduce credit risk, so that they (the illiquid) can continue to raise debt in private markets, i.e. the fund should not lend to the illiquid, rather its size, scale and influence should be such that private investors charge lower yields due to perceived lower credit risks. If the illiquid are unable to raise reasonably priced debt, then Stability Bonds issued by ESM could be used as a temporary measure while confidence re-builds. Should Italy or Spain turn insolvent, they will have access to the fund to retire private debt and thus for private lenders credit risk would be and be perceived to be low.
IMF remains important, though I do not feel they should be involved in providing access to liquidity for anyone other than insolvents. IMF has the expertise to take credit risk and money from Europe makes it possible that non Europeans could add to funds to IMF's arsenal. In addition IMF can play an important role in setting, administering and enforcing the fiscal targets of insolvents.
While there are no Stability bonds, the fact that there is a way to provide a degree of financial stability through issuance of debt outside private debt markets to insolvents is a positive, provided that the funds can be leveraged in a manner such that the fund size increases substantially - to at least euro 3 trillion. What about the solvent but illiquid members?
This brings us to the third part of the European promise.
Step 3 of the European Promise
We have the insolvents. And we have those losing access to liquidity, such as Italy and Spain. To address access to liquidity, private debt markets must function efficiently. What more, the action must be fast and decisive. Because without access, the illiquid can fast become insolvent, and I suspect that Europe does not have a solution for such an occurrence.
The ECB took some strong steps to help banks facing crippling liquidity crises, but it has yet to help sovereigns in any meaningful way. Global central bank actions to provide liquidity and help shrink TED spreads was also a powerful positive. Also a positive is confirmation that the EFSF and ESM will be managed by ECB. The final positive is that there is an indication that ESM/EFSF funds will be disbursed without requiring private sector involvement (the dreaded hair-cuts); this needs to be an iron clad commitment, because otherwise, yields will be driven upwards as credit risk will remain elevated in both primary markets for new debt and in secondary debt markets. European institutions such as NCB/ECB/ESM/EFSF must accept credit risk and signal that the credit quality based on the full faith and credit of a member is impeccable.
The problem is a lack of commitment from ECB on action in secondary debt markets. ECB as a European Institution has to lead the confidence building exercise by believing that the fiscal discipline promised reduces credit risk. It has also got to believe that the EFSF and ESM together with IMF provide a safety net which further reduces credit risk. And in recognition of lower credit risk, it has to step in to secondary debt markets to drive yields down to a level where the cost of debt is in line with the time, inflation and credit risk. They need to expand their balance sheet and have confidence in their ability to shrink the balance sheet when required at a future date. And they need the good sense to recognize that in an environment where economies contract, unemployment is elevated and spare capacity is available, inflation is not a risk; the true risk is deflation. The inflation risk due to expanded money supply is a tail risk - one which will arise if there is no withdrawal of liquidity with a return to growth, falling unemployment and shrinking spare capacity. The ECB is at a point where they may lose the ability to transmit the impact of monetary policy decisions through to the real economy.
Some significant positives, but much more is required. They need to act to ensure that lowered sovereign credit risk is priced in secondary markets; bond vigilantes need to be convinced of lowered credit risk and this will only occur if ECB together with other European Institutions and Funds accept credit risk.
There is some solid conservative thinking coming out of Europe. But Merkel and Germany remain a major problem.
They are bound by the chains of history in their fear of hyper-inflation, when the current risk is deflation, with inflation being no more than a tail risk which can be managed by good monetary policy.
Merkel and Germany also appear hell bent on austerity now; this, in my view, is not time appropriate. It makes no sense to expect improved fiscal circumstances from austerity in an environment when an economy is expected to be contracting.
Germany is also involved in magical thinking; they advocate achieving balance and growth in the manner Germany did late last century. They did it by creating massive trade surpluses, much of it from trade with now illiquid and insolvent Europe. How can Germany or illiquid and insolvent Europe expect growth through trade surpluses during a period of austerity? Who will the buyer be?
If this thinking does not change, we will likely see austerity leading to a contraction in global demand and perhaps a period of deflation. With contraction in global demand, the sharpest deterioration can be expected amongst countries which depend more on trade surpluses than on their domestic economies; Germany and China will likely feel the greatest pain, together with the commodity rich Australia, Brazil, Canada, Middle East, Russia and South Africa. Countries like US and India with significant domestic markets are somewhat safer; however, India's large deficits could prove to be a problem if the flight to safety keeps the Rs weak and weakening; though perhaps not too bad if accompanied by export growth due to a competitive Rs and with imports declining as a result of commodity prices falling more than the Rs depreciation. US could actually be okay with trade deficits falling on $ strength.
The good news is that what Europe has accomplished so far can avert disaster, if cyclically adjusted fiscal targets are adopted; if ECB steps in to drive down yields in secondary debt markets; if the funding mechanisms (EFSF/ESM) are capable of being leveraged to create a formidable size and scale, which size and scale will probably mean that the facility may never be used.
Risks remain to the downside, though perhaps slightly lower compared with the pre summit days.