Zombie Death Of A Eurozone Hard Currency Salesman

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Includes: ADRU, DBEU, DBEZ, DRR, EEA, EPV, ERO, EUFX, EUO, EURL, EZU, FEEU, FEP, FEU, FEUZ, FEZ, FIEU, FXE, HEDJ, HEGE, HEZU, HFEZ, HFXE, HGEU, IEUR, IEV, RFEU, SBEU, ULE, UPV, URR, VGK
by: Adam Whitehead

Summary

Facing increasing populist resentment Eurozone policy makers continue to press ahead with the creep towards banking and fiscal union.

Failure to hit deficit targets continues to be swept under the carpet.

Jens Weidmann's radical conversion to Saltwater economics is practically motivated by Germany's rapidly diminishing fiscal surplus.

Germany's diminishing fiscal surplus is going on immigration making it more heavily reliant upon monetary stimulus.

The creep towards fiscal and banking union, enabled by monetary stimulus, is Euro negative.

The populist rhetoric in the Eurozone and criticism of the ECB, by the established political leaders fearful of their electorates, soon began to sound like hollow canons. Through the fog of war on the Eurozone battlefield a discernible reversion to type could be seen developing. Eurozone policy makers are doing things their own way again, and the Euro will ultimately pay the price.

The pervasive rise of Eurozone populism discussed in the last report grew stronger in Spain. Podemos now fancy its chances of making inroads into the Socialist voters. It has therefore rejected calls to join a three-way coalition, which effectively pushes the country nearer to new elections. As the political situation deteriorates there is a clear attempt at window dressing, going on at the Finance Ministry, to present an appearance of financial stability.

Finance Minister de Guindos recently admitted that the nation has missed its debt-to-GDP target for the eighth consecutive year. Almost immediately, before the markets could digest this economic bad news along with the political bad news, he then announced that net government borrowing would be cut this year.

On the bright side, Spain appears to be trying to apply fiscal restraint in a sincere attempt to hit its Stability Pact obligations. On the dark side, cutting fiscal spending simply creates a stronger headwind which impacts GDP so that the debt-to-GDP target slips further away. On the dark side one could also argue that Spain is entering a negative debt spiral. The switch in perception from bright to dark side, will be governed by perceptions of the political situation. The emerging political vacuum and new election scenario, therefore appear to be catalysts for the dark side.

None of this seems to matter to the European Union or the ECB. The ECB is happy to remain a buyer of Spanish debt and even to pay the Spanish government through negative yields for its fiscal ineptitude. Based on the words of understanding from Economic Affairs Commissioner Pierre Moscovici, which are translated into Spanish as "manana", the European Union will let Spain off the hook once again. The combination of ECB and EU therefore conspires to enable the moral hazard that allows Spain to live beyond its means, even as its means continue to fall short of the fiscal subsistence point.

The ECB has received its fair share of the blame for the rise in populism. The last report discussed how the IMF sought to focus the blame back on elected politicians and their lack of stimulus and reform packages. It was also noted that when under attack, the ECB closes ranks and repels invaders. All internal and ideological divisions have been subsumed under the ECB's prime directive to remain independent.

This standard operational procedure was recently followed by Draghi critic Klaas Knot. Striking a conciliatory tone, Knot opined that Eurozone voters considering voting Populist should adopt and attitude of "patience and reality". In his opinion, inflation will rise "sooner or later", so the voters of Europe should trust the ECB and accept the erosion of their wealth through negative interest rates. The premise is absurd.

Why an individual in a region noted for its principles of liberty, freedom and equality should pay to then see the value of his/her wealth undermined by inflation seems like the double jeopardy of being robbed twice. It is therefore highly likely that Eurozone voters will take their finances and livelihoods into their own hands ultimately as they further lose faith in their political leaders and central bankers.

ECB Governing Council Member Ewald Nowotny adopted a slightly different tactic than Knot, in order to deflect the criticism away from the ECB. In his opinion the debate over deflation risk has become too emotive. He sees inflation picking up sooner than Knot, so that the current debate over it and the ECB's behaviour will swiftly become academic.

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The signs of this loss of face of policy makers with voters are very tangible. In Bavaria, bank depositors now deposit physical currency so that banks have become safe-deposit boxes. The recent perverse behaviour of the leader of the Bundesbank has done little to allay their concerns. Whilst uniting with his ECB colleagues against the attacks of the populists, Jens Weidmann said a very curious thing. In his words: "People are not just savers". This has left many wondering if he thinks that they are slaves and/or fools.

Weidmann now finds himself in the new role of playing good cop to Wolfgang Schaeuble's bad cop as the latter jumps on the political bandwagon to partially lay the blame for populism at the ECB's door. Schaeuble was noted in the last report for trying to pressurize central banks into unwinding their unconventional easing. His call was echoed by Eurogroup head Jeroen Dijsselbloem. As we shall see later, based on what Ifo is digging up in the fiscal data, Schaeuble and Dijsselbloem may be premature from an economic perspective, even if they are correct from a political one.

The conversion of Weidmann, if this is what it is, seems to be strangely coincident with a signal from the ECB that it quite literally has the intentions and capabilities to do "whatever it takes". There was a school of thought in Germany, which assumed that any losses suffered by the ECB in the event of a sovereign debt crisis would force it to recapitalise. At this point, Germany with its fiscal surplus would be ideally placed to provide greater equity capital than its neighbours and hence achieve control of the ECB.

(Source: ECB)

A recent footnote, in an ECB research paper, effectively stopped this thesis in its tracks. The ECB technocrats are adamant that it cannot sustain any capital loss, because it can ultimately print the cash to meet its obligations. A close look at the fine print of Eurozone law shows that whilst the ECB cannot monetise national deficits, there is nothing that legally precludes it from printing its own way back to solvency.

In addition, Germany will not have the fiscal surplus it requires to recapitalise the ECB, since the money has been spent on immigration. It is clear that Weidmann's conversion is therefore a consequence of practical necessity, as much as any deeply held economic convictions.

Weidmann's views also seem to be shared by the wise men of the German Ifo think tank who have given their guarded endorsement to Draghi with the caveat that monetary policy is now reaching its limits of efficacy. Like Weidmann they favour continued loose monetary policy, but feel that the recent quantum shift into negative interest rates was excessive. They also rule out Helicopter Money.

Wolfgang Schaeuble's call on major central banks to roll back the monetary stimulus may therefore just be political grandstanding. The Merkel government needs some useful idiots to blame for its falling popularity and central bankers have been selected for the blame.

Schaeuble clearly understands the economic situation, because out of the other corner of his mouth, he rejected calls on Germany to increase its fiscal stimulus in support of global growth. He did not however explain that the reason for this rejection is because half of the money has been spent on immigration, as this would have deflected the spotlight back onto his government from the ECB. By denying a fiscal stimulus, Schaeuble by default implies that monetary stimulus is still the only game in town.

German economy minister Sigmar Gabriel is even more in denial than Schaeuble. Joining the spirit of German reconciliation with the ECB, Gabriel called for coordinated fiscal stimulus in the Eurozone rather than coordinated condemnation of Mario Draghi. How this will be done when the German surplus is halved and other Eurozone nations are breaching their deficit limits remains to be seen.

The position adopted by the Ifo may owe something to its recent analysis of Germany's deteriorating fiscal position and its root causes. The Ifo now predicts the fiscal surplus to be halved this year, as a consequence of immigration spending. This is a very inflammatory finding.

The Bundeslander have already demanded 12 billion Euros from Federal sources to mitigate their immigration costs this year. Bavaria and North Rhine Westphalia estimate that this will go up to 25 billion Euros this year. Merkel's government has opined that immigration spending will stimulate the economy and boost tax receipts. Although it is early days, there is little evidence of any net benefits from current immigration. Whilst being a political bombshell this is also a significant economic headwind.

Germany now finds that its much needed counter-cyclical stimulus buffer has been halved. Since Germany wishes to lead from the front, on fiscal responsibility, it will have to preserve its surplus to some degree. The onus of economic stimulus therefore swings strongly back onto monetary policy. Mario Draghi is thus back in favour, although he should not abuse his position by getting carried away with the monetary stimulus.

Wolfgang Schaeuble may therefore be barking up the wrong tree, when he calls for central banks to pull back the monetary stimulus. Based on this author's poor understanding, of the murky world of Eurozone politics, it is just possible that Schaeuble is seeking to deflect voter attention away from his government's profligate spending (with no multiplier effect) on immigration onto the ECB.

Jens Weidmann of all people has called his bluff! Schaeuble signaled that he has conceded in principle, despite his political grandstanding for the German electorate. According to leaked sources, at a private dinner with Draghi in Washington Schaeuble shook hands and made up. In fact it is alleged that he describes Draghi as his "friend".

Compared to the Bavarians, who want Germany to demand that the next ECB President be a German, Schaeuble is a "friend" of Draghi. Bavarians do not wish to have their currency's value destroyed by a process which they associate with that which led to the emergence of the Nazi party on their own turf. They now only trust a German to save them and their savings. Presumably they think that Jens Weidmann is the German who should lead the ECB next. Closer scrutiny of the behaviour of Schaeuble and Jens Weidmann may however cause them to revisit their xenophobic beliefs.

Schaeuble's friendly dinner with Draghi was emblematic of the ineffective communique from the G20 in Washington and its implications. Whilst warning that monetary policy is reaching its limits, the G20 offered nothing in the way on concrete policy decisions that would be implemented when the policy makers returned to their respective nations.

G20's insistence that nations cannot unilaterally devalue, precludes monetary shock and awe from central banks. The failure to replace this monetary stimulus with any fiscal proposals will therefore lead to a period of economic slowdown. The IMF's pre-meeting warning that the global economy is stalling, failed to elicit the desired response from the delegates.

The period of economic slowdown which now ensues will be enabled by a continued application of the current monetary stimulus from central banks. The slowdown will not be averted, but neither will it prompt the removal of the monetary stimulus. Economic stagnation will thus become ingrained and pervasive.

Weidmann's verbal departure from the shores of Freshwater School economic theory, clearly puts him on a destination to disembark on the shores of the Saltwater School of economic thought inhabited by the MIT alumni such as Stanley Fischer and Mario Draghi. Despite ruling out aggressive negative interest rates and Helicopter Money, he has shifted his position in their general direction. This radical change in course has been widely noted by Natixis economist Patrick Artus. In his opinion the ECB has signaled what he calls the Keynesian "euthanasia of the rentier". This observation has profound implications.

Weidmann implicitly accepts the process of debt monetization and wealth destruction through negative interest rates, if it serves the greater good of reducing per capita debt levels back to a baseline from which economic growth can occur.

Voters who also are taxpayers will resist picking up the tab for a new fiscal stimulus, when the money has already been spent on immigration. Furthermore there will be less money available to bail out German banks, or even to bailout other Eurozone nations, in the event of another debt crisis. Somebody has to pick up the tab. Savers must accept the cost of this transformation process, since they are members of the polity that will allegedly benefit in the long run according to Weidmann's fuzzy logic. Despite his impeccable Austrian School credentials, the politician in Weidmann appears to accept the insidious time-honoured process of monetary inflation.

As Keynes however noted "we are all dead in the long run"; so why should savers accept this miserable life?

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(Source: Bloomberg)

Artus also has a very dangerous observation to make, which confirms the fears of the Bank for International Settlements (BIS). He sees little evidence that the deleverage process has occurred thus far. On the contrary, he sees that the current QE and negative interest rate status quo has led to the growth and perpetuation of bad debt and leverage, which would ordinarily be impossible under normal conditions. The Eurozone has thus become a Zombie Nation. Observers of Spain and its recent travails do not need to look hard for the trace of Zombies.

Taking Weidmann's acceptance of Saltwater Economics at face value along with Artus' and the BIS's observations, the Eurozone is simply headed down a route of inflated and unrepresentative asset prices combined with mediocre economic performance. This is Stagflation but not as we have known it. Asset prices are where the inflation is to be found, whilst deflation and sub-par growth pervade the real economy.

Looking beyond this point, there must be a suspicion that this scenario is Euro currency negative, in terms of its value rather than its continued existence. The Eurozone therefore hopes to exist in Zombie status, through the stimulatory effect of a weak Euro. The application of moral hazard in the cases of Spain and Portugal cited previously, are classic examples of the manifestation of this strategy. Jens Weidmann's conversion to the dark side of monetarist economics, simply serves to drive the point home.

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This point has been deeply underlined by the current spat between the IMF and the Eurogroup over the next Greek bailout. The IMF states that Greece will be unable to maintain payments under the terms of the current plan. The Eurogroup on the other hand just brushes these concerns under the carpet as it kicks Greece's debt can further down the road. Greece remains an economic Zombie whilst the Eurozone's political integrity is maintained. Evidently, the IMF doesn't do Zombie though.

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(Source: Bloomberg)

Evidently the ECB does Zombie however. The news that the European Financial Stability Fund (EFSF) bailout bonds for Greek banks will be QE eligible, sent Greek bank stocks soaring.

Other G20 members will no doubt have something to say about the new weak Zombie Nation weak currency strategy from the Eurozone. The risk of trade tensions and protectionism has therefore been significantly increased. It may actually take the effects of trade wars to shake the Eurozone out of its Zombie policies, but by then it may be too late for the Eurozone economy and its asset prices.

ECB Governing Council Member Vitor Constancio provided some further direct support for this Zombie Euro weakening thesis, at the IMF meeting in Washington, when he took the unorthodox point of commenting on what policy the Fed needs. Negative interest rates are not applicable in the United States, according to Constancio, because it is in a "totally different Universe" from the Eurozone. The implied relative strength in the United States therefore justifies a stronger US Dollar versus the Euro.

It should be noted carefully that Constancio is trying to associate a weaker Euro with a relatively stronger US economy. This indirect approach to Euro weakness thus avoids the pitfalls that have befallen the Yen, which has strengthened versus the US Dollar despite the onset of negative Japanese interest rates. The weakening US Dollar based on a reappraisal of the Fed's cautious approach to hiking is clearly becoming a cause of frustration at the ECB.

(Source: Bloomberg)

ECB sources confirmed this frustration, but also their stoic acceptance of the situation based on the G20's firm guidelines against unilateral currency devaluations. Said situation is a US economy that could be on the cusp of recession. Reckless tightening by the FOMC could trigger the next credit crunch. Based on the scale of things, the ECB and the BOJ have rationally accepted that they must be patient because the alternative is too frightening. The BOJ has been prevented from weakening the Yen, so the ECB cannot expect any overt concessions from G20.

The last report began to look into the new Italian bank private sector rescue vehicle named Atlante. The initial view was that it is too small to be effective in dealing with Italian's giant non-performing loan problem. Further investigation of the non-performing loan issue reveals that the majority of them have been created by nepotism and cronyism.

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(Source: Bloomberg)

Back in the 1990's the Italian government made eighty eight charitable foundations the stewards of its regional banks. Ostensibly this was done to stimulate the regional economies. In practice it led to the process of "Sofferenze" (loans made to insolvent borrowers), by which credit was extended for political and sometimes criminal objectives rather than for economic stimulus. This Italian banking model dates back to the Medicis so the tradition has continued to this day. Putting a charity in charge of a bank looks dubious at the outset; however, this was overwhelmed by the pecuniary power of cronyism and nepotism.

Italian banking has thus had the systemic risk of "Sofferenze" baked into it since the 1990's. Traditionally the Italian Lira took the strain of credit crises associated with the "Sofferenze". Upon joining the Eurozone, the potential to devalue and print the currency to finance these debts was gone. The delivery of low interest rates, courtesy of anchoring the Italian economy to Germany's, through the single currency has simply compounded the problem. "Sofferenze" loans have been made at low rates of interest, which bear absolutely no risk adjusted relationship to the counterparty.

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(Source: Bloomberg)

To clear up the problem, Prime Minister Renzi is pressing the Eurozone to allow the ECB to monetize the "Sofferenze". He must however pacify Brussels and the ECB that the practice of "Sofferenze" will end. In order to end the practice, he is trying to consolidate the Italian banking system into the larger banks who will swallow the smaller ones and their "Sofferenze's". The consolidated banks will then operate along conventional banking models that are acceptable in global banking regulatory circles.

The construction of Atlante is also charitable in nature. The large banks that will be the consolidators have been obliged to subscribe more than the consolidated. Since Atlante is so much smaller than the total non-performing loan mountain, Renzi is thus heavily reliant on the ECB's monetization of Italian covered bonds issued by the consolidating banks. Debt mutualization across the Eurozone, through fiscal union, would also cut the risk and the bill falling on Italian taxpayers to underwrite Atlante in the event that it is proven to be too small.

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It all sounds like a plan, but this plan could be viewed as yet another case of Eurozone moral hazard that has been institutionalized by the EU and the ECB. To underline the institutionalisation of the moral hazard, Bank of Italy Governor Ignazio Visco opined that the banking crisis has "turned the corner" now that growth is returning to the economy.

His comments seemed very conspicuously timed to coincide with the launch of Atlante. To be successful, Renzi will have to cede financial and political control of his banking system to Brussels. This is the only way that the Northern Europeans would consider underwriting Renzi's plan. At this point however the voice of Italian populists, who have lived a good life through the process of "Sofferenze" may intervene.

Renzi has the same kind of bargaining chip as the Greeks. The EU can either support him, or get paid back in worthless Lira and see the Eurozone break up. By supporting him, the weak currency behaviour in Italy is transmuted into the Euro.

Valdis Dombrovskis Vice President, European Commission, Euro & Social Dialogue was on hand to provide an update of where the EU fiscal integration project is. According to his timeline: "Right now the Dutch Presidency is intensively working on those proposals. It concerns completing the Banking Union including the creation of a European Deposit Insurance Scheme….. It concerns a Commission proposal of setting up a European Fiscal Board - where the work is already ongoing and also a legislative proposal on the external representation of the Euro Area in the IMF is also filed by the Commission…… last December the European Council tasked the finance ministers to work intensively on this and to report back to the Council by June this year and If needed are ready to modify our proposals in order to achieve consensus on those issues".

Dombrovskis not only provided a project timeline and critical pathways, but also confirmed that banking union requires fiscal union (the Fiscal Board) in order to underwrite it with Eurozone taxpayers' money. Clearly the unelected Eurozone policy makers have accelerated their move to fiscal union, even as the populist forces seek to prevent this through the national democratic process.

(Source: Bloomberg)

To confirm that the EU is working on a combined grand solution to the banking and fiscal union projects, Portugal hinted that it may too apply the Atlante model to resolve its own banking crisis. The problem for Portugal is that one of its main consolidator banks, which should contribute the most to the Atlante model, has itself received bailout support from the government. As Valdis Dombrovksis also recently noted, Portugal itself faces breaching Eurozone deficit limits itself this year; so a further state bank bailout is not on the cards either. Evidently one size of private sector bailout model does not fit all in the Eurozone. This will no doubt inspire the push for an accelerated fiscal union, which will provide the safety net for all future banking resolution models.

The Portuguese then followed the normal moral hazard protocol for deficit breaching nations, outlined by Spain earlier in this report. Working back from where they need to be to hit the deficit target, which they have no intention of doing, the Portuguese bean counters filled in the blanks in this year's budget to come up with reduced spending that hits the mark.

This academic spreadsheet exercise will then meet the academic process of review by the EU, which will then academically approve the new budget. It doesn't matter to anybody that the target won't get hit, or indeed that reduced spending will beget even lower economic growth and hence less tax receipts. The boxes have been ticked; and most importantly Portugal's membership of the Eurozone has been academically ratified.

Unequivocal confirmation that banking union is next on the agenda came in the form of the meeting of Eurozone finance ministers to discuss this very outcome. As usual, there is a French trap for the Germans. The French wish to do more than just discuss where the current timeline stands. They wish to put in place concrete procedures and protocols, which will put a centralized bank debt guarantee in place. They thus wish to underwrite banking union with a fiscal measure that will enable fiscal union further down the road. This killing of two birds with one stone, is not what the Germans have in mind however.

By some strange coincidence, the mechanism that the French wish to enable their plan with has a striking resemblance to Atlante. The French wish to use the Single Resolution Mechanism (SRM), set up in 2013, as the vehicle to enable banking and fiscal union by giving the power to access each member nation's fiscal base.

As with Atlante, the SRM's financial base of 55 million Euros is egregiously small compared to the volume of bad bank debt. This small scale virtually guarantees the need for a taxpayer guaranteed backstop. Not only is the same bailout model being used at national and Eurozone level, but the same deliberate underfunding strategy is also being applied. The central planners evidently wish the failure of the model to force the nations standing behind the Eurozone to yield their taxpayers' funds to the project.

Bavarians and most Germans will be pleased to know that the creep towards Zombie Nation status, being enabled by Merkel, Schaeuble and Weidmann is meeting some stiff German resistance. Bundesbank member Andreas Dombret has not lost the faith in the Freshwater School of economics and sound money, although he has become increasingly isolated. He recently carefully chose his words, to signal to his opponents that he is onto their game. In his opinion: "There are still many zombie banks that are kept alive for political reasons". Given what is happening in Italy, his remarks were apposite.

Dombret's solution then called on the very institutions that are supposed to prevent the mutualization of the moral hazard that has been enabled. He stated that: "The Single Supervisory Mechanism and the Single Resolution Mechanism have to assert their power to use the new bail-in regime in order to restructure a stressed credit institution or ultimately wind down virtually insolvent banks" and then called upon the ECB to use its "early intervention" powers on banks that are at risk of failing. Clearly Dombret has not been got to, in the same way that his boss Jens Weidmann has. To give Weidmann the benefit of the doubt, maybe he is angling for the ECB presidency and is just trying to look a little more politically acceptable to the central planners!

(Source: Bloomberg)

Based on the diminishing scope for fiscal stimulus and the creep towards the Zombie Nation strategy, consensus now expects Mario Draghi to put an expansion of monetary policy back on the agenda after the summer recess.

He prepared the groundwork for this at his latest press conference. Taking some comfort from the German policy makers who have lately shown support for him and the ECB's independence, he was emboldened to stand up to the German rentiers and populists.

Trying not to sound too condescending (and failing miserably in the process), like a schoolmaster addressing children with learning difficulties, "In fact real rates today are higher than they were about 20-30 years ago," Draghi said. "But I'm aware that to explain real interest rates to savers may be difficult." He is aware, but he doesn't care.

The verdict of Mr Market was given by the gold price. Having been on a rising trajectory based on the view that the US Dollar will continue to weaken, as the Fed backstrokes on the four rate hikes in 2016 story, Draghi stopped the gold rally dead in its tracks. If gold now starts to rally in Euro terms, rather than in just Dollar terms, he (Draghi) will be a happy man.

Disclosure: I/we 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.