Like Ronald Reagan's famous question, "are you better off today than you were four years ago?" a similar question has to be asked at the authorities in Brussels, Frankfurt, and most of all, Berlin. After nearly three years, is the Euro crisis actually closer to any 'solution?'
We're afraid the answer is a rather resounding no.
The Euro crisis is a rather complex, multifaceted whole, so it is useful to analytically disentangle things. It turns out there are four crises:
- A banking crisis, caused by the weakening of bank balance sheets as a result of the financial crisis.
- A sovereign debt crisis.
- A growth crisis, where there is insufficient growth
- A competitiveness crisis, where Southern members have lost competitiveness without the ability to restore this by devaluing their currency.
The horrible thing is that this is only an analytical separation, in real life, these crisis are hopelessly interlinked, creating all sorts of potential vicious cycles that can inexorably spin out of control. For example (for more details see here):
- To save banks, higher capital ratios were imposed which led to a credit crunch, worsening the economic crisis.
- A worsening economic crisis has a large negative effect on the sovereign debt crisis as it reduces GDP and tax receipts.
- Austerity to deal with the sovereign debt crisis worsens the economic crisis.
- The deflation (or 'internal devaluation,' as it is called) to restore competitiveness in the South worsens the debt crisis (sovereign and private debt).
In order to deal with these complex and potentially very dangerous and self-reinforcing dynamics, authorities have, so far, used a number of policy tools (we really hesitate to call them 'solutions'):
- Bailout packages for those with such explosive sovereign debt dynamics that they were unable to go to the markets
- ECB money
- The rescue funds, the EFSF and soon the ESM
Let's see, those bailout packages were supposed to tie over the countries for a while until they got their 'house in order' and could go back to the markets. That hasn't worked out too well so far. Greece is already on its second bailout, and it doesn't look like Portugal or Ireland can go back to the markets anytime soon.
All of these countries are in significantly worse shape than they were even a few years ago, and it remains to be seen whether populations in the center will keep on funding them with loans (which are rather susceptible to write-downs).
Then we have the ECB. We have clamored for some time for them to shoot into action, and they've finally done so through bond buying and the cheap (1%) three year loans to banks (LTRO). The good thing is, without these, the Euro would already have imploded (or exploded, depending on your vantage point). It also keeps alive some banks, but it isn't so clear cut whether this is a good thing.
Good is probably also that this is less free money than meets the eye. The ECB only intervened when the alternative was too terrible to contemplate and not before extracting firm commitments from countries to reform and austerity (even if we think the mix of that has been somewhat wrong, too much austerity, too little reform).
The bad is that this concentrates the risks on the balance sheets of the weakest banks (those in the periphery). LTRO isn't your average bond buying program, as the sovereigns aren't put on the balance sheet of the ECB. Instead, banks to the ECB's bidding, especially those in the periphery.
This works magic as long as things go well. It was meant as a confidence boost that would reduce sovereign yields, which the bank buying would reduce further, and the resulting profits and spread between the 1% LTRO funding cost and the sovereign yield would constitute nice profits for the weak banks, strengthening their balance sheets.
So banks in Italy, Spain, and Portugal have been heavy buyers of LTRO funded sovereign debt, but now that rates are going up, the neat above logic is working in reverse and they're sitting on losses.
If they need to liquidate these (for instance, because they have to roll over their own debt, some 600B Euro in Euro zone bank debt matures this year), they will have to realize these losses if nothing happens in between. Selling these bonds put further pressure on sovereign yields, reinforcing the feedback loop.
Banks are not save even if the ECB should start to purchase sovereign debt again, as increased official holdings of sovereign debt (ECB, IMF) invariably escapes any 'haircut' should that debt be restructured, leaving a larger burden on bank (and other investor) holdings.
And, of course, the more the banks get into trouble, the more the risk is that the sovereigns have to bail them out, reinforcing the vicious cycle between banks and sovereigns in the Euro zone periphery.
These mechanisms are known by the market, which is why banks, especially from the periphery, have such a hard time getting funded themselves, and why depositors and investors are fleeing them (made easy thanks to the Euro, depositors and investors alike can go elsewhere without incurring any exchange rate risk).
The temporary EFSF and the permanent ESM is where the bailout money comes from (guaranteed by member states). This has to be big enough (preferably erring on the side of safety) to impress the markets that there is enough to fund Italy and Spain for years.
To give you an idea, the German Berenberg bank calculated that 1700B Euro(!) would do the trick.
There is about 240B left in the EFSF, but these are guarantees, not actual money. The EFSF would have to sell bonds on the markets to fund that. Add to that the 500B Euro from the ESM (Germany has finally agreed that the two funds exist in parallel) and you're getting at 740B Euro. Keep in mind that it will take 3 years before the ESM is in full force, as it depends on yearly cash calls from member states.
Emerging economies, via the IMF, might add a couple of hundred billion. But still. Italy's debt alone is over 2 trillion Euro, even if they will be able to finance most of it.
Why is a solution so evasive?
Now, the question is, has this bag of tricks made the situation better? We think there isn't much reason to argue that case. Time has been bought, in the hope that things would improve. Few things have. To be fair, buying time wasn't the only reason behind these policies.
The root cause of the Euro crisis has been misdiagnosed, blaming it on spendthrift governments, only really true in the case of Greece, and to some extent Portugal, while countries like Spain and Ireland actually had budget surpluses and low public debts on the eve of the crisis. As a result, more definite solutions have not been activated, all in order to keep the pressure on these 'spendthrift' governments to embark on austerity and reform their economies.
The misdiagnosis is somewhat understandable though. Within the Euro zone, investors can move capital and bank deposits freely at no currency risks. The Greek haircut opened them up to the possibility that sovereign debt might not have a currency risk, it does have a default risk. What ensued was the following (see figure below):
Hence investors started to flee the periphery, leaving banks without funding and losing deposits, and public debt with yields spiraling out of control, all of this leading to a loss of confidence which only reinforced the capital flight.
Of course, those blaming the crisis on spendthrift governments could then point to the rising yields and argue that investors lost confidence in the public finances of these countries.
However, any glance at the state of public finances of non Euro zone members quickly revealed that this wasn't the reason that the yields in the Euro zone periphery shot up. Public finances in the UK, US, and Japan were often as bad, if not worse compared to the likes of Spain and Italy, but their yields stayed at record lows. A remarkable, and often overlooked contrast:
While misdiagnosis hasn't helped, valuable time was lost to treat the real problem, the lost competitiveness of the South. On top of that, they have to embark on severe austerity without any offsetting devaluation or monetary stimulus.
Indeed, exactly because capital can move freely without incurring exchange rate risk, the capital inflows that caused the competitiveness loss has now reversed, creating credit and monetary contractions that only compound the problems.
Light at the end of the tunnel?
That the present route hasn't brought a solution any closer doesn't necessarily mean it never will though. However, whether the Euro zone can, on the present course, save the ship which has clearly hit an iceberg really remains to be seen. It depends on numerous factors, like:
- Will economic growth return? This isn't likely with the amount of austerity and weak world demand. The risks to the downside seem way bigger.
- Can countries at least achieve a primary budget surplus? The good news is that the country which really matters most, Italy, is very close to achieving this. But Italy, with its debt of 120% of GDP is also the country with no margins for error. Greece is actually also not far off, for Spain things are a bit more problematic though.
- Hysteresis: economies running way below potential output are destroying productive capacity itself. Some percentage of unused labor and plant will become obsolete every year, reducing the present and future tax base
- Structural reform is only going to pay-off after some time
- The North-South competitiveness gap isn't likely to be closed anytime soon, even if we applauded the German pay hikes (and we're in some good company, as it turns out. Ireland is the only relative success story here, but with large wage cuts in Portugal and Greece, things are slowly improving here.
Absolutely crucial in our views is support from the ECB. They cannot afford to sit on their hands. The most credible reason they had to do so for so long (which only made matters much worse) was the fact that countries were too reluctant to embark on austerity and reform. This is no longer the case.
They should really embark on a much more massive and credible QE policy. The more credible the announcement of such policy, the less they actually have to intervene in the markets.
So much of the Euro zone is deeply depressed that inflation isn't a risk, and even if it pops up a little in those parts that are still growing, this actually helps adjusting the competitiveness gap.
It is either that, or one should start thinking out of the box for more radical solutions.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.