Markets have been bubbling up. Mario Draghi (the ECB president) seems to have tamed the eurocrisis, at least for now. He argued that the ECB will do "what it takes" to save the euro (and believe him, "it will be enough"). The markets, after some hesitation, seem to believe him. European shares have rallied, Italian and Spanish bonds have rallied. US shares have rallied in sympathy.
We also believe Draghi. We've argued for a long time that the only area where large scale bond purchases can make a substantial difference to the real economy is in the eurozone. The reason for that is that the eurozone is particularly vulnerable to self-fulfilling prophesies.
If investors and bank depositors doubt that Spain will remain solvent or stay in the eurozone, they can move their investments and bank deposits out to Germany or Luxemburg without incurring any currency risk. Such doubts are also easier to develop in Spain as the Spanish central bank cannot devalue, change interest rates, or function as the lender of last resort, unlike the central banks of countries that issue their own currency.
These doubts then feed on themselves as bank deposits and capital flies Spain (or Greece, Ireland, Italy, Portugal, etc.), while most of these countries are not inherently more insolvable than the UK or the US. If the ECB finally stands up as the lender of last resort of some form, that could allay enough of these doubts for enough capital and bank deposits to stay within the periphery, and lower rates on bonds.
That's the plan, but the ECB wants something in return. It wants the likes of Spain and Italy to come under some form of surveillance, because the ECB fears that if they will do all the hard lifting, the pressure is off the politicians to reform their economies. For Spain, this seems to imply they have to sign up for an official bailout at the European rescue funds, the (temporary) EFSF and (permanent) ESM.
Here we have the first big risk. Spain might not be willing to play game here, as it means a loss of sovereignty and a loss of face. They can't be forced into a bailout politically, but they could very well be forced economically. Remember how the ECB was instrumental in the replacement of Berlusconi last fall?
By withholding support for Spanish bonds the ECB holds great leverage over the Spanish politicians. But the rules of that game, so successfully applied to Italy last year, might very well have been changed. Draghi himself was forced into the statements about "doing whatever it takes to save the euro" by the spiraling out of control of Spanish (and Italian) yields.
The whole euro seemed about to implode at that time, with only the ECB with enough of a balance sheet, credibility and decisiveness to counter the imminent threat. There is one thing that should not be overlooked. The cost of countries leaving the eurozone is ever increasing. Here is Nouriel Roubini:
The adjustment process will take many years, and, until policy credibility is fully restored, capital flight will continue, requiring massive amounts of official finance.
That official finance is coming from the ECB, EFSF/ESM, the IMF, but increasingly from the Target 2 settling system. These sums keep increasing. Should countries leave the eurozone, much of that will not be repaid, as a main reason for countries to leave the eurozone is having build up unsustainable debt levels.
If they can't pay these back whilst inside the eurozone, they're even much less likely to pay these back outside it, as the debt (in euros) will have increased because of a currency devaluation. The simple fact that the eurozone is throwing ever more money to keep countries afloat within it increases the cost should anyone leave, and provides the recipient of the funds considerable leverage in negotiations. Here is Roubini again:
If a gradual process of disintegration eventually makes a eurozone breakup unavoidable, the path chosen by Germany and the ECB - large-scale financing for the eurozone periphery - would destroy the core central banks' balance sheets. Worse still, massive losses resulting from the materialization of credit risk might jeopardize core eurozone economies' debt sustainability, placing the survival of the European Union itself in question.
Well, he's not called Dr. Doom for nothing. So basically it is a race between 'adjustment' and the ever increasing financing. By adjustment we mean the restoration of competitiveness and debt sustainability in the periphery. The center will keep on financing as long as the periphery keeps on adjusting. How is that adjustment going? Well..
The 'finance and adjust' strategy for Greece hasn't been particularly successful. The country is entering its fifth year of recession, which by now can only be called a deep economic depression, on a scale of what happened in the 1930s. The problem is, that whatever progress the Greeks seem to make, much of it disappears because the economy keeps sinking.
It's not that they haven't tried:
Greece cut its total primary budget deficit by 8.2 percentage points of gross domestic product over two years (2010 and 2011)... Labour market liberalisation and steep wage cuts are delivering the "internal devaluation" required. If labour costs are included, Greece's effective exchange rate is at its most competitive for more than a decade. [FT]
But the economy keeps on sinking, by 7% last year, and another 7% crash is expected this year, making a mockery of IMF projections on which Greece is held to account. Here are the IMF targets and the outcomes:
Basically, they have to keep running just to remain in the same place, and sprinting to make any progress. After five years of cuts and tax hikes, the budget deficit will still be a whopping 7.5% of GDP (9.3% last year) and the debt/GDP situation hasn't stabilized despite the large haircut for private investors in Greek bonds.
And in the midst of an economic depression of rather epic proportions, the Greek government is forced (in the name of adjustment) to push ahead with another 11.5B euro austerity package including more wage and benefit cuts and firing 40,000 civil servants.
There is so much that can go wrong, from FT Alphaville:
- The coalition government could fail to agree on the new austerity package.
- The Greek Parliament could fail to approve the proposed austerity package.
- Implementation problems could continue after Parliament approval.
- Social unrest could get out of control.
- And some Eurozone members could oppose further commitment to increase funding for Greece.
So the will to keep on adjusting can't be guaranteed, to put it mildly, but then there is the will to keep on financing. From the Bundesbank to Finland and the Netherlands, the will to keep at this is steadily decreasing. Can we be certain of that? So betting on a rosy outcome.. well, as long as these bets are hedged. Properly hedged.
Then, of course, there is Spain. Basking for the moment in the glory of those Draghi words, which had quite an effect in placating Spanish yields, which were rapidly approaching the point of no return.
However, not all is well, to put it mildly. Take the Spanish housing market, the source of most of the problems.
With the economy and banks in deep slump, house prices are likely to head lower, possibly much lower.
It certainly doesn't help that Spaniards hold 80% of their assets in real estate. And for Spain's housing index to come in line with U.S. growth since 2001, it would have to drop 47% more. [Motley Fool]
What such a 47% drop would do to the balance sheets of Spanish banks we'll leave to your imagination. Here is the situation right now for the mortgages that back bonds managed by banks:
The cumulative delinquency rate for all mortgages backing the bonds is now higher than 15%. For a scary comparison, the delinquency rate in the U.S. peaked at 10.1% in 2010. [Motley Fool]
Spanish banks are already battered from all directions:
Deposits at the Spanish banks dropped by a record amount in July, -$93 billion which is a decline of -4.7% in just one month. On a year-over-year basis the decline in deposits is 12.0% but the trend in loss of deposits is escalating rapidly. [ZeroHedge]
And then we have Italy, were Mario Monti will leave. While he has done much to inject necessary reforms and market dynamism in the sclerotic Italian economy, will it be enough? Will his successor, possibly the same Berlusconi that Monti replaced, undo much of his hard work? Once again, we can't be sure, nobody can, we feel.
It's possible that Draghi will pull it off, but the road is long and littered with banana peels and the markets have quite a bit of his success already priced in..