Postcards From The Periphery

by: Shareholders Unite

While many seem to think that the euro crisis has been put on the back burner, if not solved, the news out of the eurozone periphery is nothing short of terrible. With the ECB unlimited bond buying announcement, the vicious cycle between bond yields and public finances might have been broken (at least for now), but there are plenty of other vicious cycles still operative.

The most visible and vicious is the cycle between austerity, economic growth, and public finances, and this one is running rampant all over the place.

Let's start with reform poster boy Italy:

Italy slashed its economic growth forecasts on Thursday saying it was now expecting contractions of 2.4pc for 2012 and 0.2pc for 2013 due to "a deterioration in the international environment". The government had previously forecast a shrinkage of 1.2pc in 2012.

Now is as good a time as any to remind people that public debt/GDP ratio consists of a numerator and a denominator. If the latter (GDP) shrinks, the ratio moves up, apart from a shrinking GDP having a devastating effect on tax receipts, and hence the deficit. No surprise then, that:

Italy will miss its budget deficit targets in 2012 and 2013 and its public debt will rise in both years despite the government's austerity measures, the International Monetary Fund forecast on Tuesday. The IMF said in its Fiscal Monitor report that Italy's deficit would fall this year to 2.4 percent of output, well above Rome's 1.6 percent target, and would decline to 1.5 percent in 2013, when Italy is aiming to balance its budget.

These are relatively mild deficit figures, and it should be kept in mind that Italy already has the largest primary surplus (deficit minus financing cost) in the euro area of 3%, expected to rise to 4% next year. However, public debt stands at more than 123% of GDP and is rising. Also:

The so-called tax burden - fiscal revenues as a proportion of GDP - will jump to 48.3 percent this year and rise to 49.0 percent in 2013 as a result of Monti's austerity plan, the IMF said.

Well, that's what happens when the economy contracts and most (three quarters) of the austerity measures come in the form of tax hikes - 24 billion euros alone for this year. Mario Monti, the technocrat premier, has done as much as could reasonably be expected in terms of reforms and budget measures. Monti made a promising start with the pension system and:

The liberalization reforms that were introduced in 2012 are wide-ranging, and address the energy and transportation sectors, professional services, local public services, but also, importantly, the framework for enforcing competition rules in Italy.

And there is still an enormous amount of low hanging fruit in Italy:

Italy is essentially a service-oriented economy; services represent over 70 percent of GDP. Estimates suggest that prices of services (nontradables) in Italy could be about 60 percent higher than in case of a perfect competition in the markets; this markup is estimated at about 35 percent elsewhere in the euro area.

However, the speed of reform seems to have hit a bump. Labor market reform proposals were watered down significantly in parliament and are widely seen as inadequate. With Monti gone in just six months and great uncertainty about the commitment of the next government to reform, it's hard to get optimistic about Italy. Here is Daniel Gros from the Centre for European Policy Studies:

Gros said Italy's growth potential had fallen because of years of corruption, weak application of laws and declining administrative efficiency at all levels. "Turning things around would take years of dedicated attention from a number of governments, supported at the local level and by popular consensus," he said. "I don't see that in Italy at present."

The reform effort in Italy falls well short of what is needed:

The public administration is unreformed, there have been no privatisations, no liberalisation of local public services and no changes to collective wage bargaining.

If a technocrat emergency government led by a still relatively popular PM can't do it, it's unlikely to get done when Monti is gone. What's more, laws and regulations can be adopted and enacted, but according to Gros:

In Italy the biggest problem is not so much the laws as their implementation

That reminds us of...

Well, fresh from the press, leaks from the Troika (ECB, EU, IMF) mission to Greece:

The Troika mission has announced that Greece faces a budget shortfall of around 20 billion euros compared to previous conditions agreed if the country is to be thrown another 'life-line' of emergency aid. The big miss doubles previous estimates, German magazine Der Spiegel reported Sunday.

Is that surprising? Greece is merely the most advanced nation in the vicious spiral of austerity, negative growth, falling tax receipts and having to double down on austerity. And, fasten your seatbelts:

Greece will suffer a much deeper than expected recession in the next few years, the country's finance minister said on Tuesday as negotiations with international creditors continued on a new package of austerity measures.

There is simply no end in sight, even after five years of depression. By now, it should be clear to even the economically illiterate what a powerful mechanism of wealth destruction the euro can be. While Greece shares much of the blame for their own predicament, the euro itself is a prime cause.

Joining the euro removed the exchange rate risk for Greece (and the rest of the periphery), setting off a capital inflow that wreaked havoc, producing an inflation differential with the core that accumulated over time into a large competitiveness loss, reinforced by one-size-fits-nobody monetary conditions by the ECB that were way too lose for the periphery.

Now the capital flows in the other direction, out of the periphery, and the rest of the eurozone has chosen to finance it through a myriad of instruments (Target 2, ESM, EFSF, etc.) afraid of the sudden abyss of a country leaving the euro. But over time, the financing option has simply made it too expensive to let country to actually leave.

And experiences of Iceland and Argentina show that leaving might very well have been the better option. This insight is filtering through into the public consciousness of the next peripheral country in need, where there is now a majority against the euro in some polls..

In Spain, well:

Spanish banks may need a cash injection of more than €100bn (£80bn), the results of an official stress test are expected to show this week, placing more financial pressure on to an already explosive political crisis in Madrid.... The stress test is expected to show a dramatic deterioration since the previous tests were carried out at the beginning of the summer which suggested a €60bn cash injection would be the worst-case scenario.

And this after no less a person than IMF chief Christine Lagarde reaffirmed that Spain just needs €40B for its banks just two days ago. We'll have to see how this plays out on Friday, when the results of the stress tests are due, but the omens are particularly bad.

The Spanish fiscal situation isn't going well either:

At the end of the first half, the deficit stood at 39.8 billion euros (31.7 billion pounds), around 4 percent of gross domestic product, compared with the year-end target of 6.3 percent of GDP.

And Spain is coming apart at the seams; Cataluña is considering secession after a million and a half people demonstrated in favor of this. In case you're not familiar with this, Cataluña is the richest region in Spain and has its own language. Secession might not be in the cards, but the region wants an independent treasury, giving it control over its own tax base.

With unemployment at 25% and rising, youth unemployment above 50%(!), imploding bank balances and house prices far from having reach bottom, additional trouble between the center and the regions is the last thing Spain needs. The regions are, like the states in the US, quite important for daily needs of citizens, like education and healthcare. Their dire financial state is having real effects:

The government of Valencia - which runs the health system - owes a grand total of half a billion euros to the region's pharmacies.

With pharmacies running on empty, the crisis in Spain is taking on Greek proportions.

Portugal received a bailout of 78 billion euro in May 2011 and is supposed to stand on its own feet next year. However:

Tax revenues have fallen, the recession is expected to reach 3% of GDP this year and unemployment is forecast to increase from 15.4% this year to 15.8% in 2013.... the level of public debt is set to climb to 114.4% of GDP in 2012 and 2013 or peak at 118.6% of GDP before starting to decline in 2014.

Little surprise what 3% economic contraction does to the budget deficit, despite all the austerity:

The goal of 5.9% of GDP in 2011 was reached. For 2012 it was set at 4.5%, but in the first quarter was already sitting at 7.9% of GDP, making the intended 3% goal in 2013 look increasingly precarious.

Eager to avoid having another 'Greece,' the troika (IMF, ECB, EU) dispensing the bailout targets have been 'revised':

In its fifth quarterly review the so-called troika of international lenders - European Commission, European Central Bank and International Monetary Fund - gave the country the widely claimed extra-time to reach its deficit goals. The new targets say Portugal will have to reach a budget deficit of 5% of gross domestic product in 2012, instead of the previous 4.5%. For the following year the goal was revised to 4.5%, against the initial 3%, and for 2014 the new goal was set at 2.5% from the previous 2.3%.

The sliver of good news is that Portugal achieved a trade surplus, but with the economy in a deep funk depressing demand for imports, this might not last when demand finally recovers. More ominously, after a period of relative quiet, the population is starting to revolt.

One doesn't have to be inside the eurozone for some of the same dynamics to happen. Two years ago, the Cameron government in the UK embarked on austerity to get public finances in order. The results:

In the U.K., the government posted its biggest August budget deficit on record, heaping pressure on Chancellor of the exchequer George Osborne as the recession hits tax revenue and pushes up spending on welfare.

Euro and world economy
What's not helping either is that the ECB announcement to unlimited bond buying has removed a good deal of tail risk from the eurozone from an investor perspective. That has led to a 10 cents rally in the euro. The combined effect of this rally and a slowing world economy is yet another deflationary impact on the eurozone periphery.

Leaving the euro has become ever more expensive
Leaving the euro has become a disaster for those remaining, and not only for the country that wants to leave (insofar as these are not already living a disaster). Here is why:

In essence, capital moved into the periphery in the first decade after the creation of the euro, creating booms of various proportions that turned out to be rather ephemeral. The lasting effect was a loss of competitiveness relative to the eurozone center.

Now capital is moving out even faster than it came. The crucial insight from Paul de Grauwe is that when investor sells bonds issued by a eurozone member country, he gets euros. He doesn't have to reinvest these euros in the same country (in fact, that's quite unlikely). This is a crucial difference with the situation of a country issuing its own currency.

A bond sale there will get the seller the country's currency. If he doesn't want to reinvest in the country he has to sell that currency in the forex markets. The currency will fall (helping the country's economy) until investors buy it that do want to invest in the country. That is, the money can never leave the country.

A crucial difference indeed because more or less by default, the rest of the eurozone has chosen to finance these capital outflows through a myriad of instruments (bailouts, EFSF, ESM, ECB, etc.) or mechanisms already in place (Target 2). Let's take stock of what the German austerity/finance 'solution' has brought:

  • Unprecedented economic slumps in the periphery
  • Continued rise in public debt/GDP ratio
  • Modest structural reforms and improvements in competitiveness in the periphery.
  • Financing the peripheral capital flight led to the accumulation of large liabilities of the periphery to the center

Peripheral leverage
The 'solution' was incremental and buying time. It's difficult to pinpoint the moment when quantity became quality, when the cumulative sums of finance already provided were so large as to make it inconceivably expensive for the remaining countries to deal with a country leaving the eurozone.

This has given the periphery some leverage - witness the turnaround in ECB policy. It isn't so difficult to see where this is heading:

  • If the austerity-growth vicious cycle continues (and there are few signs to doubt that), much of the rest of the periphery will start to resemble Greece. In fact, Spain is subject to other vicious cycles running from housing to bank balances and public finances, for instance.
  • We can expect further bailouts and restructuring of public debt
  • The wildcard in the situation is what will happen to France. It's situation is more dangerous than that of Italy as the latter isn't far off from achieving budget balance.

Here is what's already happening

The latter especially is put in place to be able to deal with bailouts of larger countries. In this form of debt mutualization, the eurozone is rather unique. In the US, UK, and Japan, we believe that central banks will buy up much of the public debt, and will simply perpetuate it on their books. Contrary to the alarm in certain corners, this won't be inflationary.

The private sector is too depressed, and world savings are too high for this to happen.

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.