Eurozone policies are heading for disaster - and quickly. There will need to be a radical change within the next few weeks to prevent economic and social chaos. The Greek drama continues to highlight the futility of current policies as the political drag from continuing to pursue failed policies becomes even harder to overcome. The law of diminishing returns is clearly in evidence as the political and economic cost is continuing to mount while any economic benefit is proving elusive. The euro, in turn, is increasingly being propped up by forced capital repatriation flows from weaker banks and it is increasingly the case that the cost of keeping the euro area intact is becoming higher than the cost of breaking up. A split into two or a smaller core euro area is increasingly the only viable option and it is also an option which forces caution over aggressive euro selling.
Greek political developments will be watched very closely during the week as tortuous coalition negotiations take place. Whatever the outcome, uncertainty will remain extremely high with little political mandate. The focus will also need to be on the eurozone heartlands, especially Germany. The point at which Germany calls time on the 17-member euro area must be drawing ever closer.
Amid the temporary sense of euphoria following the EU agreement, it should be noted that dollar Libor rates did not decline and there was a further creep higher over the past few days. Overnight deposits at the ECB rose to near EUR280bn at the end of last week, the highest since June 2010. There was at least some small element of positive news as the Euribor-OIS spread narrowed from 30-month highs following the ECB rate cut.
If confidence continues to erode, there will be a further flow of funds out of peripheral economies. What incentive can there be for holding deposits within Italy? At best, the return will be no better than if the funds were parked in Germany and at worst, there will be a huge capital loss if Italy is forced out of the eurozone.
Some of the bleakest market headlines last week related to the peripheral economies of the eurozone. Greece’s plight has been clear for months if not years as the economy slides further into recession. The Italian PMI manufacturing index fell to 43.3 from previously while the services index weakened to 43.1, which was the lowest figure for over two years.
Spanish unemployment rate rose to 21.5% from 20.9% the previous quarter, the highest level since 1996, with a total figure at a record high of close to 5 million Youth unemployment dipped marginally, but was still at a staggering rate of over 45%. It will be increasingly untenable for the current policies to be sustained. Democracy in many of the eurozone countries is fragile and eurozone policies are increasingly playing with fire. If Germany continues to insist on austerity and increased budget monitoring, then the political backlash threatens to be extremely high. If peripheral economies are forced to maintain deflationary policies, the risk of economic and political chaos will rise rapidly.
At this stage, there is no real evidence that the German government is prepared to stray from the path of orthodoxy. The ECB did cut interest rates by 0.25% to 1.25%, but this simply reversed the ludicrous increase sanctioned in July and the comments from Draghi suggest that the bank will not increase its buying of peripheral bonds without German backing.
The German determination to avoid change is understandable given their fundamental and deep-rooted fear of inflation. There is also increasing resentment over Germany’s financing role of the weaker peripheral economies, although it should of course be noted that Germany s receiving very attractive interest rates on its loans.
There might be grater enthusiasm for a policy shift if there were glorious example of success in abandoning fiscal control and letting budget deficits explode while at the same time engaging in quantitative easing. This has been the policy response in the U.S., but unemployment is still at 9% and the Administration is stuck with trillion-dollar budget deficits.
The lack of success in the U.S., is hardly an encouraging example for the Germans to let rip on fiscal and monetary policy.
Increasingly, the only viable escape route is to split the eurozone in two and let the weaker economies return to growth through devaluation and a reduction in real debt.
The economic data releases will have a significant impact at times over the week, but it is highly unlikely that they will have a decisive impact on currency levels at this stage. Similarly, the only central bank meeting is Thursday’s Bank of England monetary policy vote and there is very little chance of any change in policy following last month’s decision to expand the quantitative easing programme.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.