Tags: Europe | US | economy

Storm Clouds Above Europe, US Only Grow Darker

Monday, 21 November 2011 08:48 AM Current | Bio | Archive

Republican and Democratic leaders of a 12-member congressional supercommittee are set to declare failure in a joint statement to be released after three months of talks that failed to formulate a plan for deficit reduction.

Reuters reports that lawmakers are unlikely to return to the problem until 2013 as the attention shifts to the 2012 presidential and congressional elections. In the EU and especially in the eurozone, the sovereign debt crisis contagion caused by its weaker peripheral member countries is worsening by the week.

In his first public speech, at the 21st Frankfurt European Banking Congress in Frankfurt, Mario Draghi, the new president of the ECB, made it clear on Friday the markets should better not expect the ECB to act as lender of last resort for the “weaker” the eurozone members saying: “Credibility implies that our monetary policy is successful in anchoring inflation expectations over the medium and longer term. This is the major contribution we can make in support of sustainable growth, employment creation and financial stability… National economic policies [in the 17 eurozone member states] are equally responsible for restoring and maintaining financial stability. Solid public finances and structural reforms – which lay the basis for competitiveness, sustainable growth and job creation – are two of the essential elements.”

So, there is no hint whatsoever of the ECB becoming the EU lender of last resort.

At the same occasion he also said: “Activity is expected to weaken in most of the advanced economies. This is the result of a weakening of various components of aggregate demand, both domestic and foreign.

And it is evident in ‘hard’ data as well as survey data. In the euro area, downside risks to the economic outlook have increased, and the weaker degree of activity will moderate price, cost and wage pressures.”

In this context, Chinese Vice-Premier Wang Qishan made some interesting comments: “Global economic conditions remain grim, and ensuring economic recovery is the overriding priority … An unbalanced recovery would be better than a balanced recession … as major world economies, China and the U.S. would make a positive contribution to the world through their own steady development.”

Reuters notes that Wang's comments on the global economy were the most downbeat to date from a senior Chinese policymaker.

Returning to Europe, it is certainly not an overstatement to say the ECB’s rejection, at least for now, to act as lender of last resort has caused growing doubts and uncertainties in the financial markets about the its commitment to the eurozone.

It’s a fact: The eurozone will not emerge from its current debt crisis without economic growth and its growth problem cannot be resolved by productivity-enhancing supply-side reforms in the peripheral Club-Med countries alone, important though these are. Demand is also critical. But it is hard to see how demand can grow when private spending is being reined in and public spending is being cut. The current policy mix condemns the region to stagnation or even contraction.

Maybe it could be helpful to remember that one of the major causes for the increased vulnerability of the eurozone as a whole is that it is not fiscally integrated and the member states do not control the single currency (euro) in which they continue to issue and have issued their debts.

This is of extreme importance, and therefore it is only logic that the financial markets continue to punish such countries particularly severely if there are serious reasons to worry about their respective fiscal positions.

As illustration, this is why today Japan is paying far less to borrow, that stood on Friday at 0.95 percent, than Italy that paid last Friday 6.72 percent for their 10-year bonds, even though Japan’s debt ratio to GDP stands at 197 percent, which is much higher than Italy’s that stands at 121 percent.

Such worries explain the dramatic reversal of long-term interest rate spreads we have observed since the Lehman bankruptcy in 2008 that after narrowing substantially between 1999, when the euro was introduced, and 2008 when Lehman went bankrupt. Eurozone government bond yields are now as much polarized as they were before the launch of the euro.

This situation makes the “weaker” countries of the eurozone more vulnerable to death spirals that have the potential of dragging them down, even into insolvency. When we look at Italy and Spain, which are still solvent, markets are clearly losing confidence in the eurozone’s fourth and fifth economically most important member states. Since July, this loss of confidence has pushed their borrowing costs up to pre-1998 levels.

Also important is the fact that this negative feedback loop has also been amplified by the inter-linkage between “sovereigns” and banks. Doubts about “sovereigns” have caused confidence in banks to weaken, raising their potential rescue costs and consequently the risk of sovereign insolvencies. That’s the death spiral situation the peripheral eurozone member states are facing today.

Also not constructive at all, the eurozone’s latest package of measures to stem the crisis that was agreed to on Oct. 26 at the EU summit in Brussels, has failed completely in addressing any of the underlying issues clouding the future of the eurozone in its actual composition.

Investors shouldn’t also overlook the fact, even that rather modest deal when compared with what was already decided before going back more than a year and a half, required a huge diplomatic effort to bridge gaps between the different eurozone member states.

The daunting gap between what is politically possible and what needs to happen in order to secure the future of the eurozone as we know it today, which is debt no less than debt mutualization, pan-European deposit insurance, growth-orientated macroeconomic policies and closer market integration, was were not bridged at all and continue to remain as far apart as they have ever been.

The world is quietly starting to understand that the eurozone, in its actual form, cannot survive. In my opinion, some if not all of the peripheral member states will have to leave or the Northern core member states that are led by Germany will all or some have to step out.

Investors shouldn’t forget that Germany is not as strong as generally believed it is. Remember, Germany hasn’t recapitalized its banks fully yet and once it is done Germany will be worse off than the U.S. and many other developed nations in the world.

The reason for Germany it hasn’t recapitalized its banks is because it doesn’t have the money to do so. Also interesting is to take notice that the spreads between the German bund (10-year bond) and Italy and France are at “Pre-Maastricht” spreads as “if” the eurozone monetary union never existed. The bond markets are telling us that the eurozone is falling apart notwithstanding all what the eurocrats are saying and trying to do, which will be anyway, too little too late.

Maybe the one of the most important parts of all is the fact that at root, the eurozone’s sovereign debt crisis is a crisis of politics and democracy.

It is clear, at least that’s what I think, the eurozone will continue to be in the foreseeable future an unstable, crisis-prone arrangement unless critical steps are taken to place it on a more sustainable institutional footing. It is also crystal clear that European politicians have no democratic mandate in the short term to take the steps required.

The reason is that greater fiscal integration would turn the eurozone into the very thing that politicians said and voters would anyway object if it would become clear, it would never be: a “transfer union,” with joint debt issuance and greater control from the center over tax and spending policy in the member-states.

So, with no quick solution in sight, I still continue to think it will for some time to come be better to be safe than to be sorry. As a long term investor one has only to perform a couple of really good investments at really good prices during his or her whole lifetime.

Believe me, this is extremely difficult to accomplish and needs substantial amounts of patience and serious “homework.”

Most of us are most of the time obsessed by that conviction we’ll miss that train that could have left the station without us. So, take your time… and don’t try to catch falling knives.

For investors looking at the U.S., I’d like to add that, in my opinion at least, the U.S. notwithstanding it is also in dire straits, is much better off than the EU notwithstanding there is not much, if anything at all, to get really enthusiastic about. The main difference with the EU is that the U.S. hasn’t to deal with 17, let alone 27 different sovereign states.

About the emerging economies I’m remaining cautious. Their real acid test could come when the global economy will face the next big shock, that could come from the global economical and financial divergences we’re in anyway, or from an exceptional geopolitical event, or even from nature or from that “Black Swan” event, which is a metaphor that encapsulates the concept that the event is a complete surprise and has a major impact, that is surely out there, but nobody knows, but that all long-term investors should always take into account in case it should happen.

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Republican and Democratic leaders of a 12-member congressional supercommittee are set to declare failure in a joint statement to be released after three months of talks that failed to formulate a plan for deficit reduction. Reuters reports that lawmakers are unlikely to...
Monday, 21 November 2011 08:48 AM
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