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A primer on the European end game

May 6th, 2010 · 1 Comment

This is like chess, with less variants..

1) The Greek medicine won’t work

  • Greece is committed to making unprecedented budgetary cuts and tax hikes to the tune of some 13% of GDP.
  • This will make a mockery of the economic growth forecast (-4% this year, -2.6% next), the resulting recession will be far worse
  • Daniel Gros has argued that every 1% of austerity translates into 2.5% less GDP growth. Even if it will just be one-for-one, the outcome for the Greek economy are not hard to guess
  • Latvia, Lithuania and Ireland have already shown what large fiscal austerity without currency devaluation will do to an economy
  • Public finances will also be far worse as a result, the deficit/debt beast won’t be tamed any-time soon. Debt/GDP ratio will rise rapidly and may very well hit 150% of GDP next year (if the economy shrinks 10% or more)
  • With 5% real interest rates and 155% debt/GDP ratio, the Greek budget needs to run an 8% primary surplus to stabilize the debt/GDP ratio. It’s much more likely to run an 8% primary deficit..
  • Normally, inflation and/or economic growth (preferably in combination) can take care of very high debt levels, but neither are on the cards for Greece any-time soon (in fact, quite the contrary)
  • Inflation would actually worsen Greek competitiveness even further, so that’s not an option either, unless accompanied by a currency devaluation. Normally, a devaluation would soften the impact of the austerity measures, but Greece does not have its own currency..
  • Considering the very large primary deficit (deficit minus interest payments), even a default won’t help very much to reduce public financing needs. Devaluation (and debt restructuring, if not outright default) seems a very likely outcome.

2) Europe wide austerity will prolong the recession, quite possibly deepen it considerably

  • The fall of the euro is the only bright spot, but Europe trades mostly within its own borders
  • The rise of the dollar will dampen earnings of US companies (2/3 of the sales of S&P 500 companies comes from overseas), economic growth and drive stock prices lower in the US

3) Public finances will worsen as a result

  • Facing higher interest rates because of fleeing investors
  • The prolonged recession will do the rest
  • So austerity is not the answer, or at least not the only one

4) Contagion is here to stay

  • The markets know that the Greek situation is unsustainable and investors are running from European debt
  • Even France, a country that has not been mentioned in the countries with public finance problems already mentioned a three year freeze in public spending. Other countries will have to slam on the brakes.
  • The Governor of the Bank of England argued that the next UK government will be unelectable for a decade because of the austerity necessary to put public finances in order
  • One by one, the countries in the worst public finance positions will be peeled off

5) So, the present path is UNSUSTAINABLE

  • Sooner or later, something has to give
  • The weakest point are the peripheral countries (Greece, Portugal, Spain, Ireland to a somewhat lesser extent Italy). The temptation to devalue will become near irresistible when the alternative is such unprecedented austerity
  • There is another route of misery: bank runs on the countries that are most likely to leave the euro area
  • The only silver lining to the latter is that this will actually provide the opportunity to leave the euro area (announcing such a decision is near impossible because it will cause a bank-run, as Barry Eichengreen has argued, but if bankruns are happening anyway..)

6) The speed of European decision making is no match for the markets

  • Too many parties with a say, too many agenda’s, interests, very hard to make really monumental decisions, especially when not forced by events
  • Europe needs to think, and more especially act, pro-actively. There are only three options
  • Cracks are already appearing in the interbank market. This should be no surprise. European banks are big holders of Greek (and other ‘PIIGS’ debt). With further ECB inaction, this could quite easily escalate.

Three Possible Solutions

1) A large style EU/IMF (TARP like) package

  • The IMF is not large enough for this. It can only lend out some$268B
  • This would basically amount to socializing European debt. The amount of solidarity asked is too much, and the public finance situation of even the strongest countries too weak for this to make it a realistic scenario, in our view

2) Debt monetization

  • The ECB (European Central Bank) would have to buy up European debt, like other central banks do. Although the debt numbers will keep piling up, at least the interest rates will not, so the chance of negative feedback loops where higher interest rates rapidly makes the situation unsustainable have less chance)
  • They can’t do it directly (this is against the ECB charter), but they can do it indirectly, buying it off the markets
  • The Germans are dead set against this, but for how long?
  • Especially given the alternative:

3) Break-up of the euro

  • Ultimately, the Germans will have to chose between debt monetization and breaking-up the euro. Considering their history, this will be a tough choice for them. But if we had a say, this would be a no brainer.
  • Monetizing is no panacea, but it gives breathing space and keeps countries from default or having to embark on self-defeating austerity packages in the mids of already bad recessions.

Tags: Sovereign debt crisis

1 response so far ↓

  • 1 kencooksam // May 6, 2010 at 11:22 pm

    May cause Gold to rise.Europe has major problems. will shift dollars into the US I would think.