Tyndall Monthly Commentary
What Went Wrong in Europe?
Thursday, May 3rd 2012, 12:57PM
by Andrew Hunt
Only two months ago, financial market participants and, it seems, many companies within Europe's real economies were convinced that the European Central Bank, under the stewardship of its new Italian Chairman Mr Draghi, had saved the Euro project from an imminent and potentially catastrophic crisis. What Draghi chose to do, or perhaps was forced to do by circumstances, was to add at least EUR 1 trillion (in fact, we would argue that the true amount was closer to EUR1.5 trillion, or 12 times the size of the entire New Zealand economy) in new funds to the European financial system and to the banks in particular. The injection of seemingly so much money naturally brought forward claims that the ECB had finally embraced a worthwhile Quantitative Easing Policy similar to those that had already been used by the US authorities and many evidently believed that this would suffice to save the Euro and restore economic growth to the Euro Region.
Certainly, it is apparent that financial markets - although perhaps not the foreign exchange markets - believed this positive interpretation during the first quarter and perhaps more significantly many companies in Europe and particularly in Germany seemed to believe this positive spin on events as well. Therefore, just as we saw in mid-2008 when the world (wrongly as it transpired) believed that the Federal Reserve had somehow fended off a global financial crisis, measures of business confidence picked up following the ECB's actions and in some cases this new-found confidence resulted in an upturn in employment growth as some companies sought to prepare themselves for the expected strong recovery. However, what is apparent is that the revival in the business confidence indices that was so lauded by the financial markets was almost entirely the result of a pickup in businessmen's expectations of a recovery and crucially it was not based on their actual experience of current conditions or even realised order flows.
Businessmen evidently became more confident because policymakers and the markets told them that everything would be ‘all right' and, as the business confidence indices increased, the financial markets then continued to run and so encouraged yet more expectations of a recovery in a peculiar self-reinforcing, if somewhat erroneous, process.
The only problem with this situation was that, seemingly unnoticed by many, the actual economic data and the current business environment were continuing to deteriorate at this time. Consequently, we were able to remark on the big gap that opened up between expectations and reality but, as reality has slowly dawned on the markets, business confidence is now falling back and some sharemarkets are becoming disappointed that the ECB does, after all, not seem to have yet rescued Europe from last year's crisis. Instead, markets are finally working out that all that the ECB seems to have done is to place a sticking plaster over the banks in order to hold them together. While effective at solving this micro part of the problem (or symptom of the Euro disease) has done nothing to solve the more fundamental problems elsewhere in the system (which may well be causing the patient to bleed to death...)
For example, the ECB's chief strategy to deal with last year's crisis was to provide long-term loans to Eurozone banks under a scheme known as LTROs. These loans from the central bank were necessary in the periphery because the banks in these countries had by-and-large lent too much money to their domestic economies, which could no longer afford to service the debt with the result that the banks' asset quality was becoming impaired and because these banks were suffering potentially disastrous deposit flight. Savers in the embattled periphery have come to realise not only that many of their banks are insolvent as a result of their deteriorating asset quality (or they would be if property prices were allowed to fall to market clearing levels) but also that the domestic political environment is turning often violently against the levels of austerity that are necessary to restore these countries' competitiveness within the Euro System and thereby casting doubt on their likelihood of success.
It is estimated that Spanish unit labour costs may be as much as 20-25% higher than those in Germany and, since Germany seems determined not to inflate its own cost base, Spain et al now need to reduce their costs through a prolonged period of outright wage deflation. However, cutting wages in highly unionised countries (let alone democracies) with generous social security arrangements and high debt burdens is a virtual impossibility and hence savers in these countries have quite rationally come to view the probability of a Euro breakup as being non-zero as their countries' resolve to carry through the required adjustments wanes.
Given these potential risks (for which they are not compensated in the form of higher deposit interest rates), astute depositors have begun either to withdraw substantial sums of cash from their banks in the form of hard cash, or they have started to transfer their funds out of their own countries' banks and into German banks situated in Germany. Hence, we had a banking crisis in Southern Europe last year as the banks became illiquid and insolvent and, by the middle of last year, this banking crisis was also morphing into a sovereign bond crisis as the peripheral banks were forced to dispose of their existing holdings of government bonds simply so that they could raise enough cash to meet their depositors' demands.
Faced with this potential for a widespread insolvency of the peripheral banking system, which would have in all probability have caused a Lehman-style seizing up of global interbank and derivatives markets at that time, the ECB late last year launched its LTRO lending scheme. This lending scheme essentially allowed the ECB to "print" money that it then gave the weak banks so that those banks could meet the calls coming from their deposit base without having to initiate a wholesale and probably cataclysmic disposal of or calling in of their own existing and now frequently impaired assets, such as their stock of mortgage lending to households. In effect, what the ECB did was to lend European banks enough money so that they could meet their depositors' increasing demands for their own money back without become illiquid or worse.
By enacting this policy, the ECB has clearly reduced the risk of insolvency and the level of perceived counterparty risk in the system and this brought a sigh of relief the world over but it would be a brave analyst who said that Europe's banks were now "strong" as a result of this LTRO move. The banks may now not be in imminent danger of going bust but they are still not in a position to lend more money to real people in the economy - the funds added were "get-you-home fuel" rather than fuel that could take them for a new adventure. Consequently, Eurozone credit growth is continuing to weaken to the detriment of the region's economic growth rates.
Moreover, from the perspective of your average European citizen or company, all the ECB has done by providing the banking system with "settlement cash" is to ensure that you as a depositor can get your money back out of the bank whenever you want. While this clearly will have been something of a relief for many depositors, it does not mean that people in the real sector have any more money in total, it just means what they thought they had anyway is now safer. Hence, we have not seen any significant increase in monetary growth in the Eurozone in recent months despite the ECB's massive fund injections. (In fact, there has been a very modest amount of money growth as a small part of the LTRO funds have been used by some of the banks to monetise budget deficits but the amounts are relatively modest and certainly not "game changers".)
Therefore, while the ECB through its actions may have reduced liquidity risks and the risk of (global) systemic financial failure, we can also see that it has categorically not improved credit availability or the amount of money available in the all-important real sectors of the economy, which is where the bulk of the voting population lies. Moreover, the ECB's actions have clearly done nothing to solve the fundamental differentials that exist between the various member states' levels of competitiveness; the LTROs have not made Spain any more competitive or Germany any less competitive on a fundamental basis and, with this key problem still not solved, we can see why the deposit runs are continuing even despite the existence of the LTROs.
With the latest data seemingly confirming that Germany's economy is continuing to weaken and that it is certainly not inflating despite the erroneous buoyancy of the business confidence surveys, we can suggest that the onus of competiveness adjustment is now falling ever harder on the peripheral countries. In fact, we would argue that these countries are starting to fall prey to what might be described as full-blown economic depressions, although so far even this level of weakness has not been sufficient to generate the deflation demanded by the system and implied by Germany's refusal or inability to inflate.
Unfortunately, the advent of these depression-like conditions in much of Europe have both led to new increases in what were already troublingly large budget deficits as a number of countries' realised tax revenues have disappointed. This poor fiscal news together with the obvious political backlash against the depressions are now beginning to trouble financial markets and the crisis seems to be warming up once again.
Thus far, the ECB's response to this latest crisis has simply been to deny its existence and to talk in quite a hawkish fashion about the perceived need to control inflation in the EU but, with the crisis intensifying by the day, the ECB will have to capitulate and find yet another rescue package, possibly one that involves a weaker Euro that can by itself restore competitiveness to the periphery even if it is at the expense of higher inflation in Germany.
Until the ECB finally capitulates and enacts such a stance, though, despite Germany's and its own philosophical opposition to such an inflationary policy, we can only assume that the Euro crisis will continue to intensify and thereby provide occasional downdrafts for global markets. While we can see some support for global markets and risk assets in the near term emanating from the reasonable if unexciting performance of the US economy and its now rapidly expanding financial system (in this respect, we are back to 2006-style conditions in the USA but that is a topic for another commtentary), Europe will nevertheless remain an occasional rain cloud on the horizon that may yet develop into a full-blown storm if the ECB does not act effectively.
Andrew Hunt International Economist London
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