Given very weak U.S. growth and fiscal paralysis, Europe’s debt and government spending crisis remains the key variable in the global...
Given very weak U.S. growth and fiscal paralysis, Europe’s debt and government spending crisis remains the key variable in the global outlook. That’s because Europe’s banking system is so large and maintenance of the euro is so valuable to global growth and to Mediterranean security issues. Europe’s latest debt agreement kicks the can but doesn’t provide new resources or encourage government downsizing in the periphery. There was a temporary dip in yields, but we don’t expect a pickup in the European private-sector growth and investment needed to sustain lower rates. Each of Europe’s can-kicks is important — creditor and debtor nations are fighting over bailout rules and bank capitalization that may control Europe’s structure for decades. The timing and outcome are unusually important for global growth because: 1) high yields in the periphery are killing growth and bank assets; 2) Europe’s bank liabilities are more than triple those in the U.S.; 3) the euro is vital for Europe’s growth and, we think, the geopolitical balance in the Mediterranean; and 4) Europe is a big part of the world economy and corporate earnings and, for now, is in freefall. On the positive side, we think that Europe’s support for the euro is strong and pro-growth and that Europe has more than enough net worth and low-rate borrowing power to absorb the legacy costs of a decade of competitiveness and debt mistakes. The logic for a favorable outcome is clear — Germany will be richer 10 years from now with the euro intact and all European debt except Greece’s paid than it would be in other scenarios, and the gap for other euro-zone countries is even wider. On the negative side, there’s still no conceptual path forward, and fiscal deficits across the periphery (latest Greece and Spain) are getting worse, not better. The primary achievement of the latest summit is to move the debt caused by Spain’s bank bailout off Spain’s debt-to-GDP ratio, even though the debt is still owed by Spanish banks. Rather than focusing on the debt and growth crisis, however, Germany is focused on the vague desire to use fiscal union to make other Europeans more frugal. The periphery has no ability to downsize their massive governments and is more likely to argue with creditors than cut government spending or sell assets. There’s still no European movement toward limited government, which is key to restoring private sector growth. The more Germany pushes for austere socialism rather than smaller governments, the worse the private-sector growth outlook. High long-term bond yields in Spain and Italy are reducing business investment and create a downward spiral in their economies and fiscal balances. The high yields also directly undermine bank profitability and the value of bank portfolios past the point that the ongoing forbearance (ignoring mark-to-market undercapitalization) is a viable strategy. Selected European Bond Yields (last obs. July 10, 2012) 
Source: Bloomberg; Encima Global We don’t think the latest summit deal will work for long unless the periphery reciprocates with growth-oriented reforms. A successful medium-term resolution of the euro-zone debt crisis depends on a step-by-step confidence-building process in which the periphery downsizes their governments, and the creditor nations provide incremental funding through the ESM of a finite portion of the legacy costs. The current EFSF and ESM do not have enough resources to bring down periphery yields for very long, given the size of the periphery’s fiscal deficits and debt roll-over requirements and projected government spending on pensions and services. In the end, Europe will need a big mechanism that uses Europe’s very low long-term borrowing cost to materially reduce the yield on the periphery’s legacy debt. This would have to be accompanied by growth-oriented structural reforms in the periphery to downsize government and reduce government control of assets and markets so that debt-to-GDP ratios are kept very low. In sum, both the U.S. and Europe face major obstacles to growth and jobs and aren’t getting the government policy changes needed to move forward.
