Europe on the Brink

Europe’s deterioration will probably continue. The current approach to the debt crisis isn’t causing growth-oriented reforms in the weaker countries. They are falling into deeper recessions and dragging Europe toward collapse. Italy’s GDP (last obs. Q2 2012) Source: Wall Street Journal; Encima Global German Chancellor Angela Merkel and the European Central Bank want to make loans to the periphery (Spain, Italy, Greece, Ireland, and Portugal) if they need it, but with conditions attached. The ECB hopes it can maintain leverage over the countries by buying only short-term bonds. For example, it might offer to buy 10 billion euros in Spanish bonds if Spain agreed to a detailed plan to reduce its fiscal deficit. The idea is that the ECB would stop buying bonds, or might even sell its bond holdings, if the reformer (for example, Spain) stopped complying with the conditions. This approach simply won’t work. Even short-term bonds put the ECB at risk. How likely is it that the ECB will stop buying bonds from Spain if Spain owes the ECB 10 billion euros and then overshoots its deficit target? It doesn’t matter if the loan is a two-year loan or a 10-year loan — it still puts the borrower in the driver’s seat. The ECB has said it won’t insist on its special status as a preferred creditor as it did to avoid losses during Greece’s debt restructuring. In Greece, the ECB’s losses were shifted to the private sector when Greece reduced the principal value of its bonds but paid the ECB in full. If new ECB aid programs like the one proposed for Spain consisted of preferred loans like the ones to Greece, it would make private sector lending to Spain less attractive because the private sector loans would be subordinate to the ECB’s loans. To avoid this, the ECB says it will make short-term loans and not invoke its preferred creditor status. As a result, the ECB would suffer losses if the country stopped paying its debt. In the end, the ECB wouldn’t have much leverage over the country to make it carry out structural reforms. This is particularly true given the short term in office of most politicians and the possibility of a debt restructuring within the maturity of the proposed ECB bonds. There are more problems with Europe’s current approach to the debt crisis. Europe’s crisis has deepened in part because Europe’s governing institutions, especially Germany, the ECB, and the IMF, have not made a distinction between austerity in the government sector and austerity in the private sector. The former would improve the growth outlook and doesn’t really need to be subsidized with ECB loans, while the latter austerity worsens the recession and often drags down the government, as Greece showed. Politicians in Europe’s periphery want unconditioned aid from Germany and the ECB. That’s a non-starter. However, Germany’s full weight is behind “austere socialism,” in which the governments in the periphery get more power and the private sector less. For example, the reform programs to date are heavily oriented toward value-added tax increases (which hit the private sector but not the government). Spain is now talking about a “green tax” to meet its austerity goals rather than reducing its massive payments to politicians. In the latest ECB version of aid-for-reforms, the reforms would still be negotiated by governments for the benefit of governments, leaving smaller private sectors and deeper recessions. I discussed the weakness of this approach in a December 16, 2011, Wall Street Journal article titled “And the Crisis Winner Is Government.” The better approach would be growth-oriented austerity in the government through government downsizing, reform of government labor controls, and asset sales. The debate over the strings attached to an ECB loan risks diverting Spain’s attention from quickly making growth-oriented reforms that will attract private sector capital inflows (or, at a minimum, stop the outflows). The premise of Europe’s approach to conditionality is that aid can induce politicians to impose painful medicine. The natural tendency is for the politicians to fight back hard, directing the medicine far away from the capital. Until now, the ECB has papered over the cash flow problems facing Greece and Spain by allowing their banks and national central banks (i.e., the Bank of Spain and the Bank of Greece) to hollow out their assets. This means lending against collateral that is losing its value. For example, if a bank makes a mortgage when the appraisal is inflated, the bank’s assets or makes a large loan against an asset whose value fluctuates over a wide range, the bank’s net worth might decline and even become negative. The ECB keeps supplying euros to weak countries or banks by lowering its standards for evaluating the collateral being offered against the loan. We don’t think the ECB will be able to continue this process much longer given the large losses underway in the periphery. The hope is that Europe’s new financing facility, the European Stability Mechanism, or ESM, will quickly take over the financing burden from the ECB. However, if the ESM is unleveraged, as Germany has insisted, it won’t be big enough to make up the difference if the ECB begins to step aside. Thus, the ECB lending proposal, aid-for-reforms, made on September 6 shouldn’t be perceived by markets as positively as the late 2011 measures were. Those measures, which included bank supportive ECB auctions and regulatory forbearance, lowered the periphery’s bond yields for several months. The lift ended when it became clear that the periphery wasn’t using the opportunity to become more competitive. We think that’s the key variable in the current environment and are skeptical that the governments in the periphery are interested in growth-oriented reforms because it means downsizing their own power and finances. The ECB plans to sterilize the next round of bond buying as it did when it bought longer-term bonds in its 2011 bond-buying program. We don’t think it matters. In that earlier sterilization effort, the ECB auctioned seven-day term deposits to fund its bond purchases. We think European bank lending, like U.S. bank lending, is constrained by regulators, capital requirements and liquidity ratios, so sterilization doesn’t make a difference. The excess reserves aren’t “money printing” in the old-fashioned sense of the phrase because the excess reserves aren’t going to be used to create private-sector credit whether they are sterilized or not. In his Jackson Hole speech, Fed Chairman Bernanke explained that the Fed can raise interest rates on excess reserves as needed to maintain its liabilities. That’s de facto sterilization. There is one technical difference between the Fed and ECB approaches — the U.S. continues to count excess reserves in the M0 monetary base even though it now pays interest on them, whereas Europe’s sterilization program moves the ECB liability into seven-day term deposits which aren’t counted in M0. As a result of the different approaches between the Fed and ECB, U.S. M0 exploded when the Fed bought bonds whereas Europe’s didn’t. However, in both cases M2 (which measures private sector deposits) is growing slowly as part of the regulatory rationing of private sector credit. We think Europe and the euro could have been salvaged because: 1) The bad debts aren’t that large compared to Europe’s huge assets, so there doesn’t have to be a tipping point; 2) the euro is a positive-sum device, making it less fragile than pegged currencies; 3) the downsides to U.S. and German geopolitical interests from a break-up of the euro are massive; and 4) the solution is clear enough — government downsizing in the periphery in return for a sharing of the legacy debt but not the future debt. Key steps for a growth-oriented European outcome include continuation of the euro basically as is, with the single ECB mandate of price stability. We don’t think Europe needs centralized fiscal or banking overseers, though it does need stronger enforcement of leverage standards through independent audits and bank bond ratings. It also needs clear new restraint on the spending and borrowing of national governments. This differs from Maastricht by emphasizing spending limits rather than deficit limits (which invite tax hikes). To accomplish spending constraint, it should control debt-to-GDP ratios, rather than the current focus on one- or 10-year fiscal deficits, which invite procrastination and accounting gimmicks. Europe’s government should sell government assets — this is critical both symbolically and for productivity gains. We also think Germany should participate in securing low-rate, long-term funding for a portion of the periphery's legacy debt to help it get back on a growth path. In the end, Europe will need to liberalize its bond markets in order to reduce the role of Europe's mega-banks (which are currently being used to finance governments, corporation and municipalities, functions the U.S. carries out more effectively through bond markets.) Almost all of the reforms in Greece, Italy, and Spain (there haven’t been many) have consisted of tax rate increases that don’t collect much new revenue, and cuts in vital services (like medicine in Greece). Spain has 450,000 politicians (mayors, village councils, etc.) with euro-denominated, short-vesting, lifetime pensions that aren’t being reduced, leaving bond yields very high despite the ECB’s saber-rattling. With so little progress on growth-oriented structural reforms (to downsize governments, sell assets, and allow labor flexibility), recessions and fiscal deficits in the eurozone’s periphery have worsened to the point that we don’t think the Eurozone can recover intact on its present course.