Stanford Progressive

Do Leadership Changes in Europe Mark a New Phase of the Debt Crisis?

By Lee Jackson, published November, 2011

The following is an excerpt from The Opportune Time, a free weekly financial newsletter:

Quick Summary
✦   Sovereign Debt DUMPING to Continue
✦   Dare the European Central Bank PRINT in Germany’s House?
✦   Time to REMOVE the Union’s Weakest Links?

Although markets calmed during the second half of last week, the European debt crisis is far from over. The leadership of each Greece and Italy has changed, but the fiscal pictures in the two countries remain largely unchanged. The Greek government has yet to implement more debt-cutting plans, and the Italian government has passed further austerity measures that unfortunately may be inadequate.

The main tenets of the Italian government’s latest austerity plan are 15 billion euros worth of asset sales over the next three years, a gradual reduction in state-ownership of local services, and a two-year increase in the retirement age to 67 by 2026. Over the next three years, the planned asset and business sales will hardly amount to 1% of Italy’s 1.9 trillion euro debt burden. And Italy’s retirement age proposal probably will prove pointless, because the European debt crisis is happening now, not in 2026. Markets will not be convinced of Italy’s solvency unless Italian politicians take bolder steps to cut their nation’s debt.

At the end of last week, Italian sovereign borrowing costs fell sharply in response to now former Prime Minister (PM) Silvio Berlusconi’s resignation promise conditional on the aforementioned austerity measures. But another, and in my opinion more important, driver of Italy’s borrowing costs recently has been the ‘de-risking’ behavior of Italian bondholders. Italian bondholders mainly consist of banks, which are DUMPING Italy’s sovereign debt in an attempt to protect their financial health from the European debt crisis. Banks sold Italian debt in large quantities earlier this month, and I imagine they will use the latest rally in credit markets to sell more Italian sovereign paper.

There are three main reasons I suspect financial institutions will continue to cut their sovereign debt exposure. The first is I believe peripheral euro area governments have been slow to respond to the debt crisis due to reasons that are more institutional than PM-specific. Austerity will not become politically palatable, simply because the former PMs George Papandreou of Greece and Berlusconi of Italy have been replaced by so-called ‘technocrats.’ Incoming PMs Lucas Papademos of Greece and Mario Monti of Italy are qualified economists. The former served as a European Central Bank (ECB) vice president, and the latter, depicted below, served as the chief competition regulator of the European Union (E.U.). Polls currently show that both incoming PMs have widespread support from their citizens, but I am curious to see how the popularity of the two leaders fares after they propose austerity plans. I feel the risk that the Greek and Italian electorates disfavor additional austerity is high enough that bondholders likely will resume selling near-term.

Second, European sovereign bondholders are concerned about whom the market may target next. Such concerns were fueled Thursday, when Standard & Poor’s (S&P), one of the three main Western credit rating agencies, mistakenly announced a downgrade of France’s triple-A rating. I do not understand how a credit rating company accidentally posts a sovereign downgrade on its website, but I do know French investigators are determined to uncover the details. Aside from being the latest of several unpopular actions of the major rating agencies, the accidental downgrade of France is evidence that S&P, and perhaps its competitors, have been preparing to strip the core euro area nation of its triple-A status. French government bonds fell relatively sharply before recouping losses when S&P informed traders the downgrade was accidental. Nonetheless, Thursday’s price action demonstrates how jittery European sovereign bondholders are today.

Given the current level of bond market anxiety, I expect financial institutions to dump more sovereign paper in anticipation of a French downgrade. France and Germany are considered the core of the euro area, and a loss of either nation’s triple-A status will have broad implications. The European Financial Stability Facility (EFSF), which essentially is the euro area’s bailout fund, presently has a triple-A rating due to significant contributions from France and Germany. In fact, the EFSF receives almost half its funding from France and Germany, not to mention another 17% from Italy. If France loses its triple-A rating, the borrowing costs of the EFSF likely will rise, which will complicate the E.U.’s plans to expand its bailout mechanism. In the worst case scenario, the EFSF would lose its triple-A rating.  In addition, once bond market pressure builds in the euro area core, contagion likely will spread quickly through the periphery. I would not be surprised to see markets push Spain, and perhaps Belgium, into situations similar to those of Italy today.

The third and most important reason I see European bond yields continuing to rise near-term is the downward spiral of economic growth austerity creates during a recession. Government spending is a part of economic activity. Therefore, when states cut their budgets, GDP grows more slowly. Austerity is risky in today’s environment, because many European economies are contracting. Official data will not be released until next year, but consensus among economists is the euro area economy will contract this quarter and next. Assuming consensus is correct (and I believe it is), then enacting austerity now will lead to a deeper recession in the coming months.

Austerity during recessions is problematic, because markets do not care about the total amount of debt a country has outstanding. Markets care about the total amount of debt a country has outstanding relative to the size of its economy, or the debt-to-GDP ratio. GDP is a fancy term for the total of everyone’s income in an economy, and thus, taxes essentially are a portion of GDP. Hence, the debt-to-GDP ratio compares how much money a country owes relative to its revenue base. Austerity may not solve the European debt crisis in the near-term, because spending cuts will slash both debt and GDP. Therefore, debt-to-GDP ratios may not decline, which likely will beget more social unrest, as taxpayers sacrifice to no avail.

So if austerity may not be a near-term solution, then what must Europe do to contain the crisis? There is no easy answer, which is a key reason why I am bearish. The amount of spending each government must cut to ensure debt falls more than GDP and to contain the bond market turmoil may be politically unfeasible. At the same time, politicians cannot sit on their hands and watch their countries collapse. I feel there are two main approaches European policymakers can adopt, namely quantitative easing (QE) or removing countries from the euro area.

The first option is to embark on QE, or to ‘PRINT’ money. Central banks are responsible for controlling the supply of their currencies. For example, the Federal Reserve (Fed), the U.S. central bank, can create and destroy USD, and the ECB can create and destroy euros (EUR). QE is a process, in which a central bank creates money to purchase assets. In this case, the ECB would ‘print’ EUR to buy the bonds of sovereigns struggling to contain their debt crises. I put the word print in quotes, because most modern banking is done electronically, so central banks digitally print their currencies. As we have seen in the U.S. since the financial crisis, QE is controversial, because it increases the money supply and generates inflation in both the short and long run. Many economists worry that central bankers cannot reasonably predict what the long-term consequences of ‘money printing’ will be.

In my opinion, the ECB is unlikely to resort to QE. First, Germany, the dominant member of the E.U., strongly opposes policies that present moral hazard and pose risks to price stability. If the ECB ‘prints money,’ sovereigns will be less incentivized to cut their debts, and Germany and the financially stronger euro area members eventually may have to pickup the costs of any political inaction. In the past, I have cited the metaphor that using central bank policy to solve the European debt crisis is like taking aspirin for a strained muscle. The ECB can buy bonds, which will limit the pain of indebted nations for some time, but eventually, markets will lose patience and borrowing costs will resume rising. Even if the ECB announces unlimited bond purchases, the EUR would plummet, and long-run borrowing costs still may rise to compensate lenders for the common currency’s loss of value.

At the very least, the fall in the EUR’s value would pose inflationary risks. Price stability has been Germany’s main economic concern since the Weimar Republic hyperinflationary experience, which is illustrated on the left. Senior ECB officials repeatedly and publicly have opposed QE, and I have a hard time imagining they will renege on their rhetoric. In my mind, there is a reason most of the articles I have read that claim the ECB ultimately will print money are written by non-European, especially U.S., authors.

QE in the E.U. would pose risks to more than just price stability. Unlike Fed policymakers, European central bankers would be buying the bonds of countries that may default, posing serious risks to the financial health of the ECB. In addition, policymakers would risk exposing the ECB heavy political influence. Imagine the ECB announced tomorrow that it would buy Italian government bonds in unlimited quantities to lower Italy’s borrowing costs. Then countries, such as Spain and Belgium, that are in better fiscal shape than Italy but whose borrowing costs are rising, would demand the ECB buy their bonds too. I believe the situation would spiral out of control quickly, because the ECB would struggle to justify the purchase of one government’s bonds over another’s. The ECB would be biased toward ‘printing’ more to quiet the politicians, which would send the EUR plummeting. In effect, the ECB would be devaluing its currency to monetize debt, as central banks historically have done before their countries default. While I expect European policymakers to avoid the slippery slope of QE, I will turn terribly bearish on the EUR if the ECB ‘prints’ money.

I feel the more likely and practical solution to the European debt crisis is to REMOVE the most indebted nations from the E.U. There is a difference between the euro area and the E.U., mainly that the euro area is a part of the E.U. The E.U. is a political union of 27 countries, 17 of which are part of the monetary union called the euro area. On the featured map, the blue countries are euro area members, and the gray countries with red marks are E.U. members that are not part of the monetary union. Only the members of the euro area use the EUR and have voting rights in the monetary union. Currently, the law governing the E.U., particularly the Treaty of Lisbon, does not permit countries to leave the euro area and to remain in the E.U. Countries that exit the euro area must exit the E.U. entirely, and may reapply for E.U. membership, a process that takes years. In my view, laws could be amended to facilitate reapplication, or to allow members that leave the euro area to remain in the E.U.

Regardless of how European lawmakers decide to amend the treaties governing the euro area, I feel downsizing the currency bloc to include the most fiscally responsible members is the best course of action for policymakers. A smaller stronger euro area would allow fiscally irresponsible countries to adopt and devalue their own currencies, increase the competitiveness of their export and tourism industries, and boost economic growth. The debt-to-GDP ratios of fiscally troubled euro area members likely would fall sooner with insolvent countries outside of the bloc than with insolvent countries inside of the bloc. At the same time, the remainder of the currency union would not need to incur the costs of more bailouts for the weaker members that leave. In the long run, the finances of the countries remaining in the monetary union would be relatively strong, which would lead to a sounder EUR. To date, several European leaders, including German Chancellor Angela Merkel and French President Nicolas Sarkozy, openly have suggested countries may need to leave the euro area. Though painful in the short run, I feel removing countries from the euro area is the best choice for the E.U. in the long run. If European lawmakers boot bankrupt members of the common currency, I probably will become bullish on the EUR.

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© Copyright 2011 by The Opportune Time, LLC.  All Rights Reserved.
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Author Name and Electronic Mail Address:   Lee Jackson |

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