Tuesday, June 19, 2012

Four Weddings and a Funeral

This blog post is dealing with some longer-term, i.e. multi-year issues, concerning the Eurozone.
First a quick comment regarding the short term view: Markets can stabilise into the EU-summit at the end of the month, as they have always done in the past two years. It is rational to partially close shorts/underweight positions in for example the Euro or overweights in Bunds ahead of the summit, irrespective of what one thinks might be the result, and potentially increase them again after the summit. Hence, we see some stabilisation in markets but that should not be confused with a stabilisation in the underlying fundamental dynamics. In this respect I am more worried than ever.

To me, the European integration project of the last decades secured four freedoms: the free flow of people, capital, goods & services between the member countries (the four weddings). Economic integration promoted economic development and political stability. The creation of the single currency (the funeral) was meant to move even closer together in economic and political terms, however, this time the integration was neither necessary nor well-thought through threatening the whole project. A common currency is not really necessary given that corporates & households nowadays have many tools available to diversify/hedge/reduce the currency risks which were not available a few decades ago/much costlier to set up. Global capital markets offer hedging instruments and render a global portfolio allocation easy. For corporates it has also become easier to implement a global supply chain or geographically diversify their production capacities. The result is that the economic benefits of a currency union are lower now than a few decades ago. On the other side, the structure of the Eurozone has not been set in accordance with its needs (it is not a fiscal/political union).
With the birth of the Euro, yields in the Eurozone countries converged down to the German level (markets wrongly priced Eurobonds), fuelling a debt-financed boom in the periphery. This led to higher inflation in these countries which over time eroded their competitiveness. As a result, a growing number of Eurozone countries is facing a simultaneous competitiveness and overindebtedness problem (however, the two are interlinked. If the countries' corporate sectors would be competitive, their growth would be better and hence debtloads would be easier to manage). While in the case of Greece, the debtload stems from the sovereign, in the case of Spain/Ireland it originates in the banking/household sector (via the construction boom/housing bubble), whereas Italy has always had a high government debt load but amid ever lower trend growth and rising yields faces increasing long-term challenges.

There are a few things that can be done to tackle overindebtedness:
a) higher real growth
b) higher inflation
c) default
d) shift the debt to someone else

Higher real growth helps to lower debt/GDP ratios (as GDP increases which directly lowers the ratio and given higher GDP, there is more money for debt service). Peripheral countries would like to promote cyclical growth via stimulus measures (easier monetary policy, easier fiscal policy) whereas Germany would like to promote trend growth via structural measures (which though work only in the longer term). 
Higher inflation also directly increases nominal GDP and works the same way, however, in real terms, no one is better off than under a) whereas bondholders are worse off.
Default directly reduces debt but has enormous negative consequences on capital markets and the economy in the short term.
Finally, shifting debt to someone else can be done in several ways. One way is Eurobonds (where the debt is shared among a larger group of countries) but this can also be done via forcing certain types of investors to buy bonds or force artificially low yields on investors (for example this can be done via regulation for banks or pension funds/life insurers).

The drive by the  periphery to implement structural reforms is clearly waning (and in the case of France, seems to have moved the opposite way) which worsens the longer-term growth outlook. Furthermore, the ECB seems not willing to tolerate higher inflation. Finally, Germany is still against Eurobonds (even thought they might shift in favour of the so-called European Redemption Fund which would be a partial mutualisation of debts) given that Germany fears that it will have to pay for the social security net in the periphery.

Hence, out of the bad options, it seems that only the worst ones are left. Hence, the dominos will continue to fall. If no meaningful support measures for the peripheral countries are enacted, then these countries remain mired in recession while capital flight is rising sharply. Capital flight is increasing also in Spain which further weakens the banking system and leads to tighter credit availability and hence a weaker economy. With no further strong support measures, the pressures to introduce a parallel/new currency and/or default rises, not only in Greece but increasingly in other countries too. As a result, the scenario of a break-up of the Eurozone can not be dismissed.
However, should strong support measures be enacted which have the potential to stop capital flight in the periphery, then this might cause fears of sharply rising taxation and/or inflation in the northern countries (which undermines their economic capabilities) and promote capital flight there.
Overall, therefore, the risk that over the next years the Eurozone is breaking into several pieces or has to re-introduce capital controls (around single countries and/or around the Eurozone) to prevent capital flight increases. Thereby, the Euro is threatening the four freedoms of European integration.  

Personally, I would favour a combination of the above: much more measures to increase trend growth across the Eurozone (also in Germany), a substantially easier monetary policy stance (rate cut, buying of government bonds via the ECB without rendering them senior to outstanding govies) coupled with a move to nominal GDP targeting. Furthermore, this policy mix should be accompanied by a mild form of financial repression to secure demand for government debt and a move towards an ERF.
As a second best solution, the northern European countries (Germany, Netherlands, Luxembourg, France, Austria, Finland, Slovakia) could together leave the Eurozone and form a Northern Eurozone, essentially splitting the currency area into two.


  1. Hi, I have recommended this post to Scott Sumner, and he has featured it in his latest post.

  2. Daniel, what are the chances of getting a new 3 year LTRO?
    Or alternatively, how bad does the economic data have to get until they restart 3 year LTRO again?

    1. Good question. The ECB did the 3y LTROs to prevent a bank funding crisis to turn into an economy wide credit crunch. Currently, the economic data are poor but in general the liquidity situation of banks is in a better shape. It is more a question of a lack of collateral availability for some institutions, an issue the ECB tried to address on Friday with the relaxing in collateral rules.

      I think, the ECB will cut rates at its next meeting (the state of the Eurozone economy could certainly do with a lower repo/depo rate) but will not move towards another LTRO yet. To introduce another 3y LTRO (or extending the period from 3y to 5y), deflationary risks would have to be higher and/or the state of the funding markets would have to deteriorate further. Currently we are in a period where the fundamental/market environment deteriorates but at a pace which would probably see another LTRO in autumn if at all and not summer.

    2. Intrestingly, 5 year breakevens are lower now than they were when 3 year LTROs were announced, indicating either stronger deflationary expectations or higher differences in liquidity premia between regular and inflation protected German government bonds.
      Regarding bank liquidity, the problem is that markets are not certain that the current situation will persist. It is not as bad as it was after Lehman, when on most days one day liquidity was ample but banks were afraid about tomorrow. I believe these days there is some fear of a new liquidity crunch say after six months.

    3. Agreed on the liquidity situation. It is not as bad as after Lehman and also not as bad as during autumn. However, things are deteriorating.
      Concerning inflation expectations. Break-evens in Bunds and inflation-linked swaps have indeed come down to below the levels prevailing in November last year (driven by the economie's weakness and also by the collapse in oil prices). However, the 5y5y forward break-evens are still a bit above the levels in November.
      I personally think that the ECB could inject another dose of liquidity without threatening price stability, however, I think they will rather cut at the next meeting and wait with more 3y LTROs....