Concerns about banks’ solvency and sovereign default risk rippling out to the real economy are taking their toll, leaving governments and central banks short of tools, unwilling yet to risk aggressively higher bond yields.
A three-step plan:
First, how far the increasing polarisation between US and eurozone growth can go. With eurozone demand accounting directly for no more than 3% of US GDP, the US can keep growing. However, the main eurozone threat is likely to come more from default risk than trade flows.
BIS data suggest that US banks have about €170bn direct eurozone exposure (about 1.5% of US GDP), but nearer €970bn (8%) if other institutions, including hedge funds, are considered.
The second theme to consider is whether QE in all its forms runs for too long, doing more harm than good. If done in the same way as previous bouts, QE will bring inflation, but the wrong sort (cost, rather than demand-led) which undermines the rationale for doing it. If so, expect more stagflation, especially where there’s fiscal austerity in the eurozone and UK, and, from 2013, in the US.
Third, the extent to which economic convergence within the eurozone continues to be on the weakest, providing a slow drag on Germany and France. The ECB should respond now by cutting interest rates.
The difference is political risk, largely absent at the start of the crisis, which will now be at its heart, at least to Merkel’s big test in September 2013. En route, the US, China, Italy, Japan, and Australia all have elections or leadership changes. Hollande’s election in France may be helpful, given his pledge to unpick a fiscal pact in need of growth policies.
Increased competitiveness needed
However, Greece’s re-run election on 17 June will be a de facto referendum on the euro, where the pain from exit (higher funding costs, implosion of balance sheets, hyperinflation) should not be underestimated. Either way, a monetary union without political union offers more unsynchronised, short and often interrupted electoral cycles that mean the politicians promising reform today may not be around later to implement it.
Spain is potentially the biggest accident waiting to happen, given its huge private sector indebtedness (over 120% of GDP) has thus far remained off the central government’s balance sheet. Dealing with Spain and possibly Italy would stretch the ESM’s financing limits beyond breaking point.
This suggests a restructuring of Spain’s government debt cannot be ruled out. While helpful in providing liquidity, the ECB’s longer-term refinancing operations (LTRO) are doing little to raise solvency, growth, or competitiveness.
Our Misery Indices offer little hope that eurozone bond spreads can return to pre-crisis levels once the sticking plaster of the LTRO is taken off. Fiscal correction is now as much the problem as the solution, as austerity saps the growth needed to raise competitiveness. With the euro, Spain and Italy’s labour costs have climbed 23% and 35% relative to their main trading partners, two to three times faster than Greece’s (12%), while Germany’s have fallen 1%.
Correcting this will need a decade of hard work. It may even mean deflation, as Ireland had to suffer in 2009 and 2010. This then risks setting up the vicious circle of bloated real debt levels, lower credit ratings, higher funding costs and slower growth, exacerbating the deflation that caused it! In short, debt restructurings, beyond just Greece, may be inevitable.
