As I said last week I am still in search of a credible transition plan that will take the Europe you see today, with its large sovereign debt problems and every growing imbalances, to what Sarkozy and Merkel now appear to be aiming for. I have stated a number of times previously that austerity alone is not a credible plan because forcing it on any non-exporting nation with no private sector savings buffer will be a self-defeating process unless you first write-off or transfer a considerable amount of the debt. Reducing the costs of borrowing is simply prolonging the problem.
Sarkozy and Merkel met overnight, but as far as I can tell nothing at all new of any importance has been decided:
The leaders of France and Germany agreed a master plan on Monday for imposing budget discipline across the euro zone, saying the EU treaty will need to be changed in the search for a sweeping solution to its debt crisis.
President Nicolas Sarkozy and Chancellor Angela Merkel said their proposal included automatic penalties for governments which fail to keep their deficits under control, and an early launch of a permanent bailout fund for euro states in distress.
No euro-bonds, no fiscal union, no bank re-capitalisation/nationalisation plan, no ECB ‘bazooka’, so as far as I can tell no credible transition plan.
I am not alone in my assessment. I note that Credit Writedowns has come to the same conclusion:
Getting from here to there is going to be a struggle given what we already know about the economic situation in the periphery. More than that, Nicolas Sarkozy is talking about balanced budgets in the euro area by 2016. And we know that an adjustment to balanced budgets throughout the euro zone would require either an exactly equivalent offset in private sector savings down and/or in the export sector up. This is never going to happen in countries like Greece. Sarkozy also promises no eurozone member will default too.
What does that mean for policy choices?:
- It means ECB intervention to bring down rates.
- It means moving to the hard currency United Europe which practices fiscal discipline that I have outlined.
- It means severe adjustments in the periphery toward fiscal consolidation and internal devaluation aka wage and price cuts.
- It means an implicit desire for offsetting adjustment in the euro currency down to create export competitiveness and/or equivalent private sector dissaving.
My conclusion: this is completely unworkable.
A hedge fund friend wrote me using the same language:
They can certainly agree to all sorts of budget cuts and tax hikes, but a) the governments won’t have the consent of the governed, b) the austerity measures won’t work, because economic growth will fall, and all the debt/GDP sort of ratios will consequently worsen, and c) the Germans really cannot go into an Italy or a Greece to “enforce” things. It’s all completely unworkable.
Quite.
Marshall Auerback notes that under austerity imports go down even though exports do not necessarily go up. So there will be some automatic external sector adjustment. However, Marshall also says:
But exports don’t fall and may go up as imports fall even faster, as the euro zone is pretty well a closed economy and much more mercantilist than the US…
Add to that what the Fed is doing with these dollar swaps. This is theoretically unlimited uncollateralised lending from the Fed.
As of today, the 1 Euro = 1.33 U.S. dollars. So just purchasing the PIIGS debt to fund their 2010 deficits would have required the US Federal Reserve sell around $350b, which is about 5.8 per cent of the US GDP over the last four quarters.
You therefore have a potential (albeit a limited one) for a huge injection of US dollars into the world foreign exchange markets.
That should have an impact! So, it’s not at all clear the euro countries can get anything out of the external sector. The adjustment therefore would fall on private sector dissaving.
For an economy with a current account deficit and high levels of private sector debt this means rising unemployment, falling industrial production and a guaranteed final outcome that is a worse fiscal position than when you began, even though the debts still exist.
Overnight it would appear Italy took the first steps along that path, however it is possible that Mario Monti is being ‘tricky’ about this:
Italy’s new government unveiled austerity measures that European leaders and markets hope will form the first part of a wider European deal this week and mark a turning point in the battle to save the euro.
Italian Prime Minister Mario Monti, in his first test since taking office two weeks ago, outlined a three-year plan made up of €30 billion ($40.2 billion) in tax increases, spending cuts, pension overhauls and growth-boosting measures.
The package—equivalent to 1.9% of Italy’s €1.6 trillion gross domestic product—will likely be followed by Franco-German proposals on Monday to create a new regime for budget policies in the euro zone, which European leaders could adopt at a summit on Dec. 8-9.
Italy’s government debt to GDP is over 100% and the current budget deficit is over 4%. A cut of an additional €30 billion over 4 years for an economy of €1.6 trillion is quite small and is actually less than the debt issuance of the country for just the next 2 months. Since joining the euro, the Italian economy has evolved into one sustained by credit, due to what appears to be lost competitiveness. A transition back toward something considered “sustainable” under the Franco-German plan is going to be very deflationary, and I have a feeling Mario Monti understands this. You only have to look at Spain’s services PMI to be once again reminded of the futility of current policies. The Italian cuts look like a token effort by the cabinet in hope that they will trigger greater intervention by the ECB and bring down bond yields. Yesterday’s well publicised bodice tearing in parliament perhaps deserves an Oscar! The first part of the plan appears to be working, at least in the short term.
It is, however, no surprise to me that S&P are threatening to downgrade… well… just about everyone. The statement:
“Systemic stress in the eurozone has risen in recent weeks and reached such a level that a review of all eurozone sovereign ratings is warranted,”
Yes it is. I continue to be surprised by France’s AAA rating as there is nothing in their economic metrics that tells me they can survive the sort of deflationary policy Sarkozy is promising Merkel. Unless we see a meaningful and credible plan to turn Europe around in the coming week that is more than just another can kick, I expect the agencies to act on those threats.