Europe from Bad to Worse

The European crisis, in spite of some positive steps of late, is showing no sign of letting up, as highlighted by the downgrade of Portugal by Fitch to junk this week based on a project of a 3 per cent GDP decline next year.

This was followed by a move from Moody’s to similarly relegate Hungary to the ‘junk league’ with a negative outlook to boot. Even though Hungary is not a Euro-zone country, foreign investors hold 64 per cent of Hungarian government bonds and a comparable two-thirds of them are denominated in foreign currencies. Even more market anxiety followed a failed €6 billion Bund auction in Germany which attracted bids of only €3.9bn, a new Euro-era record. This seems to highlight significant continued erosion in market confidence, not in Germany, but in the Euro which still remains a hostage to fortune in a highly contested political environment at a time when economic growth prospects are growing ever dimmer.

Moreover, even though the news on the political front has been somewhat more positive of late, it also highlights the reality that the crisis has reached a new stage. Anxiety is growing that the new cross-party coalition in Greece and the technocratic Mario Monti-led government in Italy will have to produce concrete results soon. Spain voted itself a new opportunity this week with the election victory of the Popular Party. But the clock is ticking. After all, if these politically significant steps do not work, what will?

Monti has unveiled a plan to rebalance the Italian budget by 2013. This is likely to involve the reintroduction of a property tax, measures to tackle tax evasion, and lower payroll taxes to encourage job creation. In principle, this could prove an effective solution. Tax evasion costs the Italian Treasury a remarkable $340bn a year, an astounding one-eighth of the country’s $2.6 trillion national debt. But old habits die hard… The probability of tax compliance dramatically improving has to be in considerable doubt. For instance, efforts to improve this in Greece have been met with disappointing results.

Yet it is clearly necessary to bring about genuine fiscal reforms in the countries that find themselves in an unsustainable situation. The main cause of the current situation in most cases is a bloated, inefficient public sector which needs to be cut down to size if fiscal sustainability is to be ensured and recurrent crises prevented. The challenge right now, however, is to do this in a way that does not overly undermine economic growth.

Fiscal consolidation reduces economic activity but a slowing economy in turn inevitably reduces government revenues and increases expenditures (unemployment, social benefits, etc.). It is essential to manage the negative GDP impact of fiscal consolidation in an environment where historically counter-cyclical interest rates have become pro-cyclical because of a lack of market confidence in government policy. Instead of declining during an economic slowdown, interest rates are going up, making government borrowing more difficult and threatening to stifle weak economic activity even further.

At the heart of the problem is the contested role of the European Central Bank. In the US, the Federal Reserve has played a central role in the crisis response, partly because the political paralysis in Congress has made it difficult for the government to actively counteract the crisis. In Europe, the legal prerogatives of the ECB are far more limited and any attempt to modify them highly politicised. In particular, the German Chancellor Angela Merkel has repeatedly stressed her determination to combat any attempt widen the central bank’s role. By contrast, France is keen to make the ECB a genuine lender of last resort.

The main problem is that the peripheral Euro-zone economies are trying to cut government spending in order to restore investor confidence in their economic policies. If it is the case that a certain set of measures can be expected to effectively address their structural weaknesses and restore the confidence of creditors, minimising the pain imposed by such reforms while they are being implemented makes sense. Debt forgiveness may in some cases be necessary but involves a moral hazard problem. Central bank intervention is not necessarily devoid of similar problems either but can be used to create a window of reduced market stress while ensuring that the necessary reforms are carried out. The key uncertainty, of course, is the duration of that window. How to prevent an enduring addiction to cheap money?

The ECB has taken some measures to alleviate market stress by buying government securities issued by the peripheral economies. Problematically, its ability to continue to do so is doubted. It is not legally allowed to ‘monetise’ government debt, i.e. buy bonds to fund deficits. Some purchases of government bonds as part of ensuring more effective monetary policy implementation were permitted in the absence of alternative mechanisms before the creation of the European Financial Stability Facility. The facility now exists but at €440bn is not large enough to handle a crisis encompassing Spain and Italy, Hence the lack of market confidence in the ongoing reform efforts.

In the meantime, the ECB is seeking flexibility by other means, most notably longer-term loans to Euro-zone banks. The idea of 2-3-year loans is being considered in a marked departure of the current ceiling of thirteen months. Such support to the banking sector might allow the ECB to alleviate the sovereign debt crisis through the back door as longer loans would allow banks to buy more government bonds. But the acute current crisis, unfortunately, means that the ECB effectively serves as the sole source of funding for many institutions. The ability and willingness of many banks to buy more bonds is therefore in some doubt.

The whole debate highlights Europe’s biggest Achilles’ heel: political risk. In the absence of a fiscal union or clear procedures of crisis management, attempts to solve the crisis are subject to an ongoing political negotiation which each country approaching with its own domestically informed agenda.

Germany has also resisted the issuance of European bonds, which it fears might erode its own credit-worthiness. Its ability to do so on an ongoing basis has been questioned by its constitutional court. However, it is clear that delaying decisions risks is triggering more speculation and increasing the perceived costs of tough decisions. The benefits of delaying the inevitable may hence be in some doubt and risks of doing so potentially far greater.

The European indecision and crisis are all paradoxically good news for the US, although its own fiscal house, as highlighted by discord at the deficit-cutting “Super Committee,” is hardly in much better order. But as investors get cold feet about the Euro, the Dollar is the only significant liquid alternative they have.

This reality now is the making of at least a near-term Dollar rally. The benefit of this, from the perspective of the US Federal Reserve, is that it will have more leeway in terms of engaging in an unconventional monetary policy. After all, there is little in the fundamentals that would cause the Fed to see a significantly stronger Dollar. But even if the US gets a respite, the current trends in economic policy hardly inspire confidence in a timely restoration of market economics. This, however you look at it, is bad news for the world.

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