Europe Wobbles… Again!

It is déjà-vu all over again! How many times have we seen this spectacle already? Bond vigilantes attack a Euro-zone economy, an emergency meeting of the Euro-zone policy makers is hastily convened, a grand statement about billions of Euros of additional assistance is made, and the markets calm down again. A couple of week or at months later, the same eerie drama repeats itself. And now we are there again, except, once again, the front lines of speculation have been pushed out a little further, the realm of the possible extended a little bit. The markets are yet again having to think the unthinkable, with the predictable consequence of more volatility. Add to the mix the fresh Standard & Poor’s downgrade of the United States and the fond dreams of a quiet August are (once again) gone with the wind.

The main problem in Europe has to do with the combination of the near-term reality of stagnant growth, mounting costs of debt in a growing number of countries, and inept politicians. The real worry is that, even though the Union has not yet conclusively solved the problems of its three weakest peripheral economies (Greece, Portugal, Ireland), the prospects for two very heavy-weight countries have become rapidly worse. I am speaking, of course, of Spain, which has a larger GDP than the three ‘problem children’ put together, and Italy, which is the third-largest Euro-zone economy. Additional worries have been generated by the speculation that France might soon lose its AAA credit rating with its bond yields at record highs as compared to Germany. Spain and Italy find themselves in a difficult situation. They saw sharp slowdowns in their QoQ growth to 0.3 per cent and 0.2 per cent, respectively, in Q2. The momentum of last year’s ‘recovery’ hence seems to be rapidly waning. Having contracted by 3.7 per cent and 5.2 per cent, respectively, in 2009, Spain and Italy grew by a modest 0.1 per cent and 1.1 per cent, respectively, in 2010. If economy growth was supposed to help the two economies bring their fiscal houses in order, its absence is having the opposite effect. As a result, yields on Spanish and Italian government bonds have edged towards, indeed at times above, the 6 per cent pain threshold which likely marks the limit for fiscal sustainability.

President José Manuel Barroso of the European Commission stoked further market nervousness with his call for expanding the EUR440bn European Financial Stability Facility (EFSF) only weeks after the most recent summit decision to do so. Before the previous decisions had been formally ratified by the national parliaments, Barroso seemed to question their effectiveness. The European leaders subsequently claimed that the objective really is to accelerate the implementation of the decisions taken in response to the Greek crisis, something that now may indeed happen. The overhaul of the EFSF requires approval by the parliaments of the member states, a process that would not ordinarily be completed much before late September.

But even this cloud has its silver lining and aspects of it are potentially significant. The first bit of good news came from the predictable response by especially Italian politicians to accelerate political reforms. Spain, now amidst electioneering ahead of the November vote, has already taken a number of measures. Italian Prime Minister Silvio Berlusconi has announced plans for an accelerated EUR70bn reform programme which would, among other things, ensure a balanced budget by 2013, a year earlier than previously planned. Italy now has a public sector debt to GDP ratio of some 120 per cent. Italy will also seek adopt constitutional amendments on balanced budgets and service sector liberalisation. The reform of the social security system will be accelerated. Especially the constitutional changes are potentially significant in as much as Europe’s woes owe a great deal to the failure to implement the generally sensible rules everyone had agreed to.

But Italy’s true savior this time was not Berlusconi but President Jean-Claude Trichet of the European Central Bank. The ECB recently restarted its Securities Market Program (SMP) which was launched last year but was then suspended in March. By initially buying Portuguese and Irish steps, the Bank seemingly sought to reward countries that had undertaken serious fiscal reforms. This appears to have triggered the Italian crisis response. The ECB currently holds EUR74bn of Euro-zone government bonds acquired under the SMP. The bond purchases are sterilized on a weekly basis as the bank withdraws a matching amount of liquidity from the system. The move was controversial with especially the Germans and the Dutch claiming that it goes beyond the responsibilities of the ECB. By contrast, Trichet has presented SMP interventions as part of ensuring the effective transmission of its regular monetary policy, claiming that an excessive divergence between the bank’s policy rate and bond yields in certain member states is an anomaly the bank has the right to address even though its statutes rule out actual fiscal support (monetary financing). Nonetheless, even Trichet has indicated his preference for the EFSF to take over. The ECB, having raised rates twice this year to 1.5 per cent, has also signaled growing concern about the economic situation, something that has significantly reduced the probability of further action in the near term.

The ESFS, once its rules are approved, will be able to buy bonds of member states with a view to normalising market conditions and ensuring appropriate access to credit. The ESFS can in turn issue its own bonds backed up by national guarantees in proportion to the weight of individual countries in the paid-up capital of the ECB. In other words, the ESFS offers a mechanism for ‘federalising’ the debt of problem countries and potentially nudges the Euro-zone significantly in the direction of a fiscal union. While the proposed scale of the facility would not be sufficient to allow it cope with a full-blown crisis involving Spain and Italy, the ECB actions and the potential for further modifying ESFS now mean that the contours of a potentially workable solution are coming into place, provided the political will to support it can be found. The political will is still in some doubt as many countries are both sceptical of bailouts and of attempts to undermine the ECB’s orthodoxy.

But two points are worth making. First, although European politicians have not impressed with their decisiveness or unanimity, they have typically risen to the occasion when a crisis has reached a tipping point. The roadmap going forward is looking fairly clear and it is likely to be the only option if significant turmoil and major economic costs are to be avoided. Secondly, while the ECB’s orthodoxy may take a dent, its track record to date means that, compared to the US Federal Reserve, it has enormous unused firepower. A combination of Euro-zone quantitative easing and a more flexible ESFS, if combined with credible steps towards fiscal sustainability may yet restore the credibility of the Europe. But there are many if’s in the equation and it is possible that ‘controled defaults’ may have to be part of the solution.

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