Opinion

James Saft

Europe’s three simple problems

James Saft
Nov 3, 2011 11:40 EDT
ECB | EFSF | France | Germany | greece | Italy

James Saft is a Reuters columnist. The opinions expressed are his own.

The plan to rescue the euro zone faces only three hurdles; democracy, reality, and supply and demand.If they can overcome those, it is going to work perfectly, and, amazingly, they just might.

Democracy reared its rather large head when the Greek government decided suddenly that it wanted a sign-off from its voters and moved to put the plan to a plebiscite.

While it is hard to argue with the idea of a people getting a chance to vote directly on a plan that will mean tough times for the better part of the next decade, the move jeopardizes not only the confidence on which the entire rescue relies but also the next infusion of much-needed cash Greece is slated to get in November.

If the Greeks vote against the plan it means a full-fledged, badly controlled sovereign default, with all that implies for euro zone banks. Is that something the Greeks will vote for, even if it means ejection from the euro zone? Just the specter of the vote makes it far harder for euro zone officials to put the rest of their plan into effect, a number of whose planks are already looking shaky.

Democracy, or whatever alternative term you would prefer to use, is also doing the rescue no favors in Italy, where Prime Minister Silvio Berlusconi is under pressure to step aside for a government of national unity. There is also precious little faith that Italy will produce credible fiscal and structural reforms. All of this is reflected most starkly in the reality of the bond market. Italian 10-year bond yields now stand at about 6.16 percent, a level that is unsustainable, considerably higher than before the grand plan was announced, and a threat in and of itself to the rest of the plan’s moving pieces.

Remember, Italy is not only the third-largest economy in the euro zone, and probably too big to bail out, but the third-largest government bond market in the world. A plan that can’t bring Italian borrowing costs back down is one which will fail.

If anyone ever wondered where the bond market vigilantes have gone, we have our answer: they’ve moved to Europe and are providing reality therapy to governments.

Again, sometimes that kind of therapy works, and perhaps Italy will come across with the goods. The problem is time and moving parts — too little of one, too many of the other.

EFSF, RATINGS AND THE MARKET

The European Financial Stability Facility, the fund which is supposed to borrow funds under government guarantees to pay for the bailout, chose to delay a planned bond offering on Wednesday, its arrangers citing market volatility. There is also the little issue that euro zone officials have failed thus far to explain exactly how the vehicle is supposed to work.

The EFSF is supposed to create friendly market conditions by being big enough and bad enough to fund weaker countries regardless of their stand-alone fundamentals. It is not supposed to be subject to the market and the fact that it is, so soon, is a bad sign.

And the larger the number of countries which might be borrowing from the EFSF rather than contributing to it, the less solid its AAA status seems, as well as the AAA status of its backing nations.

France is the case in point — as the number of strong countries dwindles, its own AAA status looks less reliable. Bond investors drove the premium France must pay to borrow for 10 years compared to Germany to a euro-era record on Wednesday to 129 basis points.

The final issue where supply and demand are working against the euro zone plan is in banking, where banks have been given a deadline of next June to recapitalize, either in the market or with state support.

That means that many banks are going to be trying to either raise capital or sell assets at the same time, driving up the price of the first and down those of the second. It also implies a rather large credit crunch in Europe, one that probably has already begun on the fringes.

That means Europe‘s recession will get a kick downhill.

So, to overcome democracy, reality, and supply and demand Europe is going to need a force that is immune to some degree to all three. Such a force exists in most other large developed countries with independent currencies — the central bank.

The ECB can’t and won’t play a similar role, and until it decides it should and a way is smoothed for that to happen, the odds are against the plan.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns here.)

COMMENT
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Nov 8, 2011
1:23 pm EST

Meanwhile, France, teetering on the brink is AAA, while the U.S. is AA+.

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Much depends on, gulp, German consumer

James Saft
Jan 13, 2011 08:10 EST
china | consumer demand | debt | economy | euro | euro zone | Germany | U.S.

If the euro is going to survive without a Depression, German consumers are going to have to behave in ways that are, well, distinctly un-German.

While attention is focused on the suffering that the euro zone debt debacle is inflicting on the weak and the political anger the costs of bailouts are engendering among the strong, it is important to understand that the belt-tightening won’t just be a Gaelic and Mediterranean phenomenon.

German consumers will (rightly) regard events as likely to increase their taxes while doing precious little for their incomes and job prospects. If they react to this like Americans and spend like there is no tomorrow, well then, perhaps the euro zone can handle the local recessions in the Austerity Provinces. If, on the other hand, Germans behave anything like the way they have in the past, they will save more and only increase spending marginally, if at all.

“Over the four quarters to 2011 Q4 it is hard to see (German consumer spending) growth exceeding 1 percent, and easy to see it falling short, especially if budgetary rigour, rising food and energy prices, and the need for further Club Med subsidy provoke the normal reaction from German consumers,” Charles Dumas of Lombard Street Research in London wrote in a note to clients.

Against the wider backdrop this is not encouraging; U.S. demand will be weak, China is trying to stomp on inflation and the euro zone periphery will very likely be contracting. That really does leave German consumers as the engine of euro zone growth — a role that is, for them, unusual.

To put this in context, since the fourth quarter of 2001 German consumer spending is only up a bit more than 2 percent in real terms, a truly measly expansion. During the same period the household savings rate has risen from about 9 percent to just above 11 percent.

During this time, you will recall, the world experienced a go-go real estate bubble with seemingly free money, much of it German in origin, available to plough into collateralized debt obligations and the like.

If German consumers reacted soberly to the good times, imagine what they will do in coming years when confronted with the risks and costs of either staying in or exiting the euro.

Part of the reasons for German consumer reserve was a policy that constrained wage growth savagely, but again, to look for strong wage growth to emerge at this stage is wishful.

NICE RECOVERY?
Much has been made of the fact that Germany’s economy grew strongly last year, rising 3.6 percent, the strongest showing since its east and west were reunified. While this is a fine start, Germany did shrink by 4.7 percent the year before and its economy is still 2 percent smaller in real terms than it was at its peak.

While European, including German, officialdom is absolutely opposed to a euro exit, repeatedly characterising it as disastrous and unthinkable, it might not actually be that bad for German consumers, at least after a while.

Dumas of Lombard Street argues that the hit to competitiveness from a newly risen new-deutschemark would be offset by gains in consumers real income and confidence.

“A higher exchange rate would probably cause a healthy redistribution of income from business to labour, ie, consumers — the lack of which is closely connected to undervaluation and excess savings and net export surpluses in Japan and China, as well as Germany.

“Since Germany is unlikely to follow China’s route of real exchange rate appreciation by means of wage inflation, giving some possibility of a shift to consumption from exports, a break-up of EMU may actually be the only hope for achieving an increase of welfare for ordinary Germans.”

Given the current alignment of opinions that is not the most likely outcome, to put it mildly.

What does seem likely is some combination of the following: a recession among the weak in the euro zone exacerbates and is exacerbated by a failure of German demand in the face of uncertainty and limited global demand.

That will raise the rhetoric of euro zone discord and will weaken the euro, causing a problem for the dollarized world, including China. China’s willingness to spend billions to prop up demand for euro zone debt is in no small part because of this.

Europe will remain a strongly deflationary force in the global economy and the biggest risk in the near term as a force to upset the giddiness that is now dominant in global markets.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. Email: jamessaft@jamessaft.com)

COMMENT
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Jan 18, 2011
5:11 pm EST

Here is another tiresome and biased opinion from an obviously neoliberal economist absolutely convinced that transnational currencies systems can’t work. Of course the author makes it sound like sovereign debtors orbit chiefly around Germany and the entirety of the European Model is at stake. Is this overreaching? I think so. The author overlooks a lot of things. But let’s start with America’s sovereign debt, which is 60% of its GDP. With a pitiful 10% manufacturing sector, its import/export ratio cannot possibly ever hope to diminish our sky high trade deficit (that feeds our debt). While on the other hand France and Germany’s collective sovereign debts are around 67% of their GDP, they have sound austerity measures in the works, whereas we do not. Yet what the author neglects to tell you about export driven countries within the Eurozone is that they are experiencing steadily increasing trade surpluses with Germany, be they still pedestrian. The author is correct that Germany’s massive trade surplus wont shrink adequately in relation to its domestic demand, but not because the Eurozone needs that to happen to survive, it’s because–as crazy as this sounds–Germany’s population, which has stabilized in recent years, shall begin to increase slowly. And a growing population fuels domestic demand better than an aging population. And Germany, as in France, has implemented social welfare programs that are beginning to bear fruit to that extent. This brings me to the ultimate goal of the Eurozone, which has just expanded to 17 countries, which is to politically unite. This is not farfetched or ungainly, as the author would surely disagree. Political unification is the ultimate extension of currency union, anyway, especially enleu of certain states’ straddling debts requiring non other solution. A political unification structure of some kind, perhaps with functionaries in Brussels, Frankfurt, and Strasbourg, probably would probably give the Eurozone the cohesion, if not the coherence, necessary to take hold of the debt problem and begin it’s dissolution within core constituent 400 million citizens. Why would I know that Germany will not abandon the Eurozone? It is too dependent on unsustainable rates of foreign demand for many of its core products, like machinery and airplanes. Once these demands subside, it shall be back to more inter European trade; hence, Germany needs the EU more than the EU needs Germany. But they both need each other too much to not, as the directive of the Lisbon Treaty implies, politically unite [someday].

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