The seemingly endless turmoil in the euro-zone virtually ensured that 2011 would prove to be a difficult twelve months for investors in risk assets. Indeed, the increased stress evident in the region’s sovereign debt and bank refunding markets in recent months – alongside growing concern that the single currency might unravel – is the primary reason that the developed world’s major stock market indices failed to stage a meaningful recovery off the cyclical bear lows registered in the autumn.
Stock markets climbed higher during the spring and managed to retain their positive momentum in the face of higher oil prices – precipitated by political unrest in the Middle East & North Africa. However, the heightened appetite for risk struck a speed-bump towards the end of April, as a long string of negative economic surprises in the U.S. – just as the Federal Reserve’s second round of quantitative easing neared an end – caused fears of a double-dip recession in the world’s largest economy to resurface.
Stock prices in the developed world and elsewhere duly registered a bear market decline of more than 20 per cent but, just as investors’ recession fears subsided and the world’s major bourses began to stabilise, attention shifted across the Atlantic to the deteriorating and seemingly hopeless position facing the Greek government, which had seen its economy plunge into a severe downturn on the back of the harsh austerity programme prescribed by the so-called troika.
The Greek crisis and the turmoil precipitated across the euro-zone prompted Europe’s slow-moving leadership into action, who reluctantly announced to the world in September that they had just, “Six weeks to save the euro.” The disturbing rhetoric was duly followed by the fourteenth summit in less than two years and, the third comprehensive attempt this year alone, to quell the rumbling debt crisis that continues to question the viability of the region’s monetary union.
The proposals agreed to at what was dubbed the, “summit to end all summits” were received enthusiastically by investors at first glance but, upon further reflection, the measures were deemed to fall well short of what was required to draw a line under the crisis. A wave of selling followed and, the stress that was once confined to the sovereign debt markets of the miscreants in the monetary union’s periphery steadily moved inward to infect the core, and even a supposedly blemish-free Germany did not manage to escape investors’ wrath.
The tension continued to mount and the growing sense of panic among the international community was palpable as the realisation that a disorderly break-up of the single currency could no longer be considered a trivial probability dawned on observers. Not surprisingly, all eyes were focussed on the latest gathering of the European Union’s political elite in Brussels towards the end of last week.
The latest summit to save the euro appeared not to disappoint and delivered much as expected – with much of the detail well flagged days in advance – and, as a result the financial markets’ initial response was relatively mute but, two days of analysis over the weekend and investors delivered a more considered verdict – the summit had failed to move the euro-zone even one step closer to a successful resolution.
The summit’s proposals reveal that the EU’s political leaders remain in denial or are blind to the true nature of the crisis that afflicts the euro-zone and, until the politicians awake from their slumber, the odds of a successful conclusion to the sorry episode is still not much better than a coin toss.
The EU’s leadership continues to believe that profligate government spending among the euro-zone’s periphery is the central problem and, insist that fiscal austerity is the only path to future stability. With this in mind, the summit proposed that euro-zone members adopt constitutionally-binding debt brakes requiring states to maintain balanced budgets, defined as structural deficits of no more than half a percentage point of GDP.
The idea that the euro-zone’s woes simply reflect fiscal mismanagement is simply not borne out by the facts. Indeed, before the crisis struck, only Greece and Italy showed government debt ratios that were well above the Maastricht limit of 60 per cent, while both Ireland and Spain sported public debt fundamentals that seemed to be comfortably below the danger zone.
The euro-zone’s periphery came unstuck because large private sector deficits led to unsustainable external imbalances that had to be financed in a foreign currency – namely, the euro – since member states had given up their currency sovereignty upon admission to the single currency. This meant that euro-zone countries with persistently large current account deficits and dangerous levels of foreign debt as a result, were vulnerable to a sudden reversal in capital flows.
Put simply, euro member states are users of currency rather than issuers of currency and, as a result, must obtain euros to meet international payments as they fall due. The euros required can be obtained through exports, borrowing or asset sales. However, the euro-zone’s periphery increasingly relied upon the willingness of member states with current account surpluses to finance their deficits.
The music stopped once the global financial crisis struck and, in many cases, the external deficits were effectively nationalised by government in an effort to prevent an economic meltdown. Not surprisingly, fiscal deficits and government debt-to-GDP ratios subsequently exploded.
This fact seems to have gone unnoticed by Europe’s leadership, who continue to pursue the fiscal austerity route. Those of a bullish persuasion will argue that the constitutionally-binding debt brakes are a welcome step on the road to an eventual crisis resolution. However, the measure simply enshrines pro-cyclical fiscal adjustments in the currency union’s struggling member states, without any countervailing transfers from a central fiscal mechanism akin to that which exists in the United States.
Signing up to this deal is nothing short of economic suicide, as member states are effectively being asked to adopt contractionary fiscal policy when a recession strikes. The downward pressure exerted on the economy under such an approach could only be overcome by higher domestic consumption and investment or a trade surplus.
The former would be most unlikely since the private sector is already heavily indebted across the periphery, while the latter was not adequately addressed at the summit. Simply put, the chronic current account deficits in the periphery are the mirror image of the surpluses in the core and, these imbalances must be considered in any attempt to resolve the crisis.
The current approach is designed to make matters worse and all the more so, given that the member states issue debt in a foreign currency and have no credible central bank backstop. The deal to save the euro does the exact opposite and, if implemented, would hasten the single currency’s demise. As a result, financial market stress is virtually certain to continue in 2012.
As Otmar Issing, the prominent German economist once noted, “There is no example in history of a lasting monetary union that was not linked to one State.” Investors take note.
Previously posted on www.charliefell.com