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It is only a matter of weeks since a number of European leaders, including the French President Nicholas Sarkozy and Italian Prime Minister Mario Monti, declared the euro-zone crisis to be “almost over.”  Financial markets jumped to the same conclusion following the large provision of liquidity by the European Central Bank (ECB) in two large three-year long-term refinancing operations last December and late-February respectively.

The calm provided by the ECB’s unconventional liquidity facilities proved fragile however, and stress returned to the zone’s sovereign bond markets once data confirmed that economic conditions continue to deteriorate.  The contraction in economic activity is frustrating efforts to meet ambitious fiscal goals, with both Spain and Italy indicating that they will not reach the initially projected deficit targets.  The evidence confirms that the fiscal consolidation strategy is not working, and a less restrictive policy mix will ultimately be required to save the euro-zone’s troubled periphery.

The economic challenge facing the periphery is far more complex than simply reversing the large fiscal deficits and stabilising the outstanding stock of public debt relative to GDP.  The sizable external deficits that persisted in the years before turmoil struck must be eliminated in order to stabilise the level of net external liabilities as a percentage of GDP.

The average current account deficit among the periphery increased from just four per cent of GDP in 2003 to almost eleven per cent by the time the crisis struck, which caused net external liabilities to rise to more than seventy per cent of GDP in Greece, Portugal and Spain.  Meanwhile, net payments abroad averaged three per cent of GDP in Greece, Portugal and Spain by 2007, or one-quarter of the current account deficits in each country.

By 2007, external debt indicators all vastly exceeded levels that had previously triggered crises in developing countries, and continued to deteriorate in subsequent years.  The latest available data indicates that net external liabilities exceed 100 per cent of GDP in both Greece and Portugal, are close to 100 per cent in Ireland, and more than 90 per cent in Spain.  Not surprisingly, net payments abroad are capturing an ever greater share of GDP.

In order to return the external indicators to more sustainable levels and avert a balance of payments crisis, simply eliminating the current account deficits is unlikely to prove sufficient; large surpluses will be required over several years in order to paydown external debt.  However, unlike previous balance of payments crises, this task cannot be accomplished via a substantial depreciation of the exchange rate, which means that the adjustment required can only be realistically achieved in the short-term through a reduction in domestic demand.

A decline in domestic demand however, is virtually certain to lead to a contraction in economic output in those peripheral countries including Greece, Portugal, and Spain, where trade openness is relatively low.  A fall in the overall level of economic activity makes it all the more difficult to meet ambitious fiscal targets, which means that the upward pressure on borrowing costs is unlikely to abate.  In turn, the external deficit is likely to prove more difficult to finance, increasing the pressure to effect the necessary adjustment more rapidly.

Further, the ability to run a current account surplus in the troubled countries – apart from Ireland – is constrained by the de-industrialisation of these economies in the recent past.  This means that the economic structures of Greece, Portugal and Spain are such that they can be expected to run external deficits for a ‘normal’ level of domestic demand.

The bottom line is that a sizable contraction in domestic demand will be required to return external debt indicators to a more sustainable level.  The cost in terms of higher unemployment however, is a cost that the sovereigns in difficulty may not be willing to pay.  The rate of joblessness is already unacceptably high in the periphery, particularly among the young, and further declines in the numbers employed may well lead to social unrest and political upheaval.

The external position has already shown marked improvement in the euro-zone’s periphery – apart from Greece.  The current account in Ireland has been close to balance since the beginning of 2010, while the deficits in both Spain and Portugal have narrowed considerably from almost ten per cent of GDP in 2007 to below four per cent last year.  Nevertheless, despite the impressive progress, further adjustment is required and particularly so in the Iberian Peninsula where the incremental social costs may well prove to be too onerous.

The fiscal consolidation strategy currently being applied in the euro-zone’s periphery is not working, and will continue to fail so long as much-needed private sector deleveraging and a reversal of unsustainable external deficits continue to frustrate government’s best efforts.  A less restrictive policy mix will ultimately prove necessary to save the euro.

Previously posted on www.charliefell.com

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Author Bio

Major activities in the euro zone economic crisis, including proposed amendments from European leaders and austerity packages from Italy, topped our transaction of the biggest currency markets headlines.

France and Germany spearheaded negotiations about new fiscal plans for the 17-member euro zone, issuing proposed amendments to Europe’s governing treaties to provide better economic governance to nations. Meeting at Élysée Palace in France, French President Nicolas Sarkozy and German Chancellor Angela Merkel prepared proposals they would deliver to the full European Union Dec. 8. Some proposed amendments include automatic penalties for countries that exceed European deficit limits as well as the creation of a monetary fund for Europe. Sarkozy said he hoped the treaty changes would be ready for ratification as early as March 2012.

On Dec. 4, Italian Prime Minister Mario Monti unveiled for his country a 30-billion euro austerity package, which includes raising taxes and the pension age, in hopes of harnessing the euro zone crisis. He said the package was painful, but important, as he also renounced his own salary as prime minister and economy minister. Late last week, Sarkozy spoke to French voters about the economic slowdown and rising unemployment. His speech came on the heels of remarks from European Commissioner for Economic and Monetary Affairs Olli Rehn about the euro zone entering a “crucial” 10-day period. During this time, nations must focus on building “convincing” financial protections and tightening economic governance, as Sarkozy and Merkel have outlined.

While Italy, France and Germany devised reforms, Greeks returned to simpler ways of life. Because of Greece’s debt, many inhabitants have defaulted to bartering. In the small fishing village of Volos, which is about 200 miles north of Athens, many residents have been buying and selling goods from each other and vowing to neighbors during harsh economic times. In the United Kingdom, the British pound sterling emerged as a safe haven for investing because demands for British government bonds rose. Investors also turned to the pound sterling because it was up 2.1 percent against the euro since early September.

Across the Atlantic, the United States saw some signs of hope for jobs. According to the U.S. Labor Department, unemployment dropped to 8.6 percent. In November, 120,000 jobs were added, up from 100,000 from October. The good news was that the American economy grew, even though conditions abroad waned. But what weren’t waning were the wallets of some Connecticut hedge fund managers who won a $254-million Powerball drawing. The three winners pocketed the state’s biggest lottery ever and have donated some of the money to people in need.

• Sarkozy and Merkel Push for Changes to Europe Treaty, New York Times, Dec. 5, 2011
• Italy PM unveils sweeping austerity package, Reuters, Dec. 4, 2011
• Signs of Hope in Jobs Report; Unemployment Drops to 8.6%, New York Times, Dec. 2, 2011
• All Eyes on Sarkozy Speech as Euro Zone Pushes for Grand Plan, Wall Street Journal, Dec. 2, 2011
• For a Sterling Play, Look to the U.K. , Wall Street Journal, Dec. 1, 2011
• Modern Greeks Return To Ancient System Of Barter, NPR, Nov. 30, 2011
• Hedge Fund Managers Win $254M Powerball Drawing, FINalternatives, Nov. 29, 2011

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.