Remember how optimistic markets were in June when European leaders said they would provide up to 100 billion euros to recapitalize Spanish banks?
Or how about, more recently, the big rally set off by the September 6 announcement by European Central Bank President Mario Draghi of a clear plan for supporting Spanish and Italian government bonds with potentially unlimited buying from the EuroZone rescue funds and ultimately the European Central Bank itself?
How did we so quickly go from hope and rally to gloom and panicky selling in European (and global) financial markets? (And now maybe back again?)
It’s not actually very surprising if you remember this: The stock and bond markets insist on thinking about the euro debt crisis—and its specific national franchises of the Greek debt crisis, the Spanish debt crisis, etc.—as a financial crisis. In that context, the market gets giddy when some one proposes a financial fix, such as central bank bond buying or a recapitalization of Spanish banks or a new round of budget austerity in Greece.
And then the financial markets get blindsided—and react by selling—when events remind us all that this isn’t primarily any longer a financial crisis—if it ever really was—but is instead a political and economic crisis. Nothing like pictures of Greeks throwing Molotov cocktails at the police who are then engulfed in flames to bring them home. Or talk of the breakup of Spain after November elections in Catalonia that have turned into a referendum on Catalan independence.
And nothing like talk that the Spanish budget introduced yesterday means a program that would let the ECB start buying Spanish debt to send the markets back into rally mode—at least for a day. How long will it last? Will bond buying fix the problem?
If you recast your thinking about the crisis into political and economic terms—instead of the purely financial–the questions you want to answer become very different. The questions right now aren’t whether Spain can patch together a new budget that keeps the deficit from spinning out of control this year or whether climbing yields on Spanish government debt will force the government of Prime Minister Mariano Rajoy to put in a formal request for a program of bond buying and supervised economic reforms.
Instead the questions become whether the populations of Greece, Spain, and Portugal and Italian have been so crushed by the collapse of their economies that the governments in those countries can no longer deliver on the promises made to their EuroZone creditors. And whether the populations of those creditor countries are suffering such bailout fatigue that governments in those countries are seriously thinking of walking away from deals and promises to support the euro.
The first set of questions—the financial ones—will move markets in the short-term. And in that short-term those financial problems are susceptible to another band-aide solution. I think the next two weeks are likely to bring some plan that will move Spain to ask for a bond-buying program. And that announcement would lead to another short-term rally.
The second set of questions—the economic and political ones—isn’t nearly as easy to address. They certainly aren’t amendable to a financial fix. My worry is that the EuroZone has spent all its political capital and that its leaders are now looking for solutions that amount to cutting and running in order to preserve their own positions and to limit the damage to their own narrowly defined self interests.
My worry is that we’re just not entering into the very worst part of the crisis, when all illusions that relatively easy fixes will work (if they could ever be implemented, of course) are stripped away and the EuroZone falls into confusion as it attempts to reconfigure itself without Greece, potentially without Finland, and possibly without Spain.
This confusion would, unfortunately, for the global economy and global markets come at time of potential confusion in the United States (the approaching end-of-year fiscal cliff) and China (current stimulus efforts haven’t reversed the decline in growth.) Kicking the can down the road looks like it has resulted in turning three individual problems into a coordinated mess.
Let me start in Europe and then sketch in the larger picture.
My evidence for my political pessimism about Europe?
I’m increasingly inclined to believe speculation that says one party or other in Greece doesn’t want current negotiations to result in a deal. Why is the International Monetary Fund, the only member of the creditor troika (which includes the European Commission and the European Central Bank) with actual experience in conducting an economic reorganization so unwilling to cut the Greek government any slack? (The latest demand is that the Greek government immediately fire 15,000 government workers. That may make budget sense but politically it is almost unthinkable.)
One conclusion is that the IMF has decided that the current course of wrenching austerity will not result in an end to the Greek debt crisis on any reasonable time scale. (On September 26 Fitch Ratings predicted that the debt to GDP ratio for Greece would increase from 165% in 2012 to 180% in 2014.) The IMF, this thinking goes, has decided that holders of Greek debt will have to take another write down because there is no way to restructure the Greek economy as long as the country carries it current level of debt. A big problem here, of course, is that the biggest Greek creditors is now the European Central Bank, which didn’t participate in the first round of write downs. Getting the ECB to agree to take a hit isn’t going to be easy, but the alternative, this analysis argues, is continuing to pour money into a lost cause. And this simply isn’t an acceptable alternative to an IMF that already faces considerable donor backlash from its non-European members.
In Spain Rajoy’s government faces what amounts to a regional insurrection on top of the popular revolt that has put tens of thousands of Spaniards into the streets. If the government makes a formal request for bond-buying help, it will have to agree to a supervised program of economic reforms. That could result in a financial market pop that would send bond yields down again—and that would help with a Spanish budget that threatens to break the government’s pledge to reduce its budget deficit to 4.5% in 2013 from a deficit of 6.3% this year. (On current trend, interest payments in 2013 are projected to increase by 9 billion euros over the government’s 2012 budget projections to 38 billion euros. That may not sound like much but remember that Spanish GDP is just 1.1 trillion euros.)
The problem, as the draft budget for 2013 released yesterday September 27 shows, is that meeting that 4.5% target will require even deeper austerity measures. The new budget requires an additional 20 billion euros in tax increases and spending cuts. The cuts, early reads of the budget say, will mostly come out of social spending. The new tax revenue will mostly come, from an increase in the value-added tax proposed earlier in the year and set to go into effect on September 1 to 21% from 18%. Think about how an increase to a 21% sales tax—the U.S. version of the European value-added tax—would hit your family budget.
And this is likely to make the political problems in Spain worse. Madrid faces a series of regional elections that could seriously erode support for the national government. An October 21 election in Galicia could see Prime Minister Raja’s party lose in Raja’s home region. An election the same day in the Basque region could see parties advocating more independence for the Basque region win more seats. And then there’s the big contest in Catalonia, the largest regional economy in Spain. Catalonia has moved up regional elections to November 25. The goal, Artur Mas, head of the current Catalonian government has made been clear, is to get enough support to put a referendum on independence for Catalonia on the ballot.
This wouldn’t all be quite so important if the central government wasn’t trying to get the regional governments to bring their budget deficits under control. The goal is to reduce regional deficits to no more than 1.5%. The regions say reducing deficits to that level isn’t possible. Andalucía, the most populous region in Spain, has just asked Madrid for 5 billion euros from a fund Madrid set up to bailout regional governments. Catalonia has asked for its own 5 billion euros. You’d think that might have put the brakes on the move for local independence, but Catalans say that Madrid takes too much in taxes from the region, the home of about 20% of Spanish GDP, and returns too little. That issue is a very hot button in Catalonia since in 2010 the Spanish constitutional court rejected a statute of autonomy for Catalonia that would have given the region the same control of its taxes as the Basque region already enjoys. Raja’s party, then out of power, brought the petition to the court that led to the decision.
It’s hard to see in these circumstances how a Rajoy government can deliver the austerity that its European creditors now demand or how it can submit to even a weak version of the supervision that Greece now faces.
And if you look at the politics of the rest of the EuroZone, it’s not clear that the creditor countries will themselves actually deliver on their promises. For example, in June Germany, Finland, and the Netherlands seemed to have agreed that the permanent bailout fund, the European Stability Mechanism, could recapitalize Spanish banks directly. That would avoid the pattern of national governments adding to their debt so they could send the money on to banks. But on September 25 the Germans, Dutch, and Finns said that this would only be possible as a last resort and only after the EuroZone decided on a new unified system of bank supervision. Since a decision on bank supervision is months away, thanks to opposition from Germany, any recapitalization of Spanish banks by the European Stability Mechanism is very far away.
Most discussion of bailout fatigue among creditor nations has focused on Germany, but Finland is actually a much more advanced case. The Finns have been the toughest negotiator in bailout deals to date, demanding collateral not granted to any other creditor. And Finland is even more leery than Germany of being sucked into further bailouts because of the relatively smaller size of the Finnish economy and because of demographics that show a rapidly aging population will soon eat into the country’s own finances. There’s increasing speculation that Finland, and not Greece, will be the first country to leave the euro.
What happens next?
I expect another financial band-aide, most probably some deal that gets Spain the money it needs to recapitalize its banks and bond-buying support in exchange for a “supervision light” program that focuses on economic reforms. That would likely trigger another financial market rally.
Which would then fade as it became clear that the politics of the debt crisis were continuing to deteriorate and that the financial fix didn’t amount to an economic fix.
How big a problem this would be for the global economy and global financial markets depends on what is happening simultaneously in the United States and China. If the U.S. Congress, post-election descends into wrangling instead of addressing the fiscal cliff, markets could turn nasty indeed. I’m very concerned about December and January. If China looks at the potential for even slower economies in the EuroZone—the biggest market for China’s exports—and reacts with even more aggressive stimulus, I think that could help counterbalance continued confusion from Europe. (It’s not enough to balance out problems in Europe and simultaneous problems in the United States.) If that stimulus—and current efforts—don’t provide some signs that growth has bottomed in the third or fourth quarter, then investors could be facing a very big problem from yet another direction in January.
If we do get once more bounce from a financial fix in Europe in the coming weeks, I’d certainly think of it as an opportunity to reduce risk in preparation for what could be a very challenging start to 2013.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did not own shares of any stock mentioned in this post as of the end of June. For a full list of the stocks in the fund as of the end of June see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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