The half-life of the effectiveness of European summits is growing increasingly shorter. While I have been a long-term Europessimist, market participants are more willing to trade on whatever appears to be positive news, thus markets jump whenever it appears the Europeans are taking action. But eventually the game will wear thin as market participants increasingly realize European "solutions" are never more than half-measures intended to kick the can down the road another few months.
And the last summit was no exception. The reality is quickly sinking in that, relative to the dimensions of the challenge, very little was really accomplished two weeks ago. And very little will be accomplished until European leaders come to the realization that they continue to treat the symptoms of the disease, not the cause of the disease. They need to find a mechanism to address Europe's internal imbalances that does not rely exclusively on deflation as a cure. Alan Blinder provided the background in the Wall Street Journal:
All financial eyes are fixed on the euro. Europe's common currency actually has two gigantic problems. The debt and banking crisis hogs all the attention because of its immediacy, plus the high drama of all those summit meetings. But the other, slower-acting problem—lopsided competitiveness within the euro zone—is far more intractable.
Blinder sees three paths out of the resultant mess:
There are three ways for the other countries to close the gap with Germany—and remember, the gap is large. First, Germany can volunteer for higher inflation than its euro partners by, for example, implementing a large fiscal stimulus or ending its wage restraint. How do you say "ain't gonna happen" in German?
Second, the other countries can engineer German-like productivity miracles through structural reforms while Germany, relatively speaking, stands still. Good luck with that. And even if it somehow happens, the timing is all wrong. Reforms take years to bear fruit while financial markets count time in seconds.
Third, the other countries can experience deflation, meaning a prolonged decline in both wages and prices, which is incredibly difficult and painful—and generally happens only in protracted recessions. Sadly, this may be the most likely way out.
The reality of Blinder's view - that option two will not work and option three is excessively painful - is revealed by the most recent IMF update on Greece. From the report:
Meanwhile, since the fourth review, the economic situation in Greece has taken a turn for the worse, with the economy increasingly adjusting through recession and related wage-price channels, rather than through structural reform-driven increases in productivity.
Really, this is a surprise to IMF economists? Yet apparently, the IMF still believes that structural change is an immediate cure:
We recognize the need to reach a critical mass of reforms and reform synergies to jump-start growth.
I like this - the IMF does not believe in "confidence" fairies; they believe in "synergy" fairies. I keep kicking myself for missing the "synergy" fairy lecture in graduate school. Apparently all the IMF economists made it to that lecture.
Of course, it is not their fault. The IMF attempts to shift some of the blame onto the Greeks:
Structural reforms have not yet delivered expected results, in part due to a disconnect between legislation and implementation.
While likely true, this is something of a red herring. The long-term nature of reforms was no match for the pace of financial market developments, while the willingness of the population to accept externally-driven reforms is understandably lacking given the desire of the external agents to support ongoing recession. Without more direct transfers and debt relief, the IMF, ECB, and EU continue to use more stick than carrort.
Arguably, European policymakers might see the fundamental problem, but also recognize a real solution in years away. Via the Financial Times:
Member states of the eurozone have set themselves on an “irreversible course towards a fiscal union” to underpin their common currency, even if it may take years to reach that goal, Angela Merkel, the German chancellor, told her parliament on Wednesday.
Europe doesn't have years. The vice of austerity packages will eventually crush to hard, and the cost of staying within the Euro will exceed the costs of exit.
Meanwhile, the ECB is at best having mixed results. On one hand, recent actions appear to have stabilized government debt markets in Spain, Belgium, and France. On the other, Italian yields have retraced much of their collapse. Probably more importantly, however, stabilization of the banking crisis remains elusive. From the Financial Times:
But, despite the central bank facilities, the cost of obtaining dollar funding in the private market continues to soar, pointing to a dollar funding squeeze as Europe’s banks head into their all-important year-end reporting period.
The three-month euro-US dollar basis swap dropped to as low as -150 basis points on Wednesday, meaning banks would have to pay an extra 1.5 per cent premium to swap their euros into dollars for a three-month period. The premium has not been persistently below the -140bps region since late 2008, during the depths of the financial crisis.
Not good, not good at all. Also, the hopes that the ECB will provide an unlimited backstop for soveriegn debt now look to be premature at best. Via the Wall Street Journal:
With many in Europe still hoping against hope that the European Central Bank will step in more aggressively to buy bonds and bring down borrowing costs for struggling governments, Jens Weidmann, the president of Germany's Bundesbank and member of the ECB governing council, indicated his opposition to that hadn't softened.
The idea that the ECB should turn on the printing presses to help finance some debt-ridden euro-zone states should be put to rest for good, Mr. Weidmann said. Central bank "independence is lost when monetary policy is tied to the wagon of fiscal policy and then loses control over prices," he said.
Some argue the ECB is just jawboning to drive a hard bargain when it comes to fiscal and structural reforms. I am not so sure - these guys sound pretty serious to me.
And perhaps you thought the Fed would ride to the rescue. Think again. From Bloomberg:
Simply put, the Fed is politically limited in what it can do for Europe. I don't see the hopes that the Fed could step in for the ECB being realized. Moreover, US lawmakers will resist efforts to contribute more to the IMF to help Europe, especially if this is the general attitude:
The belief in fiscal austerity runs deep. We need to teach those Europeans a lesson even if it means shooting ourselves in the foot. Now, in all honesty, you really can't expect US taxpayers to offer much support to Europe when German taxpayers themselves are resistant. Because I think that fundamentally Blinder is right on the appropriate cure to save the Euro. Germany needs to issue a massive amount of debt to support demand in Europe, even at the cost of higher relative inflation. And, better yet, to support debt writedowns in the periphery. The response from Germany: Nein.
Bottom Line: I still don't see where this ends well. Play the news cycle if you are so inclined, but keep one eye on the key issue. Is Europe working to resolve their fundamental internal imbalances with anything other than deflation? As long as the answer continues to be "no," be afraid. Be very afraid.
