On the Maybe Not So Slow Motion European Train Wreck

I owe readers a longer comment on this, since we may be going into crisis mode (ah, the joys of waking up and toddling out to the computer to see what wheels are falling off the global financial system today).

Your humble blogger may be a bit jaded (two years of watching the crisis and another near year of seeing not enough done to prevent another one may have something to do with it). But this all feels like it was and will be terribly predictable, not in the particulars, but in the general trajectory.

The markets got three pieces of bad news on Friday: Hungary and rumors of large derivative losses at SocGen (which led the euro to tank) followed by a disappointing jobs report. Again, the rattled nerves evident in various news reports and blog posts may abate by Monday, but the sucking sound of deflation and creaking of bank balance sheets is finally calling into question the cheery assumption that patching up the financial system with baling wire and duct tape was a viable long term plan.

With a private sector debt overhang this large, deflationary pressures are hard to forestall. It becomes politically unacceptable to go much further in bailing out private sector entities, although the monetary authorities are creating SIV equivalents right, left an center to accomplish the same end. Defaults increasingly look inevitable on a number of fronts, from homeowners in the US who are increasingly willing to default, to the new focus on the riskiness of not just Hungary, but other Eastern European borrowers as well (some Germany-based readers have long been expecting serious trouble in Austria, whose banks were gateway lenders to Eastern Europe).

The underlying problem is that a huge amount of fiscal and monetary firepower was deployed to validate asset values and avoid debt writedowns at banks. Many advocated instead it would have been better to reduce various debt exposures through restructuring. While an injection of taxpayer funds might still have proven necessary, banks with cleaned-up balance sheets are more attractive to investors than ones that own toxic sludge.

But as bad as extend and pretend has been in the US, it has been even worse in the eurozone. And the policy errors only seem to be compounding. The latest comes via Bloomberg:

Claude Trichet and Treasury Secretary Timothy F. Geithner diverged on prescriptions to sustain growth, with Europe set to tighten budgets and the U.S. seeking stronger domestic demand.

The impact of narrower budget gaps “on growth could not be considered negative because it would improve confidence,” Trichet told reporters yesterday…

“Stronger domestic demand growth in Japan and in the European surplus countries” is needed, Geithner said at a separate press briefing in Busan. Spending in both areas is “relatively weak,” he said.

While Geithner echoed the view that fiscal consolidation is needed, he said it should be done over the “medium term.” European officials said yesterday that budget tightening needs to come next year, and German Chancellor Angela Merkel said that growth can’t come at the price of high state budget deficits.

Yves here. Consider the example of Ireland, which has embraced austerity. Real GDP is down 12%, and nominal has shrunk nearly 19%. And nominal is what is relevant in terms of paying down debt. How is Ireland going to be able to pay down its debt when its income has collapsed 19% relative to debt levels? Answer: not. This is why Trichet has his priorities backwards. What will instill confidence is not claiming governments can meet austerity targets, particularly when violence in Greece suggests that one can’t assume that the populace in all countries will accept the mission. It would be preferable to ease up on the timetable, try to get Germany to reduce its surplus with other countries within the EU by spending more, and push eurozone leaders to devise a more coherent process for working through the shortcomings in eurozone arrangements (that would likely require a considerably amount of shuttle diplomacy). What has rattled the markets most has been the divergent and mercurial remarks of some leaders within the eurozone.

A credible plan to have a plan (as in a timetable of meetings and agenda items) and a show of greater cohesion would do more for confidence than continued affirmation of commitment to austerity, when some doubt the targets can be met and others question the merits of exercise right now.


Originally published at naked capitalism and reproduced here with the author’s permission.