Despite some recent gains, the Eurozone continues to teeter closer to the periphery cliff.
During the past half a decade, the international community has consistently and systematically over-estimated the strengths of the global economy and under-estimated its vulnerabilities.
In the early days of the global crisis, the sheer idea that global growth should plunge below 4% was barely thinkable. According to the October 2012 World Economic Outlook by the IMF, the projected global growth is estimated at 3.3% and 3.6% in 2012 and 2013, respectively. Concurrently, IMF economists are struggling to model potential implications of below-2% growth scenarios.
Again, the relatively small revisions to global growth under the baseline are predicated on the vital assumption that “there will be sufficient policy action for financial conditions in the euro area periphery to gradually ease.”
The assumption is flawed.
Liquidity Quick Fixes
Following in the footprints of Japan and the United States, European monetary authorities have reacted to the elevated risks of financial instability and tighter credit conditions by keeping monetary and financial conditions broadly accommodative.
Since December 2011, the European Central Bank’s (ECB’s) 3-year LTROs (longer-term refinancing operations) have eased bank funding strains, thus slowing the pace of deleveraging in the Eurozone in the 1st quarter. Initially, lending conditions stabilized but then began to deteriorate again toward the end of the 2nd quarter. LTROs simply could not reduce the divergence between the core and periphery, which has continued to deepen.
In the absence of common fiscal policy, ECB’s common monetary policy had to come up with something new. At the end of July, ECB President Mario Draghi provided a blanket pledge to do “whatever it takes” to preserve the euro. In September, the rhetoric was followed by the European version of quantitative easing; a program of Outright Monetary Transactions (OMT), designed to offer liquidity to sovereign debt markets in the periphery. For now, OMT has reduced tensions, thus supporting market recovery indirectly.
In the coming months, LTROs and OMT will be followed by other equally esoteric abbreviations. Nonetheless, like their precursors, they can provide only a series of liquidity injections. They are a quick fix for the desperate; not a long-term boost for the disciplined.
As IMF has argued, the Eurozone has benefited from relatively strong fundamentals, bold monetary policies, and intra-zone commercial deposits. However, the challenge is that each one of these strengths is eroding.
First, while countries in the Eurozone periphery face serious challenges, the core economies make up the majority of the regional output. However, the deepening crisis has not only driven a wedge between the periphery, which feels overburdened by severe austerity measures, and the core, which suffers from growing bailout fatigue.
At the same time, this wedge is also making economic challenges more complex and political sentiments more assertive. Last week, when Chancellor Angela Merkel visited Athens to show solidarity, some 7,000 police, snipers and helicopters protected the government district from massive protests by left-wing opposition and trade unions. While the far-right Golden Dawn Party has still less than 10% of political support, every fifth Greek has a favorable view of it.
Since December 2011, the European Central Bank (ECB) has intervened boldly to contain tensions in periods of acute risk aversion. In turn, ECB chief Mario Draghi has pledged to do “whatever it takes” to save the euro. The proposals for banking union seek for rapid implementation of a Single Supervisory Mechanism (SSM) by January 2013, with the ECB empowered to act from that point on, taking over supervision for systemically important financial institutions in July 2013 and all banks from January 2014.
However, the devil is in the details. Overcoming the region’s institutional flaws would require consensus on numerous challenging issues, in record pace. In a relatively benign scenario, the Eurozone’s slow progress means that the large regional banks may offload $2.8 trillion in assets over the next two years to reduce their risk exposure, a dramatic increase of $200 billion from a prediction only half a year ago, according to the IMF. In turn, that could shrink credit supply in the periphery by 9% by the year-end 2013.
Moreover, if European policymakers fail to establish a common bank supervisor, and the periphery does not follow through with adjustment programs, the costs could be even higher, with $4.5 trillion in lost assets, and additional impacts on employment and investment. Supply of credit in the periphery could tumble by 18%.
It is true that, until recently, commercial bank deposits have stayed within the Eurozone, except for recycling from the periphery to the core. However, the longer monetary policies are on over-drive without the support of common fiscal policy, and the greater the potential political turmoil in the region, the more likely it is that these deposits will seek for alternative venues – outside the Eurozone.
It is the insolvencies, not the liquidity
Until recently, most European economies have engaged in front-load austerity measures and inadequate short-term fiscal support. In the United States, President Hoover tried similar policies, which contributed to the severity of the Great Depression. In the coming months, front-loaded fiscal consolidation will weigh heavily on growth and employment. As a result, economic fundaments are eroding, and political sentiment is turning sour.
In the past few months, spare liquidity has been swept by banks, insurers and corporate from the periphery to the core of the Eurozone. Consequently, Spanish sovereign spreads have soared record high, while Italian spreads have moved up sharply as well. Behind facades, similar concerns remain about the readiness of the ECB and the European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) to respond if worst-case scenarios materialize.
When the European crisis began, Brussels believed that the paramount problem was inadequate liquidity. As a result, most efforts have focused on liquidity support, climaxing with the launch of the European Stability Mechanism (ESM). And yet, while liquidity can be vital to alleviate problems, it cannot resolve the challenges of the big Euro economies.
The real challenge in the Eurozone is not just inadequate liquidity, but de facto insolvencies in periphery and the potential spillover effects in the core. As the fiscally conservative economies struggle to provide bailout monies, their triple-A ratings are gradually grumbling. At the same time, the region’s economic engines are slowing down. In the coming months, growth will linger in Germany, which is eroding the support of Chancellor Merkel’s CDU-led coalition. In France, President Hollande’s targets are likely to prove too ambitious, while the controversial mix of austerity policies and high taxation could alienate both households and corporations. Across Europe, stagnation is deepening.
In retrospect, the Eurozone challenges could be contained as long as problems were restricted to small economies, whose individual GDP was less than 3% of the Eurozone total (e.g., Greece, Ireland, and Portugal). Everything changed last fall, when these challenges arrived in Spain and Italy joined the gallery. The two account for almost 30% of the regional GDP. They are too-big-to-fail economies.
For now, recent Eurozone summits have failed to resolve any of the underlying multidimensional challenges – fiscal and monetary policies, banking crisis, the ECB risks, liquidity and solvency dilemmas and pro-growth policies – that now overshadow the future of the old continent.