Europe’s Periphery Cliff: Postcard from the Eurozone

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.

Eroding Fundamentals

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.

5 Responses to "Europe’s Periphery Cliff: Postcard from the Eurozone"

  1. barf   October 18, 2012 at 5:46 pm

    this is a BIG DEAL and and WONDERFUL PRESENTATION as well. I look forward to your follow up articles. "Greece is burning"…an extraordinary tragedy not being covered by the "you know you"…and that is true crime indeed. But it is also more: since Greece is part of something larger what is being covered up here is a Hitler like "Grand Lie" or "Scheme" if you will…one that if not thought through does indeed imperil the European Experiment. HONESTY is what is needed first and foremost…and first and foremost by ZEE AMERICANS because for some reason it seems sorely lacking in the EZ. Indeed I'm surprised the English haven't "entered into negotiations" myself. Clearly though the USA has the most to gain from cohesion being maintained…and that begins with an understanding…and it is a SIMPLE and HONEST understanding…of the nature of what is happening over there. People are going to hurt more…empathy is the key….but then putting forth practical solutions matter as well. For example: why is Europe paying so much for energy? Obviously this must change..and change NOW.

  2. J. Teply   October 19, 2012 at 2:33 am

    The construction of the EU was not in the first place a job of economists and not at all for solely economists. It was an issue for prudent managers who were well aware that there are many non-economic factors, which must be preferentially taken into account.
    A two-gear EU right from the start was simply the sole realistic and cheap method with a chance of success with minimum risk. The post-socialist countries should have obtained the statutes of the Third world (developing) countries and together with some weak western countries remain in at that time existing free trade zone in order to learn, to consolidate and adapt their economies. After years they would show, if they can quallify for the first (euro) group, provided they really do want to become members, which might not always be the case.
    A short summary? The EU management is a nightmare without any trace of responsibility. Common currency should have been the last step in the construction of EU. A roof covering a new solid house.What we have got now? A bad roof on top of a not yet existing house which is being built up of inadmissibly heterogenous elements.

  3. J. Teply   October 19, 2012 at 4:26 am

    BUSINESS WEEK MAY 31, 2004

    INTERNATIONAL — READERS REPORT

    Western Economic Thinking Got Lost In Translation

    Shock therapy was the principal reason for the catastrophic course of the transition of post-socialist countries to the market economy ("Poland and the EU," European Edition Cover Story, May 10). Western economists have actually never understood what was going on in so-called socialist countries and in their economies. That necessary knowledge of the internal workings of the past socialist system should have been the only possible basis for any attempt to reform it.

    Direct application of Western economic thinking to disrupted and disabled societies controlled by yesterday's men was an ill-considered business. Nationalized industry was not the main problem, but rather the destroyed natural professional hierarchy in companies and in the whole society; misappropriation; corruption; lack of discipline and morals; etc. A necessary period of political, social, and moral cure was skipped over for the sake of such insane ideas as "shock therapy" and fast privatizations.

    Poland had an outdated economy unaccustomed to a market environment, bad management, and lack of money, not to mention a network of the Communist party still in place. How could something go well or even fast without careful, in-depth preparation? The privatization of coal mines in Great Britain took more than 10 years of preparation — and that was in a market economy. A quick launch of the market system is only half of the story. The other is to convince citizens that it has been done in their own interest, and that won't be easy.

    Jaroslav Teply
    Voorburg, Netherlands

  4. J. Teply   October 19, 2012 at 4:26 am

    That's all.

  5. vasile   October 21, 2012 at 3:00 am

    We know the problem. What is the solution? Let me guess: "more stimulus"?