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Markets Insight December 21, 2011 1:37 pm How to avoid the ‘zombification’ of Europe
By George Magnus
The latest European summit captured headlines for the wrong reasons. The focus was on the spat between the UK and its EU partners, but it should have been on the more urgent fundamental issue of whether European leaders were any closer to reversing the ‘zombification’ of European economies, sovereign states, banks and financial instruments.
The short answer, unfortunately, is no.
The main problem is that European leaders have misdiagnosed the underlying causes of the crisis, ending up with a flawed agenda and inappropriate policies. They attribute the crisis to fiscal profligacy and the lack of adequate institutional fiscal mechanisms, rather than to the large external and competitiveness imbalances between member states. So, instead of coming up with an economic and debt adjustment strategy that distributes reform responsibilities symmetrically between debtors and creditors, leaders continue single-mindedly to pledge institutionalised fiscal discipline as the solution to the crisis. They have, in effect, sealed a pro-cyclical austerity zone.
In a quasi-depression environment, it is going to be difficult for debtor countries to secure the political and social cohesion to pursue the public sector governance, entitlement and labour market reforms needed to improve economic performance. It’s quite likely that eurozone gross domestic product will contract at a roughly 2 per cent rate over the coming few quarters, and the prospects beyond may not be much brighter. Eurozone economies are trapped in a circle of weak-growth or no-growth, ever-retreating fiscal and public debt targets, and more austerity that depresses growth.
Without growth, there is little likelihood of an improvement in the prospects for sovereign solvency, no matter how much European Central Bank and International Monetary Fund money is on the table. Even, or perhaps especially, with significant official financing, several eurozone sovereign bond markets will remain on official life support for a lengthy period.
Without trust in sovereign solvency, the credibility of what is being called fiscal union is on the line for at least two major reasons, even if it were possible legally for eurozone members to pursue their goals outside the Treaties, and even if the best laid plans for meeting these goals, including for eurozone-wide balanced budget constitutional amendments, were unanimously approved by parliaments and or referenda.
Firstly, although Germany would never agree to the permanent transfer of the Bundestag’s authority to a European agency, the absence of any intent to transform European sovereign bond markets into a giant joint liability European bond market is a major weakness. It is going to make it harder for investors to return to orderly sovereign debt financing in the weakest economies.
Secondly, a proper approach to fiscal union would have to recognise the interconnectedness between the creditworthiness of sovereigns and banks. In other words, the handmaiden of a new fiscal federalism in Europe means very little unless accompanied by banking federalism too.
A more believable plan would complement fiscal discipline procedures and penalties with the transfer of strong executive powers to, say, the European Banking Authority to hold sway over capital and liquidity requirements, deposit and market funding arrangements and guarantees, resolution authority, and mergers.
It is true that the ECB’s new three year liquidity measures will relieve financing stress for banks. Theoretically, the carry trade using cheap ECB money to finance Spanish and Italian bond purchases, could underpin strong local demand for bonds by local banks while protecting them from rollover risk. Markets may derive some comfort from this initiative in the short-term as default risks are reduced, but like all financing measures, it only buys time in which economic depression will undermine it. And by effectively binding banks and sovereigns even more closely together, it is a roundabout route to nationalisation of sovereign finance, which ironically, makes fragmentation of the euro more likely.
Financial markets are likely to regroup after the holidays to the sound of the rising crescendo of the next euro-crisis.
They will be looking warily at the forthcoming downgrade of the French sovereign, the resumption of large sovereign borrowing, an increasingly likely Greek default in March, and, just over the horizon, the French presidential election in early May. The ECB might step up its sovereign bond purchases, and or undertake quantitative easing. But such ECB actions will only gain traction if political leaders are willing to go beyond their austerity-depression pact to prevent zombie economies, institutions and financial instruments from souring the environment for everyone, including Germany, and even undermining the integrity of the euro-system itself.
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