On the recovery in Europe’s periphery and loss socialization

It’s not fashionable to be optimistic about Europe. But I have been a Europe bull since last April when we moved from the front-loaded austerity paradigm to a backloaded paradigm. And beginning in June 2013, I saw the data moving in that direction. Now the data now fully support this stance. But that’s the cyclical view. What about the macro secular story? Here the story is a bit more murky as it involves loss socialization, the continuing bank – sovereign nexus, and huge government debt burdens without the central bank backstop of a sovereign currency issuer.

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It’s not fashionable to be optimistic about Europe. But I have been a Europe bull since last April when we moved from the front-loaded austerity paradigm to a backloaded paradigm. And beginning in June 2013, I saw the data moving in that direction. Now the data now fully support this stance. But that’s the cyclical view. What about the macro secular story? Here the story is a bit more murky as it involves loss socialization, the continuing bank – sovereign nexus, and huge government debt burdens without the central bank backstop of a sovereign currency issuer.

Right now, the story works virtuously because we have hit bottom cyclically. The bank – sovereign nexus actually works in a favourable direction now because the lower yields and higher bids for periphery government  bonds improves bank balance sheets without the banks having to do anything regarding writedowns, raising capital or selling assets. To the degree all euro area banks have capital shortfalls, it is the core banks where the problem will be greatest given the lack of upward movement in core sovereign bond prices. So while, the economy is on an upswing, the sovereign bond convergence gives asset markets in the periphery a breather that will eventually be felt in lower default rates and more credit availability. And deficits are increasingly being overlooked. We have heard nothing about austerity outside of Greece over the last few months. So there is less pressure on the fiscal front as well. That’s the cyclical story.

The secular story is a problematic one, especially given the aging demographics, the large social safety net and the neoliberal economic policy paradigm.

First, European sovereigns have no fiscal space and have no monetary independence, which means they must always fear a new solvency crisis that makes the bank – sovereign nexus an Achilles heel. When the business and credit cycle turns down, deficits will balloon, which, under the neoliberal paradigm that limits fiscal space, will trigger then austerity without any monetary offset. Sovereigns will have to fear insolvency in this environment because euro zone sovereign yields will diverge due to the sovereign risks brought to light by the downturn. Money will be sucked out of the economy again and bond yields will rise. This pro-cyclicality will amplify the downturn just as it did during the sovereign debt crisis.

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Second, the bank – sovereign nexus will work in reverse, with lower sovereign bond prices magnifying the fragility of bank balance sheets in the periphery. Banks will either need to sell assets or raise capital. But they will definitely restrict credit due to the capital shortfall. This will further magnify the crisis.

Third, the demographic issues and safety net automatic stabilizers will cause deficits to be larger than expected, meaning the fiscal austerity response will either need to be larger than expected or bond yields will rise more than expected. Again, this factor will further amplify the distress.

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Europe has to know this day is coming. The question is what they are doing to prepare.

If you go back to May 2012, when I said the European endgame was within sight, I made two sets of predictions. One set was on short- and medium-term measures to stop the immediate crisis. Monetisation: check, EuroTARP: check (sort of), Growth pact: check (sort of), target relaxation: check, ECB backstop: check (not convincing though). The other was a long-term set of predictions based on responses to the policy constraints going forward. This post is about the second set of predictions: Grexit, Fiscal union, Defaults, and Eurobonds.

If you look at what’s going on in Austria with Hypo Alpe Aldria, the loss socialization issue becomes clearer. This Austrian bank owned by the German sate savings bank Bayerische Landesbank, was nationalized due to the economic crisis. According to the FT, “Austria’s central bank governor has warned attempts to wind down regional lender Hypo Alpe-Adria could cost a further €3.6bn this year, potentially pushing the national budget deficit above the key 3 per cent limit.” No biggie, right? We are in a backloaded austerity paradigm now. There will be no repercussions here. But the debt will take Austria’s government debt to GDP over 80%. And so, just as with France, Italy, Germany, Spain, Ireland, the Netherlands, Belgium and elsewhere in the eurozone, the state has taken on private losses by nationalizing banks. It has socialized the losses, such that the fiscal space for the next downturn is more limited.

This is why we are seeing the bail-in rules come into play. Next go round, bail-ins will be the rule, not the exception. This will protect sovereigns from having to commit to loss socialization. And the hope is that contingent capital will be sufficient to prevent credit from collapsing. I have my doubts. And note that the huge increase in global debt to $100 trillion from just $70 trillion in 2007 is in large parts an increase in government debt. This represents both a loss socialization by public sectors to prevent writedowns and economic depression as well as a net increase in aggregate debt to maintain economic growth in places like China. In Europe, the government debt increases are enormous, and can be thought of as loss socialization.

Greece’s banks are too undercapitalized and the sovereign debt burden is too large for another recession not to be fatal. And by fatal I mean sovereign default with a large public sector participation and/or Grexit. We have to remember that Greece is still in a depression with more than a quarter unemployed and an economy 30% smaller than it was in 2007. How can Greece go through another default and crushing austerity in those circumstances. It can’t. Either it gets a massive writedown or it will need to leave the eurozone.

Elsewhere, Italy is too large to even think about default. The same is true with Spain. And that means that Europe needs to prepare for volatility in those two countries via stronger fiscal ties and eventually eurobonds that mutualize some of the sovereign debt.

All of this is a long way off, meaning that Europe needs enough time to get the mechanisms in place for this to work without having another recession-induced sovereign debt crisis. I believe European leaders understand this and this understanding plays a large role in why Europe is reluctant to press for sanctions against Russia over the Ukrainian conflict. Germany has the most to lose regarding sanctions. And somehow, France thinks it can play tough, acting as the chief US ally against Russia. I do not know why France is taking that stance but I don’t think it will come to anything within the EU.

In the meantime, the economy in Europe continues to improve and markets are rallying. We do, however, need to keep in mind that the longer-term outlook is very murky in Europe. An exogenous shock will bring the sovereign debt crisis back and the policy space this time will be much more limited than it was last time.

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