European Economic Commentary Week Ended 4/3/2011

As other investment advisors have told me, institutional investors are blasé about the global financial threat inherent in the eurozone currently, because they either believe the eurozone will just keep muddling along or it is doomed to collapse and the ECB and EU will provide sufficient backstop; these high level investors just do not want to think about the threat to the global financial system.  Interestingly, the same holds true for the high probability of a housing double dip in the United States and a financial system which has become more concentrated and systemically dangerous, more politically powerful,  and has successfully resisted significant regulatory change.  At the same time China is on the brink of slowing and slowing rapidly until it suddenly jumps back on economic growth with excessive investment.  In the past, I have characterized the Chinese adjustment problem as similar to a driver in an automobile with two accelerators and two brakes.  These are all serious potential threats to the global financial system.

Last week we wrote about "Reorganizing Irish Banks" in which the ECB has refused to provide necessary medium term bridge financing, in which the EU is not willing to discuss lower interest rates for loans to Ireland, and the Irish people are becoming increasingly dissatisfied with how other European banks and countries are being beneficially fire-walled at the expense of the Irish people.  That article took a lot of the European commentary for the week, but much has been left.  I realize my former weekly "Economic and Market Commentary" were very popular, but they took an average of eight hours or more to organize and write and after two weeks I was only half finished with the week ending 12/25/2010.


While the QNA report showed annual declines in Ireland's GDP and GNP were <1%> and <2.1%>, the year to year quarter comparison showed a real GNP gain of 2.7% and a GDP decline of <.6%>.  The nominal effects on the budget deficit were not encouraging for a country which does not have a fiat currency.

During 2010, the average price for a house in Ireland dropped 10.8%.

In the UK anti-austerity demonstrations were allowed by authorities to get out of hand, despite knowing the plans of fringe groups to be disruptive and destructive in other wise peaceful demonstrations.  The UK Chancellor defended the austerity cuts as necessary to create growth and jobs.  As we have written numerous times, there is significant economic theory from different economic theoretical schools which shows the opposite will happen, except for a small elite class.  Meanwhile, UK productivity is disappearing, although I doubt it is the result of rising business regulation and more the result of less demand creating less investment.

In France right wing nationalists have softened their speech to appeal to larger segment of the French population and are gaining support.  The True Finns, a nationalist party, is expected to get 18-30% in the elections in Finland.  The nationalist party in the Netherlands, as the third largest party, remains a policy influential coalition partner in the government.  In Germany, the nationalist concerns with immigration, debt and budgets, and EU fiscal transfers have caused divisions which have allowed the left Greens and SPD to benefit in Baden-Wurttemberg state election.

Greek unemployment was up to 14.8% in December and austerity is making the social problems more toxic.  Increased demonstrations and strikes are occurring and increased fees and taxes are being ignored by the people.

It has been popular to blame the current eurozone problems on unit labor cost in the different countries and the degree of debt to GDP.  While the period after the adoption of the euro did show a significant increase in unit labor costs, except for Germany, debt was not a problem until the global financial crisis.  Since nominal depreciations are precluded in the eurozone and fiscal transfers are not sufficiently available in the monetary union which has failed to provide fiscal union, the common currency is central to the problem.  Looking at unit labor costs in relation to other competitiveness indicators would appear to show that it is a misguided analysis and that internal devaluations will not work as the real lack of competitiveness comes in the export basket of each nation --- and I would add in what they import.  Unfortunately, movements towards fiscal centralization have been to enforce fiscal stringency and not to reduce the problems of a common currency.  Consequently, continued austerity, as the Australian economist Bill Mitchell has inveighed, will mean a slow, sluggish recovery in Europe.

While Spain has been actively building a firewall against contagion, its efforts to bolster the capital strength of its banks is being constantly questioned.  The merger of four Spanish cajas (savings banks) failed when they asked for 2.78 billion euro from the Fund of Orderly Bank Restructuring after the Bank of Spain had estimated their need at half that amount (1.45 billion euro).  Later in the week, another savings bank, CAM, was not able to complete a merge and the Bank of Spain began hunting for a buyer.  This has been seen by many as a prelude to what will come.  While the Bank of Spain has estimated savings banks capitalization needs at 15 billion euro, others are estimating 23.6-29.2 billion euro.  I have maintained for some time the Spain is the keystone and will be the next target after Portugal whether it deserves to be or not.  Meanwhile the Bank of Spain is estimating unemployment will rise to 20.7%.  This unemployment is wide spread across age and education. While the EU dithers and looks to punish rather than preemptively help, Norway's (not in the eurozone) sovereign wealth fund is looking to invest in Spanish companies. 

The new Basel III bank rules, which German banks are fighting, may mean that European banks have to raise 2.3 billion euro in capitalization at the same time insurers, at the same time as the largest buyers of bonds, are be forced to limit bond purchases under the EU Solvency II rules.

Portuguese debt yields soared.  The resignation of Portugal's government means it will be very difficult to negotiate a bailout, which is not politically popular in Portugal, during an election.  S & P downgraded Portugal's five largest banks for what was essentially seen as not financial reasons but the political situation.  The Portuguese opposition party has endorsed a plan of budget cuts without tax increases as a conservative attempt to gain votes despite heavy public opinion against austerity.  The Portuguese government maintains it can meet its bond redemptions in 2011, although there are those who say it will not have the liquidity to meet May redemptions.  The government also announced it had a budget deficit of 8.6% rather than the target 7.3% in 2010.  When Portugal did sell 1.6 billion euro of short term bonds due June 2012, it was at 5.793% versus 4.331% on one year bonds sold on March 16th, just two weeks earlier.

A German finance minister has joined several other European countries in suggesting covered bonds be included in Level 1 assets as there are not enough sovereign bonds to fulfill the asset level needs for banks.

As we wrote last week, the European Council's emergency funding creation the ESM is being recognized as a threat to the perceived credit worthiness and credit ratings of peripheral countries, because it would require default and/or restructuring of debt for assistance.  Portugal and Greece were both downgraded by S & P on concerns the ESM would force them to restructure debt and S & P called the ESM a negative game changer.  Even the Italians have shown skepticism and referred to the ESM reforms as the Germanization of the euro.  The French, despite France's faithful companion role with Germany, have expressed the observation that the ESM is imperfect and requires immediate revision. While the ESM has been hailed as the Grand Bargain, it has failed to create an exit from crisis at an acceptable political cost, it has complicated the fiscal costs of the financial crisis, and it has failed to create a mechanism which will deal with and prevent fiscal crisis in a system which does not allow orderly fiscal transfers.  Munchau has also pointed out the ESM "Grand Bargain" will be phased in and not fully funded until 2018 to appease German voters, everyone is guaranteeing everyone, the EFSF has no capital making default a risk to guarantors and is the emergency mechanism until 2013, and the fiscal adjustments of a guaranteed payment will not be politically acceptable to national governments.  Institutional ownership of Greek and Portuguese bonds has melted away to the point where not even short, via demand to borrow bonds, positions are dead. The S & P lowered Ireland's credit rating to BBB+ from A- citing the  possibility of restructuring under the ESM.  The IMF is, according to Der Spiegel, rumored to be urging the Greek government to restructure its debt now with lower interest rates, extended maturities, or actual haircuts on the debt.

The ECB has informed Ireland that if it wants a medium term funding facility, it will need to guarantee the debt.  Prior to the release of the Irish bank stress tests, the Bank of Ireland made a plea to the government to avoid nationalization.  The ECB does not fear default by Ireland or other peripheral countries, because the central banks of all eurozone countries are borrowers from the ECB, which means the risk is piling on other central banks and money flows from one national central bank indirectly through the eurosystem.  This means, for example, that Germany has actually provided more funding than estimated.  The European banking system is highly interconnected with, for instance, German banks exposed to 22% of Greek external debt, 21% of Spain's external debt, 20% of Ireland's, and 14% of Italy's.  While the ECB sees hidden burden sharing, the Irish do not see burden sharing.  The eurozone is flying without a safety net and with a higher possibility of a potential significant drop in aggregate demand than is discounted.  The ECB and the eurozone cannot afford a sovereign default and, yet, the newly designed emergency fund would require default and restructuring before assistance is given a country.  How is the ESM "Grand Bargain" not the the Grand Shaft for the peripheral countries?

Despite having been rebuffed by the ECB on lower interest rates on its bailout, Ireland still intends to argue for lower interest rates at future EU meetings and with the visiting IMF team.  As I have argued in past articles and as was discussed in the above paragraph, if the ECB ultimately fails to provide the medium term funding facility, is the ECB willing to take the blame for the ECB and other European national central banks being left with what would remain of the Irish banks and the losses of the Irish bank senior bond holders, who are banks in Germany, France and the UK among others.  Politically, the new Irish government sees no possibility in turning back on their election promises to the people.  Some informed commentators in Ireland believe the recent bank stress tests did not disclose anything which was unexpected and the more serious problem are domestic and international market commentators who do not understand Ireland's financial condition and have ulterior publicity motives in claiming default is inevitable.  What begs the question is, how will the Irish government answer to its people if the ECB and European Council run the country for the greater benefit of mainland Europe?

The possibility the ECB will raise the interest rate in response to German inflation is ignoring the very negative economic impact such a move will have on the peripheral countries.  It will be like throwing oil on the fire.  While some might argue that inflation will cause greater cohesion in unit labor costs as Germany adjusts internally, it is still acknowledged that ample discord will result within the eurozone over inflation and the ECB response.  Jurgen Stark has confused the states within the fiscal union of the United States with the nations of the eurozone and jumps from the Fed does not create policy for individual states (because they are part of a fiscal union with fiscal transfers) to the ECB cannot tailor monetary policy for individual eurozone (which has no fiscal union) countries.  They are not comparable except in contrast.  As far as Stark and others are concerned, including the ECB, the peripheral countries can suck it up and suffer.  The German view prevailed at the European Council and provided limited liabilities in an emergency funding ESM mechanism, which will not take effect until 2013 but is now negatively affecting the peripheral countries credit worthiness and ratings.  The German viewpoint is actually accelerating the problem of domino credit attack and crisis on one eurozone country after another.  Bill Mitchell has elaborated in lengthy detail on how the eurozone is pursuing the wrong goals.

This completes this European/eurozone economic commentary for the week ended 4/2/2011.  It took over six hours and I have not touched any market commentary for that week or any general economic commentary, or United States, China, Japan, or the Middle East of which I have plenty left.

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