Thursday, December 01, 2011

Europe's Seemingly Inevitable Slide Towards Financial Disaster...

Posted At : November 27, 2011 11:03 AM | Posted By : Satyajit Das
Related Categories: Global Sovereign Debt Crisis
A crucial element of the plan is the ability of Spain and Italy to take action to improve their finances and maintain access to funding at reasonable cost. The EU communique specifically refers to the need for actions by these two members at some length. There is considerable doubt as to whether this will occur.

Spain’s economy is weak, with low growth, low productivity and high reliance on debt. As the country has sought to bring its finances under control, Spain’s growth has slowed with an increase in the unemployment rate to 21% and youth unemployment above 40%. Spain’s banking sector remains heavily heavily exposed to the real estate with the likelihood of further losses. It is difficult to see Italy, weakened by internal political strife, making rapid progress to making required structural changes to its economy and cutting public debt.

The austerity and balanced budget measures, reinforced and reiterated in the plan, cannot deal with the primary problem - the deflation of the debt-fuelled bubble. Strict enforcement of limits on deficits and level of debt would prevent counter cyclical spending by Governments undermining economic recovery and lock the Euro-zone into a death spiral of budget deficits, further budget cuts and low growth.

The problem is compounded by the competitiveness gap between Northern and Southern countries, estimated at 30% difference in costs. For many of the weaker countries, the best option would be to devalue its currency in the same way that the US and Britain are debasing dollars and sterling respectively. The EU’s refusal to contemplate a break-up or restructuring of the Euro makes dealing with this problem difficult.

Unable to devalue or control interest rates, these weaker countries are trapped in a vicious and ultimately self-defeating cycle of cost reduction.
An additional problem is the internal imbalances exemplified by Germany’s large intra-Euro-Zone trade surplus at the expense of deficit states, especially the Club Med countries like Greece, Portugal, Spain and Italy. German reluctance to boosting spending and imports makes any chance of resolving the crisis even more remote.

German banks lent money to many countries to finance exports, which benefited Germany. Germany also gained export competitiveness from a weaker. Reluctance to confront these problems makes a comprehensive resolution of the crisis difficult.

The latest plan has bought time, though far less than generally assumed. The European debt endgame remains the same: fiscal union (greater integration of finances where Germany and the stronger economies subsidise the weaker economies); debt monetisation (the ECB prints money); or sovereign defaults.

The key element of the 27 October Plan was the unwillingness or inability of Germany and France to increase the size of their commitments. Germany is increasingly unwilling to increase its commitments. It is restricted by the German Constitutional Court’s decision, which makes it difficult to increase support for bailouts without a new constitution.

For the moment, Germany cannot or will not go above Euro 211 billion in guarantees for the bailout funds already committed –about 7% of its GDP. Fiscal integration would have a higher cost than Germany is willing to pay or can sustain without affecting the country’s creditworthiness. France is at the limit of its financial capacity. France’s GDP is around US$2 trillion and its debt to GDP around 82%. Following the assumption of the liabilities of the failed Franco-Belgium financier Dexia, the rating agencies have indicated that France faces a rating downgrade.

Netherlands, Finland and Luxembourg are too small to make much difference. Fragile coalition governments in Netherlands and Finland are increasingly reluctant to increase its commitments to the bailout process.

The ECB is not allowed and seemingly unwilling to print money. Theoretically, it would need a change in European Treaties although the ECB has stretched its operational limits. Germany’s Bundesbank opposes debt monetisation. There would be deep-seated unease about printing money in Germany, which is still haunted by the memory of hyperinflation in the Weimar period.

The accepted view is that, in the final analysis, Germany will embrace fiscal integration or allow printing money. This assumes that a cost-benefit analysis indicate that this would be less costly than a disorderly break-up of the Euro-zone and an integrated European monetary system. This ignores a deep-seated German mistrust of modern finance as well as a strong belief in a hard currency and stable money. Based on their own history, Germans believe that this is essential to economic and social stability. It would be unsurprising to see Germany refuse the type of monetary accommodation and open-ended commitment necessary to resolve the crisis by either fiscal union or debt monetisation.
Unless restructuring of the Euro, fiscal union or debt monetisation can be considered, sovereign defaults may be the only option available.

© 2011 Satyajit Das All Rights Reserved. Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (November 2011)

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