Very quiet session today, but notable in that modest good news on China trade did not simulate the m...
Europe's financial crisis is now clearly a political crisis--which, unfortunately, will make it harder to fix
11/10/2011 2:43 pm EST
Just in case you needed proof, the stock market moves of the last few days should have convinced you that the euro debt crisis is a political crisis and not, now, a financial crisis.
That’s not to say there aren’t financial repercussions. The effects on European, U.S., and developing country financial markets are huge. And, I hate to say this, but we’ve just started to see the capital crunch at European banks start to ripple out into the global economy.
But the huge sell off on Wednesday November 9 was primarily a judgment on the politics of Italy, the European Central Bank, and Germany. The market said loud and clear that it doesn’t think the leaders of those bodies have the political will to fix the crisis that is now engulfing Italy. And without that political will the next step is the break up of the euro.
Not today. But, the market is saying, the breakup is absolutely certain. Prove us wrong, investors who are selling the euro—and the global economy-- are saying. And so far the silence in response is deafening.
On Tuesday, November 8, the market got excited—by Italian politics. News that Italian Prime Minister Silvio Berlusconi had promised that he would resign after the Italian Parliament approved a new austerity package required by the EuroZone produced a rally in European and U.S. shares.
And then, overnight, the market focused on exactly how vague that promise was and on the dysfunctional realities of Italian politics. The austerity package that was supposed to lead to Berlusconi’s departure hadn’t, as of Wednesday afternoon, been delivered to the budget committee of the Italian Senate. And it looked like nobody would vote on the package until next week.
And then what? If Berlusconi resigned then, would it be in favor of a caretaker government of technocrats, as many hope, that could push through austerity measures and economic reforms?
Frankly, it didn’t look like any of the proposed leaders of such a government would have the political backing to get the needed changes into law.
And maybe, politicians like the Northern League’s Umberto Bossi were saying, any post-Berlusconi government should be headed by the leader of Berlusconi’s party.
And maybe rather than a caretaker government to push through reforms, everything should wait for new elections—in February or March.
In other words, nothing in Italy might change at all. Which is exactly what the financial markets fear and is the source of the panic that drove yields on Italian government 10-year bonds to a peak near 7.7% on Wednesday.
But Italy could act. And in fact it did so—sort of—after the Wednesday rout. The Senate and the Chamber of Deputies agreed on a faster schedule so that the austerity package would be voted on this week instead and Berlusconi might be out the door in a few days. But that still leaves the question of who will head a successor government and what the agenda of that government will be up in the air.
But even this limited move is a reminder that the Italian crisis is actually easy to fix compared to that in Greece, for which there may not be any solution except default.
The Berlusconi government has already passed an austerity and reform package designed to balance Italy’s budget by 2013. But that plan, European Union inspectors have said recently isn’t sufficient to get to balance by 2013 since economic growth in Italy (and in all of Europe) has slowed and is slowing further. Hence the need for a new austerity package, the one that hadn’t been delivered to the Italian Senate as of Wednesday afternoon. (It was finally delivered on Wednesday evening.)
The size of that new austerity package? Just $63 billion.
This crisis is about $63 billion?
No way. Italy is a relatively rich country. It could come up with that kind of money. In fact Italy’s private wealth of 10 trillion euros is five times the country’s public debt of 2 trillion euros. Italy isn’t bust. Far from it.
But that private wealth is irrelevant if Italian politicians don’t have the will to tap it. Or the will to get the country’s bloated public sector under control. Of the will to reform Italy’s pension system. Or to …. (See any parallels to the financial situation in the United States? Of course not.)
And that’s what the markets fear—and what has created a panic that threatens Italy’s access to the financial markets.
The markets essentially said on Wednesday that they aren’t going to lend Italy any more money, except at ruinously high interest rates, until it gets its political act together. And that’s a big deal since Italy needs to refinance about 300 billion euros (a little over $400 billion) in 2013. Doing it at 7.5% interest would blow out the government budget and require yet more austerity cuts in order to get it back into balance.
But it’s not just Italian politicians that the market judged and found wanting on Wednesday. German officials such as Finance Minister Wolfgang Schaeuble have responded to the Italian crisis by saying that Italy should go to the European Financial Stability Fund for financial rescue.
The market knows that’s nonsense.
Italy needs about 260 billion euros to get it through the next six months if it is locked out of the financial markets by ruinously higher interest rates. The European Financial Stability Fund has only 250 billion euros left of its original 440 billion euros—and of that 139 billion euros belong to Italy. Subtract what Italy can’t borrow from itself and that 250 billion balance goes down to 110 billion. Clearly not enough to do the job.
Could the European Union fix this problem by increasing the firepower of the facility? Sure, but the markets are saying that German politicians will refuse to pony up cash and that plans to leverage the fund will take too long to put into action.
By the way, the International Monetary Fund, the other source of cash that European politicians are so fond of waving about these days, doesn’t have the money either. The IMF has only 300 billion euros on hand. Supporting Italy for six months would pretty much clean the fund out.
That leaves the European Central Bank. But here the markets are saying that while the European Central Bank has the necessary power—it can effectively print all the money it might need—it won’t use it because of the politics of the bank. The hard money contingent—Finland, the Netherlands, and most vocally Germany—have publicly stated that they think the bank’s job is assuring price stability (that is, fighting inflation) and not acting as the lender of last resort in this crisis. The bank, the markets believe, won’t throw aside its roots in the inflation-fighting Bundesbank and become a European Federal Reserve.
At the end of the day on Wednesday, the markets got confirmation that there is no such thing as being too cynical about the willingness of European politicians to act. Sources that included Reuters and Germany’s Handelsblatt reported that Germany and France were in talks to break up the EuroZone.
"France and Germany have had intense consultations on this issue over the last months, at all levels,” a senior European Union official in Brussels told Reuters. "We need to move very cautiously, but the truth is that we need to establish exactly the list of those who don't want to be part of the club and those who simply cannot be part," the official said.
Does that seem nuts to you? After all that’s not the kind of thing that reassures the markets during a crisis. And it’s not a solution to the current problem since any change in who belongs to the euro would require treaty amendments that would take months to negotiate.
But I don’t think the report is crazy. In a speech to students in Strasbourg on November 8 French President Nicholas Sarkozy said that a two-speed Europe was the only model for the future.
And German Chancellor Angela Merkel has called for changes to the European Union treaty that would include tighter integration among EuroZone members and a change in who belonged to the euro. European Union officials have told Reuters that changing the European Union treaty will be on the formal agenda at a December 9 summit in Brussels.
That probably doesn’t strike the markets as a solution to the current crisis.
So where does that leave us in this crisis?
It leaves us watching EuroZone leaders outside Italy attempt—again—to build a firewall that will prevent the crisis from spreading further. This time the firewall is designed to stop the crisis before it engulfs France and the mechanism is a rule that requires selected big European banks to raise more capital. The idea, I guess, is that the markets will decide the European banking system is safe and solid if banks meet these rules. (Why this requirement should convince anyone is beyond me since it so clearly bends accounting rules to favor some banks. Especially French banks.)
As of Thursday the financial markets didn’t look like they were buying that effort. Yields on 10-year French government bonds climbed 0.2 percentage points that day.
Unfortunately, even with this extra capital, markets know that if Italy goes down, French banks go down. French banks hold 100 billion euros of Italian government debt and 300 billion euros of Italian private debt. That’s more than enough exposure to rattle the big French banks.
The perverse effect of this attempt at building a firewall to prevent Italy from torching other countries in Europe may be a global credit crisis that hits developing economies especially hard. European banks have made it clear that they will meet the new 9% capital ratio rules by shrinking their balance sheets. That means selling off existing assets and making fewer new loans. That’s a big deal since continental European banks are the source of about 21%--or $530 billion—of the outstanding international bank loans in Asia (excluding Japan) at the end of the second quarter of 2011, according to the Bank for International Settlements. If loans are harder to get or simply become more expensive, that will be a drag on growth for these economies in a world where economic growth in general is slowing.
Could the market be wrong in its Wednesday panic? Certainly.
Italian politics could be less than completely dysfunctional and a caretaker government with a degree of credibility with the financial markets could emerge from the morass in Rome. That looks possible with Italian President Giorgio Napolitano doing his best to usher Berlusconi out the door and to create an agreement on a new government. And that government could push enough reforms to restore some faith in Italy’s finances in the financial markets. Remember that although Italy faces huge long-term challenges in generating sufficient economic growth and in increasing productivity, the country is by no means broke in the near term unless it wants to be.
But I don’t think any action in Rome alone will be enough to turn the tide.
Somebody on the EuroZone stage will have to step up and prove the markets wrong. I don’t see this coming from France’s Sarkozy, who is too busy managing his own domestic political battles and his own austerity budget. I certainly don’t see this from Germany’s Merkel who has been hamstrung by the German constitutional court and the Bundestag.
The only possibility is the European Central Bank’s new president Mario Draghi, who could—after Italy has proven that it’s worth rescuing by passing the austerity package—move to buy enough Italian bonds to get yields back below 7%. The bank has the power. Does it have the political will?
If not Draghi, who else? I don’t see another candidate.
I think we’ll know within the next two weeks. If Italy passes the austerity package and the European Central Bank intervenes enough—more than it did on Thursday even though that was enough to bring yields slightly below 7%--to start bringing yields on Italian government debt down, we’ll have our answer.
If not, the crisis will get worse.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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