The Real Problem Plaguing Europe
09/28/2012 9:00 am EST
Numerous financial rescues and fixes have come and gone, each one setting off a rally in the markets. Here's why, despite the solutions, the crisis won't go away, writes MoneyShow's Jim Jubak, also of Jubak's Picks.
Remember how optimistic markets were in June, when European leaders said they would provide up to €100 billion to recapitalize Spanish banks?
Or more recently, how about the big rally set off by the September 6 announcement by European Central Bank President Mario Draghi of a clear plan for supporting Spanish and Italian government bonds with potentially unlimited buying, using Eurozone rescue funds and ultimately the European Central Bank itself?
How did we so quickly go from hope and rally to gloom and panicky selling in European—and to some extent, global—financial markets? (And now maybe back again?)
The Wrong View
This shift is not surprising if you remember this: The stock and bond markets insist on thinking about the Eurozone debt crunch—and its specific national franchises of the Greek debt crisis, the Spanish debt crisis, etc.—as a financial crisis.
In that context, the market gets giddy when someone proposes a financial fix, such as central bank bond-buying, a recapitalization of Spanish banks, or a new round of budget austerity in Greece.
And then the financial markets get blindsided—and react by selling—when events remind us that this crisis is no longer primarily financial, if indeed it ever was. Instead, it's a political and economic crisis.
There's nothing like pictures of Greeks throwing Molotov cocktails at police to bring this home. Or talk of a potential breakup of Spain after November elections in Catalonia that have turned into a referendum on Catalan independence.
And there's nothing like talk that the Spanish budget (introduced Thursday) would let the ECB start buying Spanish debt to send the markets back into rally mode—at least for a day. How long will it last? Will bond buying fix the problem?
If you recast your thinking about the crisis into political and economic terms—instead of purely financial ones—the questions you want to answer become very different. The questions aren't whether Spain can patch together a new budget that keeps the deficit from spinning out of control this year. Or whether climbing yields on Spanish government debt will force the government of Prime Minister Mariano Rajoy to formally request a program of bond buying and supervised economic reforms.
Instead, the questions are whether the populations of Greece, Spain, Portugal, and Italy have been so crushed by the collapse of their economies that their governments can no longer deliver on the promises made to their Eurozone creditors. And whether the populations of those creditor countries are suffering such bailout fatigue that their governments are thinking of walking away from deals and promises to support the euro.
Bandages Aren't Enough
The first set of questions—the financial ones—will move markets in the short term. And in that short term, those financial problems are susceptible to another Band-Aid solution.
I think the next two weeks are likely to bring some plan that will move Spain to ask for a bond-buying program. That announcement would lead to another short-term rally.
The second set of questions—the economic and political ones—aren't nearly as easy to address. They certainly aren't amenable to a financial fix. My worry is that the Eurozone has spent all of its political capital, and that its leaders are now looking for solutions that amount to cutting and running in order to preserve their own positions, and to limit the damage to their own narrowly defined self-interests.
My worry is that we're entering the very worst part of the crisis, when all illusions that relatively easy fixes will work (if they were ever implemented, of course) are stripped away, and the Eurozone falls into confusion as it attempts to reconfigure itself without Greece, potentially without Finland, and possibly without Spain.
This confusion would—unfortunately for the global economy and global markets—come at a time of potential confusion in the United States (the approaching fiscal cliff) and China (where current stimulus efforts haven't reversed the decline in growth). Kicking the can down the road looks as if it has resulted in turning three individual problems into a coordinated mess.
Let me start in Europe and then sketch the larger picture.|pagebreak|
No Answer in Europolitics
My evidence for political pessimism about Europe?
I'm increasingly inclined to believe speculation that says one party or another in Greece doesn't want current negotiations to result in a deal. If not, why would the International Monetary Fund, the only member of the creditor troika (which also includes the European Commission and the ECB) with actual experience in conducting an economic reorganization, be so unwilling to cut the Greek government any slack?
The latest demand is that the Greek government immediately fire 15,000 government workers. That may make budgetary sense, but politically it's almost unthinkable.
One conclusion is that the IMF has decided that the current course of wrenching austerity will not result in an end to the Greek debt crisis in any reasonable time frame. (On Wednesday, Fitch Ratings predicted that the ratio of debt to gross domestic product for Greece would increase from 165% in 2012 to 180% in 2014.)
The IMF, this thinking goes, has decided that holders of Greek debt will have to take another write-down because there is no way to restructure the Greek economy as long as the country carries its current level of debt.
A big problem here, of course, is that the biggest Greek creditor is the ECB, which didn't participate in the first round of write-downs. Getting the ECB to agree to take a hit won't be easy.
But the alternative, this analysis argues, is continuing to pour money into a lost cause. And this simply isn't acceptable to an IMF that already faces considerable donor backlash from its non-European members.
The Pain in Spain
In Spain, Rajoy's government faces what amounts to a regional insurrection on top of the popular revolt that has sent tens of thousands of Spaniards into the streets.
If the government makes a formal request for bond-buying help, it will have to agree to a supervised program of economic reforms. That could result in a financial market pop that would send bond yields down again—and that would help with a Spanish budget that threatens to break the government's pledge to reduce its deficit to 4.5% in 2013 from 6.3% this year.
On the current trend, interest payments in 2013 are projected to increase by €9 billion ($11.6 billion) over the government's 2012 budget projections, to €38 billion. That may not sound like much, but remember that Spain's GDP is just €1.1 trillion.
The problem, as the draft budget for 2013 released Thursday shows, is that meeting that 4.5% target will require even deeper austerity measures. The new budget requires an additional €20 billion in tax increases and spending cuts. The cuts, early reads of the budget say, will come mostly out of social spending.
Most of the new tax revenue will come from an increase in the value-added tax—proposed earlier in the year and set to take effect September 1, 2013—to 21% from 18%. Think about how an increase to a 21% sales tax—the US version of the European value-added tax—would hit your family budget.
This is likely to worsen the political problems in Spain. Madrid faces a series of regional elections that could seriously erode support for the national government:
- An October 21 election in Galicia could see Rajoy's People's Party lose in Rajoy's home region.
- An election the same day in the Basque region could see parties advocating more independence for the Basque region win more seats.
- And then there's the big contest in Catalonia, the largest regional economy in Spain. Catalonia has moved up regional elections to November 25. Catalan President Artur Mas has made clear that the goal is to get enough support to put a referendum on independence for Catalonia on the ballot.
This wouldn't all be quite so important if the central government weren't trying to get the regional governments to bring their budget deficits under control. The goal is to reduce regional deficits to no more than 1.5%. The regions say reducing deficits to that level isn't possible.
Andalucía, the most populous region in Spain, has just asked Madrid for €5 billion from a fund Madrid set up to bail out regional governments. Catalonia has asked for its own €5 billion. You'd think that might have put the brakes on the move for local independence. But Catalans say that Madrid takes too much in taxes from the region—the home of about 20% of Spanish GDP—and returns too little.
That is a hot-button issue in Catalonia, since in 2010 the Spanish constitutional court rejected a statute of autonomy for Catalonia that would have given the region the same control of its taxes that the Basque region already enjoys. Rajoy's party, then out of power, brought the petition to the court that led to the decision.
It's hard to see in these circumstances how a Rajoy government can deliver the austerity that Spain's European creditors demand, or how it can submit to even a weak version of the supervision Greece now faces.
And, if you look at the politics of the rest of the Eurozone, it's not clear that the creditor countries will deliver on their promises.|pagebreak|
For example, in June, Germany, Finland, and the Netherlands seemed to have agreed that the permanent bailout fund, the European Stability Mechanism, could recapitalize Spanish banks directly. That would avoid the pattern of national governments adding to their debt so they could send the money on to banks.
But on Tuesday, the Germans, Dutch, and Finns said that this would be possible only as a last resort, and only after the Eurozone decided on a new unified system of bank supervision. Since a decision on bank supervision is months away (thanks to opposition from Germany), any recapitalization of Spanish banks by the European Stability Mechanism is very far away.
Most discussion of bailout fatigue among creditor nations has focused on Germany, but Finland is actually a more-advanced case. The Finns have been the toughest negotiators in bailout deals to date, demanding collateral not granted to any other creditor.
And Finland is even more leery than Germany of being sucked into further bailouts, because of the relatively smaller size of the Finnish economy, and because its rapidly aging population will soon eat into the country's own finances. There's increasing speculation that Finland—not Greece—will be the first country to leave the euro.
Too Many Problems at Once
What happens next? I expect another financial Band-Aid, most probably some deal that gets Spain the money it needs to recapitalize its banks, along with bond-buying support, in exchange for a program that is light on supervision and that focuses on economic reforms.
That would likely trigger another market rally. But that rally would fade as it became clear that the politics of the debt crisis were continuing to deteriorate, and that the financial fix didn't amount to an economic fix.
How big a problem this would be for the global economy and global financial markets depends on what is happening simultaneously in the United States and China. If the US Congress, post-election, descends into wrangling instead of addressing the fiscal cliff, markets could turn nasty indeed. I'm very concerned about December and January.
If China looks at the potential for even slower economies in the Eurozone—the biggest market for China's exports—and reacts with even more-aggressive stimulus, I think that could help counterbalance continued confusion from Europe. (It wouldn't be enough to balance out simultaneous problems in Europe and the United States.)
If that stimulus (added to current efforts) doesn't provide signs that growth has bottomed in the third or fourth quarter, investors could be facing a very big problem from yet another direction in January.If we do get one more bounce from a financial fix in Europe in the coming weeks, I'd think of it as an opportunity to reduce risk in preparation for what could be a very challenging start to 2013. Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Freeport McMoRan Copper & Gold, Goldcorp, and Yamana Gold as of the end of June. For a full list of the stocks in the fund as of the end of June, see the fund’s portfolio here.