Monday 10 May 2010

Europe has bought short-term stability at the expense of long-term survival

I started work this morning aiming for productivity, by instead was distracted by yet more outlandish headlines. Yesterday the European Central Bank decided the massive resumption of quantitative easing by agreeing, for the first time, to intervene directly into public and private debt markets in the Eurozone. This is a massive departure for an institution which, until yesterday, was legally barred from purchasing government debt.

In addition to this, the Eurozone states agreed to EUR 500 bln in loan guarantees in a “European Stabilisation Mechanism”, designed to inject liquidity in panic situations. The total price of the package (including associated IMF commitments) is calculated at roughly $ 1 trillion.

It seems that European leaders can move fast when the main economies are threatened: their alacrity to announce yet new spending in the space of about 4 days is a major contrast with their dithering on Greece, which took over 4 months.

And yet, I wonder if this is really the correct way to go. We are developing yet another layer of structural stability which will be dominated by political consideration, while the dual root cause of the problem—burgeoning public debt and unrestricted short-selling—go unaddressed.

In fact, these are not root causes at all, but symptoms. The root cause is a declining economic and demographic situation in most OECD countries which is putting the post-WWII socio-economic model at risk. Pumping more money into Eurozone public administration is a valid policy response, only if there are signs that these administrations are taking meaningful and sustainable measures to change their fundamental economic and social models.

Are they? I’m in “ground zero” of this sovereign debt contagion, and I don’t many realistic solutions being promoted by the Socialist government. Greece still does not have a list of basic priorities or clusters for investment; its national educational policies does not link to its economic policy; it’s doing little to promote productivity and innovation in the economy or the workforce; it’s doing little to seriously reform the public sector to deliver lean, value-adding services.

In fact, the entire European, and to a lesser extent North American debate is being dominated by the past, not the future. Public policy seems to be oriented towards crafting a nation of placid consumers rather than producers or innovators. The link between public investment in innovation, and actual innovation delivered, is abysmal. The Common Market exists in name, but not in practice. Bureaucratic complexity across the EU is astounding: it’s still impossible, for instance, to electronically file a single corporate income tax statement for a company or individual operating in more than one EU country.

On January 19th, I posted my concern about the coming crash of 2010. The main hypothesis was that the end of quantitative easing would occur in the early spring, leading to a major financial contagion hitting the weaker Eurozone economies. Unfortunately, this scenario turned out to be true. Check my conclusions on this post:

Conclusion: we will probably (55-65% probability) see a rapid contagion in sovereign debt markets by March or April 2010 if QE ends and governments are forced to rely on the open market for funding. Public sector debt will crowd out private sector issues, exacerbating the existing liquidity crisis and leading to a renewed “flight” to alternative asset classes (such as gold) or to “safe havens” as the panic spreads. For smaller, exposed markets such as Greece, Ireland or Spain, this contagion will constitute a major barrier to future debt issues. This will lead to the need for the ECB or larger European countries such as Germany to buy or guarantee this debt, changing for good the rules of the game.

This is exactly what has happened.

If you are a follower of Paul Krugman, the answer now is yet more quantitative easing, more financial stimulous and deficit spending, so governments can buy stability at any price. Normally, I would agree with this hypothesis. But given the absolutely dismal record of most European or US administrations in deficit reduction or general economic policy in the past 10-15 years, do we really expect this to happen?

So here are my next conclusions:

In May 2010, the governments of the Eurozone in conjunction with the IMF and the European Central Bank announced a new financial stabilisation package. While this enables short-term financial stability, it risks the long-term equilibrium between public and private spending in the Eurozone and, by extension, North America. It masks the true liabilities in sovereign debt, and removes an important part of the external financial discipline for national expenditure.

The root cause of the problem—that national governments are spending too much, and are relying either on quantitative easing or financial sector borrowing—has not been addressed.

As a result, neither the United States, nor many European countries are taking the meaningful steps to cut public sector expenditure, or at least allocate it to those sectors capable of producing employment and economic value.

The medium-term impacts of this decision will be to:

• Increase inflation as central banks resort to printing more money and expand their balance sheets radically;

• Place the basic credit policies of the ECB and the Fed under question;

• Increase the sense of moral hazard in the financial sector, as both banks and economies (or sovereign debt) became “too big to fail”;

• Increase the trend in public sector expenditure and unfunded liabilities, leading to a vicious cycle of higher taxation and unproductive spending, at a time when demographic changes were leading to an inexorable change in the basic social and economic fabric of most countries;

• Increase the total national debt (public + corporate + household) of most European countries as well as the United States;

• Cause business investment to increasingly be channeled to offshore or lower-tax locations;

• Increase the political power of Germany and, by extension 2-3 other Eurozone countries at the expense of the entire European Union. Rarely has decision-making in Europe been dominated so extensively by Germany, and the previous occasions when this occurred were not happy times.

I believe that with this current decision, the Eurozone has bought time and stability, without a real commitment to fundamental public sector reform. The root causes of the problem are firmly in place, and accelerate as demographics change and Asian economies become more competitive. An alternative solution should be found, before the potential scale of the cost of dealing with these root causes becomes prohibitive.

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