Thursday 21 July 2011

Waiting for the Next Eurozone Summit (Haven't we Seen this Film Before?)

There is little substantial progress to report since my last blog post on the Greek debt crisis (The Greek Debt Crisis and International Contagion: July 13, 2011). But there is much to report by way of commentary.

I was most interested by an article published by Larry Summers, the former US Treasury Secretary, on Reuters on Sunday, 17 July, in which he states:

"It is to be hoped that European officials can engineer a decisive change in direction but if not, the world can no longer afford the deference that the IMF and non-European G20 officials have shown toward European policy makers over the last 15 months"

In this article, Summers offers three realties which must be recognised if there is a chance of success at resolving the crisis:

a. The maintenance of systemic confidence of essential in a financial crisis. Given the rise in Spanish and Italian bond rates in the past week, it’s becoming clear that system confidence is failing.

b. No country can be expected to generate huge primary surpluses for long periods to the benefit of foreign creditors. It is ironic that the European Union and IMF have apparently so quickly forgotten the lessons of German reparations after the First World War.

c. Whether a country is solvent depends on only on domestic policies but on the broader economic context. This has been a consistent observation I’ve been making: see for instance my post of November 28, 2010: Watching the Decline:

The micro- and macro-economic environment against which Greece is making its reforms appears to be almost ignored. We are working in an environment characterised by three major trends:

•  The long-term trend of declining international competitiveness, both within Greece, but also within the EU. In this environment, Asian producers are increasingly winning market and value share, and climbing the innovation ladder. Greek and wider European producers, in contrast, rely excessively on protected markets or subsidy schemes, most of which nurture sunset industries such as agriculture or cotton textiles, while penalising (through regressive tax systems) future industries.

•  The fact that we are not fighting against the deflation of one bubble, but two. The first bubble is the high sovereign debt issues which characterised most countries in the past 10 years, and which are regrettably set to continue into the future. The second bubble is the fact that nearly every sector in Greece (and Europe) is characterised by massive overcapacity, at a very time when public and private sector consumption must fall to balance excessive debt. Much of this overcapacity is value-destroying (based on sunset or protected industries) rather than value-creating, or is based on the import of Asian products (textiles & garments, electronics).

•  The fact that the primacy of the state as a means of development is still followed avidly in Europe, and particularly in Greece. This is despite the fact that state spending in Greece has crowded out and distorted (through corruption, regulation and subsidies), private sector investment, and created much of the overcapacity mentioned. Until the dead hand of the state relinquishes its rigor mortis grip, we cannot expect serious economic development, i.e. development based on commercial viability rather than government subsidies, protectionism or crony capitalism.

I also strongly believe that, for quite some time now, we have been treating the symptoms, not the root causes of the crisis. Refer to my blog post of May 10, 2010: Europe has bought short-term stability at the expense of long-term survival. My conclusions here are that:

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.

The Eurozone did indeed buy time and stability in May 2010—just until the Irish bail out in November 2010. At that point, the crash of the dominos began which has not yet finished.

Absent drastic policy measures in the near future, there will be two main impacts of this summer crisis:

a. There is a strong chance that Greece will be unable to make its debt payments in July and August absent a second bail-out. Greece faces sovereign debt repayments of approximately EUR 15 billion to the end of August, of which approximately EUR 10 bln in capital and EUR 5 bln is interest. It is unlikely that the country will be able to finance these payments. Absent new emergency funding, a Greek default will create a firestorm; further European vacillation may lead to the same result.

b. Pressure will continue to increase on highly-indebted countries, including Ireland, Portugal, Spain, Italy and possibly Belgium. The first signs of contagion will hit France.

A technical default by the United States will accelerate this process, into areas we cannot begin to imagine.

I have low hopes for this next summit. It’s clear that on the one hand, a plan is not ready. On the other hand, any real plan will probably have to be approved by national parliaments, creating further uncertainty. Together with the uncertain progress of the US debt negotiations, I’m counting on a long hot summer, and in the case of Greece, a continuation of instability well into the fall and 2012 (don’t forget elections must be held by 2013 at the latest). There is also a 30-40% chance of a catastrophic outcome in the next 45 days.

© Philip Ammerman, 2011
Navigator Consulting Group

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