By Bernard Hickey
The Eurozone has chosen over the last 48 hours to take the American and Japanese route to salvation from its debt morass. Unfortunately for Europe, and for the rest of world (including New Zealand), it will fail and the failure may well be bigger in the future than if it had chosen to deal with its problems now.
We should all prepare for more of these sporadic financial crises and the weight of debt de-leveraging bearing down on growth in the developed economies for decades to come. It means slower growth, lower exports, weaker lending and flat to falling asset prices. For decades.
Eurozone finance ministers, the IMF and the ECB announced they plan to transfer the risk of toxic sovereign debt from private sector balance sheets (the banks) to the taxpayer (some vague European fund and the ECB). They hope this will be enough to stop contagion and protect the euro (and their banks) from an implosion that would cause economic chaos.
They genuinely believe that if they can get through this crisis they can manage the markets and their own spending to skip through without a catastrophe.
They are hoping that no one notices the chronic deficits and debt that afflict much of the Eurozone and the problem will go away some time in the future, hopefully thanks to some tough medicine taken by future politicians and future voters. They believe avoiding and disguising the pain now will avoid or reduce the pain altogether.
As Darryl Kerrigan said in my favourite Australian film The Castle: "Tell em they're dreamin."
The problem is not one of contagion driven by hedge funds and speculators. It is a problem caused by too much debt and it cannot be solved by shuffling the debt. (See charts throughout this article, courtesy of De Spiegel) At some point there needs to be a default, either openly through a debt restructure, or implicitly, through a period of inflation driven by debt monetization (money printing).
Neither option is attractive. But, believe it not, it is much better than the long slow Japanese-like death of debt deflation and little or no growth that is now in prospect. Japan has coped so far (although there is doubt about the future) because it is socially homogeneous and right next to the world's most dynamic and fast-growing economy in China.
Europe has none of those advantages.
PIIGs eating German cat food
It now faces a huge battle herding all its various cats together and stopping them from eating out of each others' bowls. The particular problem is the German cats. They have managed to avoid the other Southern European cats eating from their bowls until now. Yesterday's announcement essentially says that Southern Europe (Portugal, Italy, Greece, Spain) will be able to eat from the same bowl as the Germans. The Germans, meanwhile, are hoping the PIGS can control their appetites.
There is fat chance of that with no market discipline and no constitutional or political pressures to stop them from spending now and lumping the cost on future generations.
The Germans fundamentally understand that and are coming to the inevitable conclusion that the euro zone is unsustainable without a political and Treasury union. That's part of the reason why Angela Merkel was beaten so badly in regional elections on the weekend.
Eventually the political will become the financial
The markets may well have sighed with relief last night that Europe's banks have avoided the hundreds of billions of euros of writedowns that would have inevitably come with a rolling series of sovereign defaults through Greece, Portugal, Spain and into Italy.
It may also be relieved that banks can now start lending to each other again, avoiding the sort of post-Lehman freeze in inter-bank markets that could have ground global trade to a halt again.
But how long will it be before another crisis?
Firstly, the Germans will have to get any new arrangements through their parliament and their constitutional courts. Then the Greeks, the Spaniards and the Portuguese and the Italians will have to slash their government spending and lift taxes.
This will all have to be done in an environment where their economies aren't growing in either nominal or real terms. Deflation is quite likely.
Will the ECB print?
The key will be whether the European Central Bank sticks to its promise of 'sterilising' the bond purchases it has promised. If it sterilises it will effectively buy sovereign and other bonds from banks and then sell back to the market higher quality European (which means German quality) debt.
This is an exchange which tries to apply cheap German style interest rates to otherwise expensive Southern European bond issuance.
That is fine, but it will do exactly the same to the economy that has happened in the United States. The banks will sell their toxic debt to the central bank and in exchange receive pristine ECB bonds. They won't lend their money to businesses and consumers because they still need to build up their capital. They'll do that borrowing cheaply from customers using the very low interest rates set by the ECB and lend out at slightly higher rates for longer terms.
Europe faces a long grind of low lending growth, weak GDP growth and a slog led by bankers who will spend the next decade or so rebuilding their (actually) shattered balance sheets. Assuming, of course, the markets let them get on without the usual molestation of grumpy shareholders and creditors.
Until next time
The problem here is that a Japanese style couple of decades of slow growth and inexorably rising public debt is not an option. Unlike the Japanese, who had a population of high savers in the prime of their income-producing lives and a relatively low unemployment rate, Europe has an already aged population with very high unemployment and high public spending.
Japan was able to fund its deficits internally. The only way Southern Europe can fund its deficits is by borrowing from the Germans at very low interest rates. Hoping that relatively high nominal GDP growth will fix the problem is a waste of time.
Germany would have to allow the ECB to print money to get some decent nominal GDP growth (ie default by inflation). That is politically unacceptable. The Germans are more than likely to pull out of the euro before that happens.
So we're back where we started. The euro-zone was a monetary union without the political and fiscal union to back it up. Now that internal inconsistency is being exposed. And, unfortunately, there is no mechanism to fix it without either a mass devaluation fueled by money printing, which is politically unacceptable to the Germans, or a mass default and debt restructure, which is financially unacceptable to the Germans and French.
The only real option is the breakup of the euro
I wonder if anyone out there still thinks a Trans-Tasman currency union is a good idea? Methinks not.
I welcome your views and insights below.