The euro zone crisis
by Buttonwood
IF TRADERS were planning to spend December in a drunken round of parties, they will have to think again. Yesterday saw the outline of a Merkel-Sarkozy plan to stabilise the euro, and it also saw S&P, the rating agency threatened by EU reforms, defiantly put the whole zone on negative credit watch.
The S&P move is interesting, to say the least. One could imagine two outcomes over the next few months. Option A would be a plan for the creditor nations to subsidise the latter, in which case one might expect creditor downgrades and debtor upgrades. Option B would involve a break-up of the whole region, in which case Germany and the Netherlands would keep their rating but some of the others would follow Greece into junk status.
S&P's reasoning seems to be based more on the short-term economic outlook. It cites five factors.
While this seems unfair, it is all part of the "wouldn't start from here" problem that faces the region. This blog has consistently argued that we have created too many claims on wealth in the form of debt that cannot be satisfied. These debts will thus be defaulted on, or inflated away; choose your poison.
In that light, we can see the euro zone leaders wriggling on the hook, but they won't get free. The latest plan may buy them some time. The European Central Bank has hinted that, if governments promise to be fiscally good, it will step up the level of its bond purchases. Angela Merkel and Nicolas Sarkozy hope they have come up with a plan that can do the trick. The idea seems to be a souped-up Stability and Growth Pact, with automatic sanctions for those who breach the 3% of GDP deficit rule; previously, the sanctions tended to be waved. Furthermore, the European Stability Mechanism, the fund designed to bail out member nations, would start next year, not in 2013.
The key provision for market participants seemed to be that private sector creditors would not be penalised in any future bailout, as they were in Greece. It has been the 50% hit to Greek creditors that has helped cause the run on other countries; the ECB was right to oppose this.
Can this work? Well it might be enough to satisfy the ECB which is under a lot of political pressure to do the "right thing". But backward-looking sanctions seem unlikely to satisfy the markets. What would happen in a deep recession? If a country is heavily indebted, how does it help to impose a fine? How will it pay the fine?
The issues that will dominate 2012 will likely be: if Germany demands austerity as a price of bailouts, what will be the effect on euro zone GDP, which may already be falling? How does any bailout deal with the lack of competitiveness that has plagued the southern European nations? And, without debt writedowns and without economic growth, how will the debt burdens be eroded?
The S&P move is interesting, to say the least. One could imagine two outcomes over the next few months. Option A would be a plan for the creditor nations to subsidise the latter, in which case one might expect creditor downgrades and debtor upgrades. Option B would involve a break-up of the whole region, in which case Germany and the Netherlands would keep their rating but some of the others would follow Greece into junk status.
S&P's reasoning seems to be based more on the short-term economic outlook. It cites five factors.
(1) Tightening credit conditions across the eurozone;To an extent, the euro zone is damned if it does, and damned if it doesn't. Failing to have a plan to reduce its debts will result in a downgrade but austerity plans will hit economic growth that will also result in a downgrade.
(2) Markedly higher risk premiums on a growing number of eurozone sovereigns, including some that are currently rated 'AAA';
(3) Continuing disagreements among European policy makers on how to tackle the immediate market confidence crisis and, longer term, how to ensure greater economic, financial, and fiscal convergence among eurozone members;
(4) High levels of government and household indebtedness across a large area of the eurozone; and
(5) The rising risk of economic recession in the eurozone as a whole in 2012. Currently, we expect output to decline next year in countries such as Spain,Portugal and Greece, but we now assign a 40% probability of a fall in output
for the eurozone as a whole.
While this seems unfair, it is all part of the "wouldn't start from here" problem that faces the region. This blog has consistently argued that we have created too many claims on wealth in the form of debt that cannot be satisfied. These debts will thus be defaulted on, or inflated away; choose your poison.
In that light, we can see the euro zone leaders wriggling on the hook, but they won't get free. The latest plan may buy them some time. The European Central Bank has hinted that, if governments promise to be fiscally good, it will step up the level of its bond purchases. Angela Merkel and Nicolas Sarkozy hope they have come up with a plan that can do the trick. The idea seems to be a souped-up Stability and Growth Pact, with automatic sanctions for those who breach the 3% of GDP deficit rule; previously, the sanctions tended to be waved. Furthermore, the European Stability Mechanism, the fund designed to bail out member nations, would start next year, not in 2013.
The key provision for market participants seemed to be that private sector creditors would not be penalised in any future bailout, as they were in Greece. It has been the 50% hit to Greek creditors that has helped cause the run on other countries; the ECB was right to oppose this.
Can this work? Well it might be enough to satisfy the ECB which is under a lot of political pressure to do the "right thing". But backward-looking sanctions seem unlikely to satisfy the markets. What would happen in a deep recession? If a country is heavily indebted, how does it help to impose a fine? How will it pay the fine?
The issues that will dominate 2012 will likely be: if Germany demands austerity as a price of bailouts, what will be the effect on euro zone GDP, which may already be falling? How does any bailout deal with the lack of competitiveness that has plagued the southern European nations? And, without debt writedowns and without economic growth, how will the debt burdens be eroded?
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