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December 13, 2011

Where is Western Europe Headed?

Global markets hang in the balance as Europe's economy grapples with financial crisis. 

The European Union accounts for 20% or more of global GDP and has a huge middle class that consumes  on par with their Socialistic governments.  There are 27 countries in the EU, of which 17 are part of the Eurozone who adopted the Euro as their currency.   Germany, France, the UK, and Italy appear to be on paths of modest but sustainable growth; but a debt crisis in Portugal, Ireland, Greece, and Spain (so-called PIGS) has put these countries into likely recession.  With the globe climbing a delicate path of recovery, problems in Europe cannot be discounted. 

To understand where Europe is headed, we must first tune into the nature of their current problems.  Europeans in general have been responsible consumers and did not entirely follow the path of Americans’ wild, debt-fueled consumption journey over the last decade.  Unfortunately, many of the European governments were not nearly as responsible as their citizens and other countries around the globe.  These governments behaved more like US consumers, accumulating debt far in excess of what their economies could support.  In fact, Greece, Italy, Portugal, Ireland, and Spain have debt levels of more than 1.25 times their annual GDP.  The most troubled of these have debt that is close to 2 times annual GDP.  History has shown us that debt levels of over 1.5 times GDP generally have led to default or at least severe inflation after attempts to monetize the problem.

Given this situation, global investors have stopped loaning money to the troubled PIGS group, while other nations on the cusp of trouble have seen their borrowing costs skyrocket.  In the near-riot that has resulted in the European financial markets, counter-party risk is difficult to understand. Banks have curtailed mutual lending for fear of what debt the others might hold in their portfolios.

Is there a solution to the problem?  Will light emerge at the end of the EU tunnel?  While central banks generally intervene during a financial crisis, the European Central Bank has not been quick to act with strong monetary medicine in the way the Fed has in the US. The Fed supports just one nation with a dual mandate of price stability and full employment, giving the US central bank flexibility to use monetary policy to stimulate growth.  The Fed has not had inflation concerns with buying US debt because the US Treasury is the most responsible borrower in the world and can borrow at the lowest rates. 

In contrast, there are a couple of reasons the ECB has been slower to act.  First, it’s set up differently than the Fed, supporting 27 nations with a sole mandate of price stability.  Second, when a central bank like the ECB seeks to lower interest rates to stimulate growth or provide liquidity for a system in crisis, it buys treasury debt of the nations it supports, and must choose its borrowers carefully. But the 27 nations supported by the ECB are not all responsible borrowers.  Some of EU members may create inflation with borrowed funds or take on too much debt and risk default.  This is the potential problem in Europe. 

As a result, the ECB is now playing a game of poker with the EU’s troubled nations and refusing additional loans without asserting control over spending. The most recent signs of progress emerged when an agreement was reached at an EU summit the week of December 5, 2011. All but one of the 27 member nations conceded mild control of their treasury spending, with the UK holding out over national sovereignty.  With few choices left, the Euro-zone’s troubled nations seem to be willing to accept even tougher terms set by the EU.  Among their few options:  

1)  Leave the union and revert back to their own currencies
2) Fan the flames of chaos and hope the riot forces the EU to help them without concessions
3) Accept the EU’s terms

Neither of the first two options would seem to produce a winning hand for the PIGS.  Leaving the EU would be devastating to their liquidity needs and most certainly cast them into a long recession.  Another riot is possible but not likely as central banks around the globe have already formed credit facilities to keep markets orderly during this period of negotiation.

The likely outcome?

It seems reasonable that the European Union will eventually get limited control over the spending of its members so the ECB can provide needed market liquidity to keep Europe on a path of growth.  While Europe is clearly evolving for the better, the process will take time. Meanwhile, markets are impatient due to the delicate global balance.



At December 13, 2011 at 9:39 PM , Blogger Sardul said...

Mitch, I think the agreement in Brussels, with Britain casting a veto, will lead to a continent-wide depression and the EU investments will take a bad hit. Germany is forcing all countries to reduce spending and debt, which would normally be a good thing. But these are not normal times. Belt tightening is already leading to depression in Greece and the other PIIGS will follow. Germany and other Northern European countries can't grow because they can't any more export to the Southern members of the EU or to China because of slowing economy there. The PIIGS need to grow, which can happen only with massive sale of bonds by the ECB to them. This won't happen and they will go into depression. The austerity program that Angela Merkel is forcing on Europe is plain pig-headed. European economies and the Euro are heading down.

At December 14, 2011 at 4:19 PM , Blogger Mitch Pletcher said...

I agree with you that now is not the time for strong measures of austerity. They must first get the economy on a stable path of recovery and then begin the gradual process of belt tightening over the next 5 years. I believe that the EU leaders have now realized this as well. This is why they shifted from demanding immediate cuts in spending to gaining control over future spending by taking control of their Treasuries. Once this is accomplished the ECB can bring liquidity to the dry markets.


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