Downward Spiral

Europe's crisis is morphing again -- for the third time in only 12 months -- and the implications for the global economy are even more complex, unsettling, and troubling.


DECEMBER 15, 2011


Europe entered the year with an acute emergency in the periphery of the eurozone, the European Union's elite 17-member club that shares a common currency. Misdiagnoses and inadequate policy responses allowed the contamination to travel sequentially from the outer reaches of the zone (Greece, Ireland, and Portugal) toward its inner core.


In this first of three morphings in 2011, Italy and Spain were disrupted as interest rates soared, turning liquidity concerns into solvency ones. France was then impacted, with its AAA rating threatened by its exposure to the neighborhood's problems. Then Germany, Europe's strongest economy and the one that everyone looks to for a solution, had to contend with the embarrassing failure of a highly visible government debt auction.

A sovereign debt crisis is bad news for anyone with large holdings of government bonds. As European banks are the largest such holders, they quickly found themselves losing the confidence that is so central to the normal functioning of any financial system.

Credit lines were cut, making too many banks heavily dependent on European Central Bank financing for raising the liquidity they need for daily operations. Equity prices collapsed as investors worried about bank profitability, thereby limiting the scope for injections of new capital. To make things worse, some depositors got nervous.

This series of events led to the second 2011 morphing of the European crisis. Having entered the year on the receiving end of the sovereign debt crisis, banks evolved into becoming a stand-alone source of disruptions -- most acutely in the periphery, but also in some core countries. Suddenly, banks were in the grips of the threatening trio of liquidity strains, capital inadequacy, and concern about asset quality.

The alarm bells in European capitals rang even louder, prompting a subtle change in the policy emphasis. It was no longer just about saving the eurozone's periphery. It became ultra-important, to use French President Nicolas Sarkozy's words, to "refound" Europe.

As the crisis got bigger, Germany and France decided to dispense with the niceties of collective European deliberations and essentially specified the steps needed to strengthen the EU's fiscal and institutional core. These measures found support, but not unanimous agreement.

At the highly anticipated December summit of European leaders in Brussels, German Chancellor Angela Merkel and Sarkozy failed to overcome fierce opposition from British Prime Minister David Cameron, who decided to veto the proposed treaty changes, essentially removing Britain from the constraints of enhanced European governance. With Britain providing a demonstration effect, four other EU countries expressed discomfort in the week following the summit.

This was the catalyst for the third 2011 morphing of the European crisis. Europe now found itself facing an even bigger problem -- namely, a crisis of the 27-member EU as a whole. Questions multiplied as to the stability and ultimate viability of a multispeed EU.

These three distinct morphings have surprised many. They should not have. After all, the underlying dynamics are not that different from what many emerging economies have experienced in the past. Economists describe this as "path dependency." It is a process of "multiple equilibria" in which each successive outcome takes you even further away from the initial starting point.

While familiar to emerging economies, these dynamics are very different from what Western countries are used to. Specifically, for the West, it is no longer about economic cycles that involve temporary and reversible deviations from a familiar anchoring mean. It becomes a secular phenomenon that -- in a fundamental manner -- speaks to structural changes, institutional mishaps, and a whole series of the unthinkable becoming facts. In the process, policy measures lose effectiveness, consumer sentiment is disrupted, and healthy balance sheets retreat to the sidelines, thereby increasing volatility and accelerating deleveraging.

This is an unfamiliar world whose complexity increases exponentially as policymakers fall further behind the accelerating path-dependency dynamics. The engineering of a rescue becomes considerably more difficult and the politics even more intricate. That's not even counting the implementation difficulties that inevitably accompany hard policy choices.

Structural challenges require structural solutions that, usually, involve a component of immediate sacrifice for the promise of welfare enhancements down the road. This tradeoff, between short-term costs and long-term benefits, is not one that comes easily to political systems heavily influenced by the election calendar.

Long-standing social compacts are threatened for a citizenry that is already angry with what has transpired. In some cases, such as Greece, this can lead to wide-scale protests, violence, and paralyzing general strikes.
Turnovers in government become the rule -- it should come as no surprise that there have been so many changes in Europe already, including two countries (Greece and Italy) that have opted for unelected "technocratic governments."

These are consequential developments whose impact will be felt for years, and the latter is not limited to Europe. Virtually every country in the world is exposed.

When it comes to the global economy, Europe is systemically important for at least three huge reasons. First, it is the largest economic area in the world and, as such, an important source of demand for the rest of the world. Second, with its banks holding large claims on nonresidents, their forced deleveraging will transmit waves of credit rationing well beyond the EU. Third, by fueling volatility and uncertainty, the European crisis has a material influence on the functioning of global markets.

To make matters worse, this crisis comes at a time when the United States is struggling to regain growth and generate enough jobs. Moreover, though the large emerging economies (Brazil, China, India, Indonesia, and Russia) are much healthier, they lack both the willingness and the ability to compensate fully.

It is critical for the welfare of billions around the world that Europe get its act together now. The continent faces an increasing probability of having to navigate a fourth potential morphing in the next few months. Should it materialize, this would take one of two forms: either a disorderly and highly disruptive fragmentation of the eurozone, or the establishment of a smaller and less imperfect eurozone that has a different relationship with the rest of the EU.

Both possibilities involve yet another set of immediate disruptions for Europe and the global economy. As such, the temptation among politicians will be to avoid making any active choices. But that would constitute a huge mistake. It would further reduce their future degrees of freedom due to an even narrower set of possibilities and, with that, erode their ability to influence outcomes.

As time passes, the option of a smaller and less imperfect eurozone is becoming the only way to "refound" a union that would have the chance to stand the test of time and, thus, constitute a key component of medium-term efforts to restore global financial stability, meaningful economic growth, and plentiful jobs. It is not an absolute best, and it would be a messy process involving the risk of collateral damage and unintended consequences. Yet, when judged in terms of feasibility and desirability, it sure dominates the alternative of a full fragmentation.

December 18, 2011 9:05 pm

Mario Draghi: tasked to save the euro

By Lionel Barber and Ralph Atkins in Frankfurt

The new head of the ECB weighs his words and draws on Italy’s prior experience of crises to illuminate how he will confront the eurozone’s troubles

Mario Draghi

Mario Draghi was always the underdog in the race to win the top job at the European Central Bank. It did not matter that the former central bank governor, Treasury official and Goldman Sachs executive was far from the caricature happy-go-lucky Italian. Conventional wisdom dictated that only a German steeped in economic orthodoxy would succeed Jean-Claude Trichet, whose eight-year term as ECB president ended in October.

But in February everything changed. Axel Weber, Bundesbank president and Berlin’s favoured candidate, resigned, swapping central banking for academia and then the private sector. Eurozone leaders fell back on Mr Draghi, a sober man with steady nerves that served him well in Rome’s Byzantine politics. His crowning moment came when Bild, the mass circulation German tabloid, depicted him in a Pickelhaube, a Prussian spiked helmet.

The tabloid image was both an accolade and a warning. Only by steering an unwavering anti-inflation line based on strict budgetary discipline could Mr Draghi hope to maintain the support of the German people as guardian of their currency. Yet the new ECB president must now tackle a euro crisis that threatens 50 years of European integration. Little wonder, in his first interview since becoming president, Mr Draghi has the air of a man walking a political tightrope.

Sitting in his 35th-floor office in Frankfurtbarely changed from the Trichet era save a few memento photographs of his 20-plus years in public serviceMr Draghi, a fluent English speaker, weighs every word. In an hour-long discussion he avoids words such as crisis or emergency, preferring to talk about challenges and creatingtrust”, especially when discussing the ECB’s pivotal role. While politicians beyond Germany demand that the ECB rescue the euro by expanding massively its government bond-buying programme, Mr Draghi argues instead for “a system where the citizens will go back to trusting each other and where governments are trusted on fiscal discipline and structural reforms”.

These words implicitly recognise German-led demands that the ECB’s actions stick to the letter of European treaties going back to Maastricht in 1992, which paved the way for the launch of the single currency seven years later. But how does Mr Draghi reconcile what many regard as the plodding political response to the crisis and the galloping demands of financial markets that are increasingly challenging the creditworthiness of sovereign borrowers, not simply Greece, Ireland or Portugal but now Italy and France, the heart of the eurozone?

Mr Draghi believes the recent summit in Brussels made useful progress. European leaders, he says, took a first step towards a eurozone fiscalcompact”, with binding rules on public finances, backed by automatic sanctions. Just as important – but overshadowed by the controversy over Britain’s veto of a European Union-wide treaty backing the fiscal compact – were the ECB’s own bold measures a day earlier to aid stricken eurozone banks.

For the first time, the ECB is ready to offer banks three-year loans – in whatever quantity they require. The ECB also made it easier to borrow central bank funds by broadening the assets banks can use as collateral.

These measures, alongside two consecutive interest rate cuts, bear Mr Draghi’s stamp. They significantly extend the “unlimited liquidity policy started by Mr Trichet. Some – including President Nicolas Sarkozy of Franceappear to believe they are a device to encourage banks to buy sovereign bonds at cheap rates.

Mr Draghi disagrees. The main aim was to ease banks’ funding difficulties and thus help small and medium-sized enterprises, the engines of growth and jobs. “What we are observing is that small and medium-sized banks are the ones having the biggest funding difficulties, and they are generally the ones who provide most of the financing for the SMEs.”

Still, initial favourable market reaction has slipped into familiar disillusion. Critics say there is too much emphasis on fiscal austerity and not enough on breaking a vicious circle in which poor public finances, weak banks and a disastrous loss of competitiveness is plunging some eurozone countries into an economic slump.

Mr Draghi, marginally more forthcoming than the famously elliptical Mr Trichet, comes close to admitting official errors have been made. One was to press ahead earlier this month with fresh bankstress testsidentifying further capital needs for Europe’s lenders.

Ideally, the sequence ought to have been different,” he says. The EU could have waited until its new bail-out fund, the European Financial Stability Facility, was fully operational. “This would have had certainly a positive impact on sovereign bonds, and therefore a positive impact on the capital positions of the banks with sovereign bonds in their balance sheet.” His concerns are striking as, before taking the top job at the ECB, he was active at the global level in strengthening bank regulation.

A second problem was German-led insistence on “private sector involvement” in government bail-outs – a euphemism for making investors take losses on bond holdings. Since the effect was to undermine investor confidence in the eurozone, was PSI in retrospect a strategic mistake?

A pregnant silence follows. A press aide shifts uncomfortably. Finally Mr Draghi refers to anothersequencing slip. “Neither the EFSF was in place, nor were banks recapitalised before people started suggesting PSI . . . It was like letting a bank fail without having a proper mechanism for managing this failure as had happened with Lehman.”

But he remains adamant: “There is no trade-off between fiscal austerity, and growth and competitiveness.” While tax rises and public spending cuts will hurt economic activity in the short term, markets should respond positively to lower budget deficits as long as two conditions are met: first, national economic policies must be designed to boost growth and job creation, and second, “it is necessary to have the right euro area designs . . . so that confidence is fully restored”.

Few German conservatives – or indeed the UK’s current coalition government, for whose policies Mr Draghi has warm words – would dispute this restatement of economic orthodoxy. Mr Draghi cites Italy’s experience in the early 1990s, when he was director-general of the country’s Treasury and public finances had spun out of control. Then there was no option of help from an EFSF-style rescue fund nor the International Monetary Fund.

An important lesson, he says, is that exchange rate devaluation – an option for Italy then, but not for struggling eurozone countries today – was double-edged. “It brought a temporary respite to the economy, so that exports could grow, but it also widened sovereign bond spreads because the exchange rate risk came on top of sovereign risk.”

But what if the eurozone broke up, allowing devaluations outside the single currency straitjacket? Not so long ago, politicians and central bankers would have considered such a question impertinent, if not irrelevant. But Mr Draghi, like others, is ready to break the taboo.

Even if it were possible for countries to leave the eurozone, it “wouldn’t help”; currency devaluation would lead to inflation “and at the end of that road, the country would have to undertake the same reforms . . . but in a much weaker position”. Nor would it be in the interests of remaining eurozone countries. “You would have a substantial breach of the existing [EU] treaty. And when one starts with this you never know how it ends, really.”

Many market observers argue that the unlimited firepower of the ECB is the only weapon able to calm the markets and save the euro. Mr Draghi favours a big firewall to protect stricken sovereigns but this should be provided by the EFSF not the ECB.

“The delay in making the EFSF operational has increased the resources necessary to stabilise markets. Why? Because anything that affects credibility has an immediate effect on the markets. A process that is fast, credible and robust needs less resources.”

On a positive note Mr Draghi points out that last week’s summit restated a €500bn lending capacity for the EU’s rescue funds and agreed a further €200bn could be provided for the IMF providing confirmation of the firepower for shoring up the eurozone.

Two other points were overlooked, he adds. First, the EFSF’s resources would be reviewed as early as March – a hint that they could be increased. Second, the ECB had agreed to act as “agent” for the EFSF in market operations speeding its full launch.

This raises questions about the future of the ECB’s ownsecurities markets programme” in which it buys government bonds to relieve market tensions and drive down borrowing costs. The ECB’s hopes that the eurozone rescue fund would take over that role have been dashed by delays and worries about the rescue fund’s firepower.

“We have not discussed a precise scenario for the SMP,” Mr Draghi says. “As I often said, the SMP is neither eternal nor infinite.”

Across Europe, politicians have argued that in fact the programme needs to be stepped up dramatically. The obstacle, Mr Draghi argues, is the EU ban on “monetary financing” – central bank funding of governments. This reflects German fears about a repeat of 1920s hyperinflation driven by central banks running the money printing presses. “We have to act within the treaty,” he says.

It is a sometimes legalisticat times, even theologicaldebate. But behind Mr Draghi’s comments is also a widely-held view at the ECB that if it had massively expanded bond purchases a year ago, governments – including Italy – would not have made any progress towards implementing economic reform, or agreeing tougher fiscal rules.

Under Mr Trichet, the SMP was undermined by public criticism from the Bundesbank’s Mr Weber. Because the ECB’s governing council was split in public, the central bank had to spend more to convince financial markets of its intentions.

Ultimately central banks have unlimited financial firepower – they can after all simply print money. The ECB could simply announce that it would intervene in the bond markets to stop yields going above a certain level. If the central bank was sufficiently credible, financial markets would not test the limits and the ECB would end up spending little, or so the argument goes. (The Swiss National Bank has taken similar steps to stop its currency appreciating.)

Mr Draghi appears unimpressed. Any extra cost countries pay to borrow is typically a result of their own financial health and policies. “Monetary policy cannot do everything,” he says. One possible worry is that by pegging an interest rate, and pledging to buy unlimited amounts of bonds if necessary to defend the peg, the ECB would lose control of money supply.

He is also reluctant to discuss whether the prospect of a eurozone recession might force the ECB into “quantitative easing” – large scale government bond purchases aimed at boosting economic growth. “The important thing,” Mr Draghi says, “is to restore the trust of the people citizens as well as investors – in our continent. We won’t achieve that by destroying the credibility of the ECB. This is really, in a sense, the undertone of all of our conversation today.”

As the interview draws to a close, Mr Draghi is reminded of the huge volume of European bank and state refinancing in 2012. Some €300bn of eurozone government debt has to be refinanced in the first quarter. Global growth will also slow, he warns, although he stops short of forecasting a world recession, “and uncertainty has risen”.

Mr Draghi is obviously hedging his options. Those who know him, however, suggest that this is a pragmatist who listens to advicepreferably crisp thinks through his options and settles on a course from which he is loath to budge. As he prepares for a break over Christmas, he will doubtless be working out how to reconcile the conflicting demands of the politicians and the markets. He does not have much time. For 2012 may well mark the moment when the euro’s fate is settled.

International Italian

Mario Draghi studied economics at university in Rome, where he was born in 1947, and became the first Italian to gain a doctorate from Massachusetts Institute of Technology.

He was a professor of economics in Italy and worked at the World Bank before taking over as director-general of the Italian Treasury in 1991.

He stayed for a decade, overseeing Italy’s entry into the euro and earning the nickname super Mario”.

After a spell at Goldman Sachs, Mr Draghi became governor of the Banca d’Italia in 2006 and for five years chaired the Financial Stability Board, responsible for drawing up much of the global response to the financial crisis.

Copyright The Financial Times Limited 2011.

Sorting Out the Euro Mess

John Mauldin's Outside the Box

I had the pleasure of spending the morning and part of the afternoon today with Louis Gave and Anatole Kaletsky at a seminar here in Dallas; and we shared a long lunch, where Europe and China were the topics of conversation. So, with their permission, here is their latest "Five Corners," in which Charles Gave and Anatole Kaletsky discuss last week's summit, and then engage in an internal debate about whether Italy really has a significant trade deficit with Germany.

As I expect from GaveKal, it's not your typical analysis. And since I have to run to dinner – and glean more insights from their team (there will be homework when I get back!), this introduction to Outside the Box is short, and we can jump right into today's piece. Have a great week.

Your feasting on information analyst,

John Mauldin, Editor
Outside the Box

Sorting Out the Euro Mess

By Anatole Kaletsky, Charles Gave, Francois Chauchat – GaveKal
Starting With the Bad News...

Although the usual post-summit rally should not be too hard to orchestrate in the thin markets around Christmas, there was more bad news than good for the dwindling band of bureaucrats and politicians who are determined to save the Euro, regardless of the costs to the democracies and economies of Europe. We will begin with the "bad" newspartly because our bias is to treat bad news for the Euro as good news for the world and Europe, but mainly because this so-called comprehensive and final "fiscal compact" was no more comprehensive and final than any of the previous failed deals. As in all the previous summits, the only truly definitive decision on Friday was to have another meeting in three months' time, when a new agreement would supposedly be cooked up to resolve all the controversial issues left undecided on Friday. Once the holiday season is over and investors start to think seriously about this "fiscal compact," the economic and political uncertainties are bound to intensify, building to another crisis ahead of the next summit in March.

The summit failed to satisfy the first (and maybe not the second?) of even the minimum necessary conditions to give the Euro a chance of medium-term survival. These are (i) creation of a fiscal union, which will take at least one to two years to set up, and (ii) unlimited ECB lending to bridge the gap between this multi-year political timetable and a market timescale measured in weeks or months. While the ECB may still end up being more pro-active than Mario Draghi suggested last week (see next page), the summit's most obvious failure was on the fiscal front.

Despite the self-congratulation among EU politicians about their "fiscal compact," the fact is that Germany vetoed the most important characteristic of a true fiscal union, which is some degree of joint responsibility for sovereign debts. Since Germany refused even to discus Eurobonds or a vastly expanded jointly-guaranteed European Stability Mechanism, the summit did nothing to reassure the savers and investors in Club Med countries that their money will be protected from either devaluation or default.

Secondly, the summit raises huge political uncertainties. With the UK failing to climb on board, an intra-governmental deal will need to be arranged outside the EU legal framework. Will all 17 countries in the EMU ratify the new treaty and how long will this take? Will Ireland be able to avoid a referendum in a period when Europe is viewed by the public as a hostile colonial power?

Will all 17 members insert German-style debt-brakes into their constitutions to the satisfaction of the German courts? If a country fails to legislate or implement an adequate debt-reduction programme, will it be expelled from the Euro? If so, can the Euro be described as "irrevocable" any longer and does it really differ from any previous fixed currency peg? Worst of all, perhaps, how will this deal affect French politics? If Marine Le Pen and Francois Hollande denounce Merkozy's "fiscal compact" as a betrayal of French sovereignty and democracy, then this agreement will be worthless until after the French presidential election on May 6.

Thirdly, and most decisive in the long run, is the economic and political incoherence of what Merkozy are trying to do. Even if the fiscal compact could be immediately put into practice, even if it contained provisions for joint-liability debts and even if the ECB backed it with unlimited monetary support, it would aggravate the Club Med's economic nightmare of unemployment and economic stagnation.

Small open economies such as Ireland and Sweden may be able to deflate their way out of a debt crisis, but for large continental economies in the Eurozone this is arithmetically impossible. In this respect at least, Keynes's key insight of the 1930sthat workers and taxpayers are also customersremains as relevant today as it was then. By imposing permanent austerity, the fiscal compact guarantees permanent depression—and that in turn guarantees that the citizens of Europe will eventually turn against Merkozy and the Eurocrat elites.

...And Now for the Good News

Now let us turn to the good news, at least for the Eurocrats and perhaps, in the short-term, for the European markets. The potential support from the ECB is the one part of the summit deal that could turn out to be much stronger than it seemed at first sight. While Mario Draghi's public statements were less than helpful, they were presumably directed at a German audience, as was Bundesbank president Jens Weidman's astonishing decision on Thursday to vote against even a -25bp rate cut. This seemed to confirm our longstanding view that, whatever the preferences of Angela Merkel and other politicians, the Bundesbank would like to sabotage the Euro if it can.
Behind this macho posturing, however, the ECB may be moving towards a programme of sovereign debt monetisation and quantitative easing on a scale that even Ben Bernanke and Mervyn King would never contemplate.

The three-year unlimited liquidity operations announced last Thursday could provide infinite monetary support for European banks and through them, their sovereign debt markets. Once these three-year repos get started, banks in the Club Med countries will be able to borrow as much as they want from the ECB at 1% and use this money to buy government bonds now yielding 6% or more.

Because of the unprecedented maturity of these repo-operations, banks will now be able to theoretically acquire unlimited government bond portfolios without exposing themselves to rollover or maturity risks. Banks will therefore be able to pick up 500bp of carry, with zero risk-weightings, by hoovering up all the debt their governments can throw at the markets. Of course there would be risks—we cannot say banks will want to jump on this deal, but in theory they can.

This Ponzi scheme could potentially result in an even bigger money-printing operation than anything the US, British and Swiss central banks have done on their own accounts. It would allow the banks to rebuild their equity with no dilution to shareholders. And if the banks in Italy or Greece became too "profitable" by using cheap ECB funding to buy up their entire sovereign debt markets, then the Italian or Greek governments could always recover the "excess" profits with special taxes. The governments could thus effectively reduce their own cost of funds to the 1% rate offered to banks by the ECB. Of course if the Italian government defaulted on its debts, Italian banks would go spectacularly bust. But these banks would go bust anyway if the Italian government ever defaulted. All the incentives for Italian bank management will therefore be to go for broke in their sovereign debt markets, making maximum use of the new ECB credit lines.

That said, however, the European Banking Authority's recent stress tests forced banks to assume mark-to-market losses in the stressed scenarios. These demands from the EBA may inhibit banks from adding more sovereign riskunless the EBA uses the "fiscal compact" as an excuse to ease up on the stress tests.

And it is crucial to remember that banks are likely to use the ECB credit lines only to buy the bonds of their own national governments, partly in response to political pressures but also for prudential reasons. If the Euro were ever to break up, Unicredit would not want to own any Greek or Spanish debt, since this would entail unpredictable currency risks. An Italian bond, by contrast, would be redenominated into the new Lira and would be matched perfectly against Unicredit's borrowings from the Bank of Italy, which would also be redenominated into Lira.

Thus, the result of the ECB's covert QE via the banks will be gradually to re-nationalise the banking systems and the sovereign debt structures in Europe. This process will help Club Med countries avoid sovereign debt defaults, but it will make eventual breakup of the euro much less painful– and therefore more likely.

The Long March of the Euro Communist Economies

As we look forward to the coming year, we can bet our bottom drachmas that French and Italian trade deficits are going to continue to crater. Industrial production in most European countries will continue falling (who will invest given the uncertainty and the constant changing rules?). Unemployment is going to go ballistic.

This is because Europe's problem is fundamentally not one of excess debt (look at how Japan, the UK or the US are dealing with debt). The true problem is that half of Europe is uncompetitive and falling into debt traps (see page 5). As a result, budget deficits are going to explode. Remember that Greece after the first fix was supposed to grow in 2011? With hindsight, this looks like quite a joke. Though not a very funny one.

Nearly a decade ago, in the ad hoc Communist France vs Capitalist France (or in French the book Des Lions menes par des Anes), I wrote about the growing weight of government sectors (and employment) in the economy of France. It seems to me that everything that happened in the latest EU summit was about saving the "communist economy" (by guaranteeing its financing at a low rate); even if that meant sacrificing the "capitalist economy".

It is also hard for me to imagine that much in the way of reform will actually take placewhy should one reform if money is readily available from one's domestic banks? Because we have signed on to a tougher, tighter fiscal treaty? We did not even manage to respect the previous, easier, treaty. Why assume that it will be any different this time? Fool me once, shame on you; fool me twice...

The media all over the world, but especially in France, are presenting the crisis as a financial one, as if the governments and the politicians have no responsibility. This crisis is in fact very typical of a communist system arriving at the end of its ability to borrow and make the productive system service the debt it has accumulated, simply because the productive sector is going bust.

And nowhere is it more visible than in France. The "communist sectors"—which I define as the sectors in which there are no market prices and lifetime employment—have grown remorselessly since 1980. The market sectors are falling by the wayside one after the other as everybody can see:

This is not a banking crisis but a political crisis, and as Toynbee wrote, political crises always occur when the elites have betrayed. For reasons that I have never really understood, such crises tend to end either with reforms (in countries where people drink beer) or in revolutions (where people drink wine). As far as France is concerned, it seems to me that we drink both, but with a marked preference for wine.

Have Southern Europeans Bought Too Many BMWs?

We are often being told that the first decade of the Euro led to artificially low rates in the South, which provoked a credit-led consumption boom that allowed the poor guys in Valencia or Lecce to buy a BMW. This story is supposed to provide a colorful illustration of the intra-Eurozone imbalances accumulated over the last decade. Yet, as we show below, the deterioration of the Southern European trade balances with Germany has accounted for a relatively modest part of the rise of their trade deficits. More importantly, the story misses the essential point about the main cause of these deficits.

Take the example of Italy. Italy had a €25bn trade surplus when the Euro was introduced in January 1999, and has a €35bn trade deficit now—that is a €60bn swing. Germany has accounted for €13bn, or 22% of the total deterioration, and this was in part caused by declining German imports during the first half of the last decade. But as the chart below illustrates, the bulk of the deterioration of Italy's trade deficit came from oil first (€60bn since 1999), and China second (€20bn). Excluding China and oil, Italy today runs a comfortable trade surplus that is almost twice as high as it was in 1999 in nominal terms, and that has remained roughly stable as % of GDP (3% to 4%).

Thus, the idea that the rise of Southern European trade deficits was essentially due to (or reflected in) intra-Eurozone trade imbalances is largely a myth. The additional consumption of Italian and Spanish households benefitted oil-producing countries, China and other Asian countries first and foremost. And viewed from the German side of the equation, only 13% of the rise of German exports of the last decade went to Southern Europe.

Most observers and analysts now tend to interpret everything that has happened in the Euro area during the last decade as a consequence of the Euro experiment. But they hugely underestimate the fact that the rise of China during this same decade, and the accompanying explosion of commodity prices, has had even more impact on the Eurozone economies than the monetary union. This is especially true of trade development in Southern Europe.

Looking at the trade deficits in Italy and Spain, we can see that their main challenge is not to regain competiveness against German producers, but to reduce their dependency on oil imports (through the development of solar energy, for example). This will obviously take its time, and in the meantime the deleveraging Southern European countries will begin (Italy) or continue (Spain, Portugal, Greece) to improve their current account balance through lower import volumes. This would have to take place even if they left the Euro and devalued. We doubt, however, that BMW will prove to be the main victim of this inevitable development.

The Triumph of Southern Italy over Northern Italy

On the previous page, my colleague argues that Italy's balance of payments problem is not caused by the Euro, but instead by the China factor and rising commodities prices. Besides the fact that Italy would have better adjusted to the pressures of a rising China and higher commodities prices were it not for its artificially high foreign exchange rate under the Euro, this theory fails to explain Italy's disappearing industrial sector.

As the chart below shows, up to 2000 Italy's industrial production and GDP grew roughly at the same rate. Then the Euro was invented, and Italian GDP growth has basically flat-lined. But the situation was far worse for the country's industrialists as these days IP is some -15% lower than 2000 levels:

This dichotomy reveals a very sad reality—that the relative stability of GDP in Italy is thanks only to the relentless growth of the public sector:

The industrial production index gives thus a perfectly good representation of the state of the private sector in Italy—it is going out of business. Meanwhile, the free loaders' economy of southern Italy has won the day.

Unfortunately, the bill will have to fall on Northern Italy. And needless to say, if you tax Northern Italy a little more every year for the primary surplus to remain a surplus, Northern Italy grows even less, which means that the following year, you need to tax Northern Italy a little more...eventually Rocco and his brothers in the South will also find themselves in trouble.

So the Euro has in fact led to the triumph of Rome and Southern Italy over Northern Italy and of course of the rentier over the entrepreneur. Is it sustainable? No more than the Soviet Union was...