May 26, 2013 6:55 pm

Europe’s future looks more Japanese than German

By Wolfgang Münchau

The process to resolve the crisis will take many years to complete

Flags are reflected in a window at the European Council building, a day before an E.U. heads of state summit in Brussels March 12, 2008. REUTERS/Thierry Roge (BELGIUM) - RTR1Y6RS©Reuters

Solving the eurozone crisis is a piece of a cake. I was reminded of that last week when I heard an economist cutting through all the complexity with a classic what-goes-up-must-come-down-type argument.

Germany improved its relative competitiveness against the eurozone during the first decade of the 21st century through wage moderation. But now German wages are rising at a slightly faster speed than those in Spain and Italy. Depending on your favourite metric for competitiveness and your own personal estimate of the required scale of adjustment, you can do the maths on how long it will take to complete the reversal.

Austerity drives this adjustment. It has turned current account deficits into current account surpluses by depressing imports. As countries deflate, exports become more competitive and, proponents of this view hope, growth will begin to rise slowlyexactly what happened in Germany in the 2000s.

The latter expectation, however, is wrong because it underestimates two factors. The first is the self-defeating impact of austerity on growth when interest rates are close to zero, as discussed many times on these pages.

The second factor is the presence of an unresolved banking crisis and an associate credit crunch, which will further depress nominal growth. In an environment of low nominal growth, high debt will not inflate away. The European Central Bank will not accept higher inflation. And Germany will not accept eurozone bonds, not even after its general election in September.

Policy makers are clinging to the hope that banking union will resolve everything. But can this new regime, once it is in place next year, do the job? Can it force a large-scale restructuring of the sector, close down unprofitable institutions, merge others or force partial nationalisations? Of course not.

First of all, the banking union in its initial stages will be mostly nationally funded. It will consist of a central supervisor with a series of nationally co-ordinated resolution regimes, but without a central backstop. This itself would not be half as bad were it not for the renationalisation of finance, which has been the key characteristic of the financial resolution policies of the past few years. What it means is that resolution would end up merely reshuffling debt from one sector of the economy to another. If, for example, you bail in an Italian pension fund that owns Italian bank bonds, the Italian state may end up supporting the pensioners. While the eurozone has some debt-absorption capacity, the indebted peripheral member states do not.

The second reason is more subtle. There is simply no tradition of radical bank resolution in Europe. European bank supervisors are national operators by temperament, not international referees. They see their job as colluding with their national banking sectors to protect them against foreign competition. When a crisis occurs, they let the next economic recovery take care of the problem, rather than resolving it by reducing banking capacity. While I do believe that a banking union constitutes an important reform in the long run, it is very naive to think that the newly appointed bank supervisors are going to resolve the European banking sector with a determination they never displayed in their capacity as national supervisors.

This leaves us with a bank resolution strategy – if you want to call it that – that begins with an inadequate bank recapitalisation, on the basis of dubious stress tests and asset quality reviews, and is followed by further piecemeal steps in later years as the shortcomings of the strategy become more evident. All this will be accompanied by regulatory forbearance. We are already seeing this process at work in Spain.

Leaving it to the next recovery to take care of the problem will not work this time because the credit crunch and debt deflation prevent the recovery. Resolution is a precondition for growth. But since policy makers are in denial over the problem of debt deflation and the wider impact of austerity, I do not expect to see any real radicalism.

What about the resolution of sovereign debt? It will come in the form of a hidden debt mutualisation for peripheral government debt through loan extensions and lower interest rates. Take both to the extreme limits and you end up with the paradox of a perpetual zero coupon bondmeaning a total loss for creditors, never officially recognised. The European Stability Mechanism thus turns into a vehicle to deliver hidden eurozone bonds.

So, overall, we are looking at a mixture of financial and regulatory forbearance, small-scale recapitalisations and deleveraging, a process that will take many years to complete. During this period of financial retrenchment, the private sector will remain weak, while the public sector will be constrained by treaty obligations to run large fiscal surpluses.

On the positive side, I would expect the export sector in the periphery to grow moderately but not nearly enough to compensate for those two effects. We are looking at a decade of low growth and zombie banks, similar to what has blighted Japan in the past 20 years.
Copyright The Financial Times Limited 2013.

05/27/2013 11:24 AM

Austerity About-Face

German Government to Gamble on Stimulus

By Sven Böll and Christian Reiermann

Photo Gallery: Loosening Up on Belt-Tightening

With the euro crisis refusing to relent, the German government is backing away from its austerity mandates and planning to spend billions to stimulate ailing economies in Southern European. But can the program succeed?


Wolfgang Schäuble sounded almost like a new convert extolling the wonders of heaven as he raved about his latest conclusions on the subject of saving the euro. "We need more investment, and we need more programs," the German finance minister announced after a meeting with Vitor Gaspar, his Portuguese counterpart.

The role he was slipping into last Wednesday was new for Schäuble. The man who had persistently maintained his image as an austerity commissioner is suddenly a champion of growth. If Germany couldn't manage to trigger an economic recovery, "our success story would not be complete," he said. And as if to convince even the die-hard skeptics, he added: "The German government is always prepared to help."

After three years of crisis policy, it was an impression shared by very few people in countries like Portugal, Spain and Greece. They are more likely to associate Schäuble and his boss, Chancellor Angela Merkel, with austerity mandates ushering in hardship, deprivation and unemployment.

But a new way of thinking has recently taken hold in the German capital. In light of record new unemployment figures among young people, even the intransigent Germans now realize that action is needed. "If we don't act now, we risk losing an entire generation in Southern Europe," say people close to Schäuble.

Berlin is making an about-face, even though it aims to stick to its current austerity policy. The German government has stressed budget consolidation and structural reform since 2010, when Greece was on the verge of bankruptcy. Berlin has been arguing that this is the only way to instill confidence among investors in the battered debt-ridden countries and help their ailing economies recover.

But now, several rounds of cuts later, the politicians who had set out to save the euro must now look on as the economies of ailing Southern European countries are once again slumping while unemployment is on the rise.

To come to grips with the problem, Merkel and Schäuble are willing to abandon ironclad tenets of their current bailout philosophy. In the future, they intend to provide direct assistance to select crisis-ridden countries instead of waiting for other countries to join in or for the European Commission to take the lead. To do so, they are even willing to send more money from Germany to the troubled regions and incorporate new guarantees into the federal budget. "We want to show that we're not just the world's best savers," says a Schäuble confidant.

Worries about Image and Elections

The government's change of heart isn't just a sign of selflessness and compassion. More than ever, the chancellor and the finance minister are worried that Berlin's tightfisted, heartless, austerity-obsessed image could solidify throughout Europe and do irreparable political damage. An exporting nation that sells two-thirds of its exports to other European countries cannot be unconcerned about its image abroad, they reason, especially when its government fears that constant criticism from the center-left Social Democratic Party (SPD) and the Green Party, claiming that it is acting as the gravedigger of the euro and dividing the EU, could hurt it in the upcoming election campaign.

Merkel and Schäuble hope that their initiative could help Merkel's coalition government of their center-right Christian Democratic Union (CDU), its Bavarian sister party, the Christian Social Union (CSU), and the business-friendly Free Democratic Party close its open flank. This time, instead of just acting in concert, cabinet ministers with the three coalition partners are actively cooperating.

Last Tuesday, Schäuble sent a letter to Economics Minister Philipp Rösler in which he proposed that the coalition partners act together. "I believe that we should also offer bilateral German aid," he wrote, noting that he hoped that this approach would result in "significant faster-acting support with visible and psychologically effective results within a foreseeable time period."

Schäuble needs Rösler's cooperation because the finance and economics ministries are jointly responsible for the government-owned KfW development bank. The Frankfurt-based institution is to play a key role in the German growth concept that experts from both ministries have started drafting for Spain. Spanish companies suffer from the fact that the country's banks are currently lending at only relatively high interest rates.

But since it is owned by the German government, the KfW can borrow money at rates almost as low as the government itself. Under the Berlin plan, the KfW would pass on part of this benefit to the ailing Spanish economy.

Sharing the Benefits of Low Interest

This is how the plan is supposed to work: First, the KfW would issue a so-called global loan to its Spanish sister bank, the ICO. These funds would then enable the Spanish development bank to offer lower-interest loans to domestic companies. As a result, Spanish companies would be able to benefit from low interest rates available in Germany.

Under the plans, Germany could also invest in a €1.2 billion ($1.6 billion) venture capital fund that could be used to support new business activities. Madrid hopes that the program will generate a total of €3.2 billion in new investment.

The agreements with Spain are intended to serve as a blueprint for similar aid to Portugal and possibly even Greece. How high the payments to these countries will be has yet to be determined. "It will be nothing to sneeze at," say Finance Ministry officials. The German government envisions spending a total in the single-digit billions on the program. Schäuble plans to fill in the budget committee in the German parliament, the Bundestag, next week.

This is necessary because the KfW is supposed to serve as an agent of the federal government rather than act on its own account. For this reason, the federal government will back up the KfW program with guarantees, which require parliamentary approval.

In his letter to Rösler, Schäuble also suggests that Berlin should advocate an easing of the guidelines for aid to crisis-ridden countries. He notes that Germany already acquired valuable experience in this regard during the difficult post-reunification period when it was developing the areas that once belonged to communist East Germany. "I think the situation in some EU member states is certainly comparable to Germany's situation at the time," Schäuble writes, and he urges Rösler to promote the plan at the EU Competitiveness Council meeting on Wednesday.

If Rösler is successful, some €800 million in funding could be released that was already made available for aid to Portugal but is still being blocked owing to competition-related concerns.

A Mini Marshall Plan?

The fact that the finance minister and the chancellor are suddenly willing to do things that have been off-limits until now also has something to do with an internal Chancellery dossier from mid-May. The government headquarters had asked the ministries to take stock of the EU growth pact that was approved in June 2012 to support the austerity programs. The results were, in fact, supposed to demonstrate how well the German bailout strategy was working. But the officials' conclusions shocked even calculated optimists. In their report, they painstakingly documented that debt-ridden countries, especially those that have not taken advantage of EU bailout programs, have hardly made any progress in terms of needed reforms.

Since they had no other successes to report in their study, the authors listed items like the expansion of store hours in Italy. They also wrote, on a positive note, that France has begun preparations to open up competition within its railroad network beginning in 2019. And Spain was given credit for relaxing its residency regulations for investors.

The report's assessment of reforms in countries such as Greece and Portugal was more positive. But, as the authors soberly noted, it will take time for significant changes to take hold within the real economy. In light of the disastrous economic situation in many countries, the authors added an urgent warning: "For this reason, an additional challenge, in terms of the success of the pact, is to make a visible contribution to overcoming pressing short-term problems." In other words, they argued, the effects of the growth pact must be "felt within the population as quickly as possible."

Schäuble's new program is meant to achieve this. Similarities with the Marshall Plan -- that is, the billions the United States spent to help a devastated Europe get back on its feet after World War II -- are certainly not unintended. But, given its size, the current German plan could be characterized as something akin to a mini-Marshall Plan.

Still, it is hardly to be expected that the new programs will achieve similar results. At the moment, it is purely a German effort, and plans to get other countries on board are still little more than wishful thinking. Countries such as the Netherlands, previously considered to number among possible donor nations, have since been sucked into the crisis themselves.

Slim Chances of Success

Indeed, Berlin faces a dilemma. Europe lacks the money for massive economic stimulus programs, and so far the German government has insisted that incurring new debt isn't the way to solve Europe's debt crisis.

In addition, Germany will elect a new parliament in less than four months, after elections in September. With her administration facing pressure from the anti-euro party Alternative for Germany, and despite her offers to help Southern European countries, Merkel doesn't want to be accused of throwing even more good German money after bad. To avoid this, the goal in Berlin is to achieve the greatest possible results while spending as little as posible.

All it takes is a look at previous European initiatives to conclude that this feat cannot be accomplished. The Eurocrats are exceedingly proud of the fact that an additional €6 billion has been set aside for the coming budget period, between 2014 and 2020, to fight youth unemployment. But owing to the complicated structure of the funding, the money will only be disbursed slowly. According to internal European Commission estimates, only about €3.5 billion of the total will actually be spent by 2020.

It also remains completely unclear what the effect of the greatly hyped €10 billion capital increase at the European Investment Bank (EIB) will be. The EIB intends to issue about €60 billion in new loans by the end of 2015 and hopes to thereby stimulate a total of €180 billion in investments.

But the economic stimulus program threatens to fall flat. So far, the EIB has shown little inclination to distribute the billions exclusively where they are more urgently needed: in Southern Europe. And, as EIB President Werner Hoyer has implied at every opportunity, the bank is determined to keep its top rating so that it can continue to finance itself at low rates.

Ironically, the Finance Ministry in Berlin backs Hoyer's stance. An internal Finance Ministry memo reads: "To preserve the portfolio quality and the AAA rating, the federal government is in favor of having the EIB continue to promote projects in AAA countries while implementing the anti-crisis program."

Likewise, even if there are well-meaning decisions and sufficient funds for programs, implementation remains a problem. Government administrations in Southern Europe are still too slow, the EU bureaucracy in Brussels is still slowing things down, and governments are still dragging their feet on promised reforms.

Instead, these governments are pressuring Brussels and the Germans, as the negotiators from Berlin for the European Council meeting in June are currently experiencing. While the federal government continues to insist that the crisis-ridden countries clean up their economies and government finances in the long term, the countries themselves want short-term relief. More than anything, what they mean by this is: a lot of money for new economic stimulus programs.

Translated from the German by Christopher Sultan

Are There Any Gold Bulls Left In The U.S.?

May 26 2013, 09:56

 by: Tim Iacono

Volatility returned to precious metals markets in recent days after a wicked Sunday night sell-off and more big moves at mid-week when the Federal Reserve sent mixed signals about its money printing effort. The bears remain firmly in control as gold short positions surged to record highs.

Selling of gold and silver ETFs continued as more U.S. money managers rotated out of precious metals and into equities as the economic outlook continues to improve. But, in a possible sign of things to come, gold was one of the few assets to rise from Wednesday morning to Thursday afternoon after bearish developments at the central bank sent the price of nearly every other risk asset lower.

Physical demand for precious metals in Asia remains quite strong despite even more efforts in India to curb demand and there is some potential for a big short-covering rally if equity markets continue to falter, though most analysts seem to think that even lower metals prices are ahead.

For the week, the gold price rose 1.9 percent, from $1,360.20 an ounce to $1,386.30, and silver rose 0.6 percent, from $22.26 an ounce to $22.39. Gold is now 17.2 percent lower for the year, down 27.9 percent from its 2011 record high, and the silver price has fallen 26.2 percent in 2013, down some 54.8 percent from its all-time high reached in April of 2011.

Silver futures plunged more than 9 percent last Sunday night after yet another big sell order was placed in thinly traded markets triggering stop-loss selling and pushing prices sharply lower in what many called a "flash crash". The silver price fell to its lowest level since late-2010 in yet one more example of markets that appear to be manipulated by big traders who have very little fear of regulatory agencies.

Both metals rebounded sharply on Monday, in part due to a new warning on U.S. debt from credit rating agency Moody's, ending with big gains for the day and holding those levels until Wednesday. Fed Chief Ben Bernanke then sent markets on a wild ride by first appearing very dovish on central bank stimulus, but then responding to a question from Congress by saying the Fed could begin slowing their bond buying as soon as next month.

This sent stocks and commodities tumbling.

Precious metals rebounded on Thursday, whereas most other asset classes did not, and this development is worth remembering if equity markets continue to react negatively to the threat of Fed policy changes.

The $1,400 level is now key for the gold price after testing that level on multiple occasions last week, but this is likely to be a difficult task for gold bulls given the record short positions as shown below.

According to the accompanying story at Bloomberg using data from the Commodity Futures Trading Commission, hedge funds and other large speculators held 74,432 short contracts as of May 14th, the highest since they began collecting this data in 2006.

Of course, record short positions also hold the potential for a record short covering rally since, in recent years, high short positions have been followed by big moves higher.

This occurred on at least four occasions between 2007 and 2011, however, given the technical damage that has been done in the last few months, some new major catalyst would likely be required to convince futures traders to change course since, along with record high short positions, net long positions for hedge funds and other large speculators are now at their lowest level since mid-2007.

This same bearish sentiment remains for metal ETFs as institutional investors, hedge funds, and retail investors continue to sell.

As shown below via the World Gold Council's Gold Demand Trends, gold ETF holdings fell by over $9 billion during the first quarter of 2013, the equivalent of 177 tonnes of the metal being sold into the market.

(click to enlarge)

This accelerated in April after the mid-month price plunge and, as of last week, over 450 tonnes of gold are believed to have exited the world's many gold ETF products.

Gold ETF holdings are at their lowest level since July 2011 as U.S. investors continue to sell the SPDR Gold Shares ETF (GLD) and buy stocks, a trend that showed only the slightest sign of slowing last week.

Last month, the GLD trust shed 143 tonnes of gold and holdings have declined by 62 tonnes so far in May, including last week's 22 tonne drop, the biggest since mid-April.

After rising during the first four months of the year, silver ETFs are now also seeing large outflows as holdings are now declining at the iShares Silver Trust (SLV), down 230 tonnes last week in its biggest decline since January.

This follows outflows of 188 tonnes the week prior, erasing the year-to-date gains and suggesting that retail investors have recently become bearish on precious metals along with institutional investors and hedge funds.

Another possibility is that silver investors are converting their SLV holdings to physical coins and bars as U.S. premiums for these products remains quite high by historical measure.

Also shown in the chart is that demand for gold in jewelry, bar, and coin form rose sharply in the first quarter, offsetting most of the decline from metal ETFs. Gold premiums reached fresh record highs in China just last week as lower prices attracted more buyers and, the second quarter data from the World Gold Council (to be released in August) should be one of the most highly anticipated reports this group has ever published.

Record buying in Asia didn't begin until prices plunged in mid-April and one of the most important questions for precious metals markets in the months ahead is the amount of gold buying that has occurred in India and China over the last month or so, relative to the selling from ETFs in the U.S.

While Asia can't seem to get enough gold (and some shortages persist), you have to wonder just how many gold bulls are left in the West.

To some degree this is understandable since, aside from the small "hard money" crowd, there is no cultural affinity for the metal in the U.S. and, despite once-unimaginable central bank money printing, inflation has (so far) failed to materialize. Physical metal continues to flow from the West to the East as Americans sell gold and silver (mostly in paper form) to buy stocks and real estate where prices are rising.

Someday, precious metals will be relevant again here. When that occurs, those who sold their gold and silver in recent months will regret doing so.