Eurozone downturn and lack of reform presage existential crisis

A slowdown mixed with a monetary union unwilling to repair itself would be a risk to the global economy

Wolfgang Münchau

Puzzling decline: German industrial production has been weak since December and European car sales fell 5 per cent in March © Bloomberg

Over the course of the past week, we learnt two new things about the eurozone. Germany has closed the doors on serious reform. Angela Merkel and Emmanuel Macron’s meeting in Berlin exposed deep differences about the German and French leaders’ visions of the future.

What also transpired more clearly is that there has been a sudden decline in the eurozone’s economic activity. The latter is puzzling. It could be a fluke, but a number of recent indicators have all surprised on the downside.

German industrial production has been weak since December. But it took a real dive in February, when it fell by 1.6 per cent against January. The European Automobile Manufacturers Association reported that car sales were down by 5.3 per cent in March. One of the more reliable gauges is the business cycle indicator of IMK, the German economic institute.

It now registers a recession probability of one-third, up from almost zero a month earlier.

Now add these two pieces of news together. We know for certain that Germany will not agree to a central eurozone budget to weather macroeconomic shocks. There will be no single safe asset.

There will be no common deposit insurance. The big project of a European banking union will remain forever uncompleted.

Then add something really dangerous — a recession — into the mix. I have no idea whether the next crisis will originate in sovereign bond markets, in the banking sector, or somewhere else. But the combination of a slowing and possibly retracting economy and a monetary union unwilling to repair itself constitutes one of the biggest risks to the global economy right now.

Can we be sure about the economic downturn? No, we cannot.

The confidence indicators may be temporarily affected by fears of a trade war. If President Donald Trump of the US prioritises China as his main target for trade sanctions, those fears may soon go away.

If not, then yes, the eurozone would be particularly vulnerable because of its large current account surplus.

There are also seasonal factors to consider. The winter was harsh in Europe — in the north and the south. That could have played a role in depressing industrial production and investor sentiment. The combination of a warm summer and a distracted US president may go some way to solving the problem. But there are other reasons to suspect that something else might be afoot.

The first has been the appreciation of the euro. The daily nominal trade-weighted exchange rate of the euro has increased by almost 7 per cent over the past year. For an economy with an extreme degree of export-dependency this is a big move. Most of the change occurred last year, but it would be normal for the economic impact only to become notable with a delay.

Second, the financial crisis may have lowered the eurozone’s potential output permanently. The reported strong growth rates during 2016 and 2017 could have been a blip — a temporary relief after years of austerity. What is now disguising itself as a downturn may in time be revealed as a return to a depressed normality.

Italy has registered almost no productivity growth since becoming a founding member of the eurozone in 1999. Yet, 2017 was a relatively good year for the economy. It matters a great deal whether a country with a debt-to-GDP ratio of 132 per cent can manage average real growth rates of less than 1 per cent or 2 per cent. That gap is the difference between solvency and insolvency. Italy is the best example of why eurozone reforms are existential. The EU has no instruments to cope with an Italian sovereign debt crisis. Italy is too big to fail and too big to save. The European Stability Mechanism, the rescue umbrella, is too small to cope. I have no doubt that the euro itself will survive in some form or other, but without reforms the risks of a fracture are greatly increased.

Even President Macron’s reform agenda does not fully address this problem. But it would at least open the door to the infrastructure that is needed to do the heavy lifting in a crisis — a single safe asset and a fiscal backstop to the financial sector. The German position has been to reject these ideas from the outset.

After years of following the eurozone debate, I have come to the conclusion that Germany will not agree to reforms unless it is confronted with a take-it-or-leave-it choice. A eurozone break-up would be a disaster for Germany. It would destroy the country’s export-led business model, and shrink its massive stock of external assets.

But it is the prevailing assumption behind the refusal to accept institutional reforms that such a challenge would never happen. This assumption is correct. For now.


Mario Vargas Llosa explains why his politics changed

A Latin American liberal’s testament

IT IS not every novelist who sits down to write a serious work of political philosophy. But Mario Vargas Llosa has always been as much a political as a literary animal. He describes “La Llamada de la Tribu” (“The Call of the Tribe”), published in February as its author turned 82, as an account of his own intellectual history. That is a journey from youthful flirtation with communism and existentialism; enthusiasm for and then disenchantment with the Cuban revolution; followed by a conversion to liberalism in the British sense. This stance makes him exceptional among Latin American intellectuals, many of whom are still bewitched by anti-imperialism and socialism.

The book is an account of the lives and thought of seven liberal philosophers. Apart from Adam Smith, they include Karl Popper and Isaiah Berlin, both of whom the author met (as he did Margaret Thatcher, who impressed him too) while living in London in the 1970s. Also on the list are France’s Raymond Aron and José Ortega y Gasset of Spain. Some readers might query the absence of John Stuart Mill or John Rawls. The book is not “a history of liberalism” but rather a “personal account of writers who made the biggest impression on me”, he explains in an interview at his home in Madrid.

For the reader, it all makes for an enjoyable return to university. Mr Vargas Llosa has read nearly everything his heroes wrote, and his exposition of their thought is lucid and balanced.

He says what he thinks they got wrong, such as Friedrich von Hayek’s praise for Chile’s dictator, Augusto Pinochet, Popper’s disregard for clear writing and Ortega’s elitist view of culture. The book’s title comes from Popper, who saw the “spirit of the tribe”—a longing for a collective world free from individual responsibilities—as the source of nationalism and religious fanaticism.

Mr Vargas Llosa’s liberalism is not without inner tensions. Some of his newspaper columns seem to espouse anti-state libertarianism, others liberal social democracy. In the book he stresses core liberal beliefs: economic, political and cultural freedom, which he sees as indivisible, but also tolerance of disagreement and equality of opportunity—and thus the importance of education. He is particularly critical of those who would reduce liberalism simply to the free market, though that is an integral element of it. Liberalism has been traduced and distorted, he says, by being presented as identical to reactionary conservatism when it is, rather “the most advanced, progressive, form of democracy”.

This “ignorance” of liberalism is one reason the liberal tradition is so weak in Latin America, says Mr Vargas Llosa, who is Peruvian. Others are the region’s deep inequality, the fact that its 19th-century liberals “did not believe in the free market” and the more recent misappropriation of the term by dictatorships such as Pinochet’s.

He spies today “a big opportunity” for liberalism in Latin America because its rivals, from military dictatorships to Cuban and Venezuelan socialism, have failed so completely. That has destroyed “the Utopian, socialist, collectivist model”, he says. “Who wants their country to be a second Venezuela? Nobody in their right mind.” He thinks that the corruption scandals linked to Odebrecht, a Brazilian construction firm, have “rendered a great service” and will help cleanse the region’s democracies of corruption by exposing it.

“La Llamada de la Tribu” is a reminder that ideas matter. Its author has put that belief into practice. In 1990 he ran for president in Peru. It was a quixotic venture that ended in defeat at the hands of Alberto Fujimori, who went on to rule as an autocrat for ten years (and who is a particular bête noire for Mr Vargas Llosa). But he writes that “many of the ideas we defended…and which are in this book, far from disappearing…constitute part of today’s political agenda in Peru.” Recently Mr Vargas Llosa spoke at mass rallies in Barcelona against Catalan separatism. He did so, he says, because “the great danger in our time is nationalism.” While fascism and communism are outdated, nationalism is still alive, “available at times of crisis for exploitation by demagogues”.

Many Latin Americans who call themselves liberals are in fact conservatives or libertarians. They either bless a status quo that embodies inherited injustice or oppose state action to remedy it. Too many other Latin Americans remain in thrall to populism or archaic versions of socialism. That makes Mr Vargas Llosa’s book relevant. The challenge is to make its ideas attractive to the Latin American masses.

Black Swan? The 'Vicious Steepener' Risk

by: The Heisenberg

- Everyone wants to talk about the relentless flattening of the U.S. curve.

- What very few people seem to realize is the extent to which the current dynamic may be setting the stage for a dramatic steepening episode down the road.

- If you're looking for an underappreciated risk, here's one for the ages.
There's been a ton of chatter lately about relentless flattening in the curve and what it might or might not portend for the U.S. economy.
Although the 2s10s steepened for three straight sessions to close the week, that was off a decade low of just ~41 bps on Wednesday.
This has become a veritable obsession for pundits, even as analysts have variously attempted to take a more nuanced approach by trying to discern whether a flat or inverted curve necessarily means what it used to or otherwise has the same predictive power it may have had in past cycles.
Here's what one analyst I spoke to over the weekend had to say:
I think in general this whole discussion about curve inversion as a predictor of recession is incorrect. I mean, there was some connection in the past, but causation has changed. The connection no longer holds. Even in 2007, the curve inverted for different reasons; it didn't know about the recession, otherwise we would have avoided it.
Whatever the case, there likely won't be much in the way of respite from the flattening in the near term. In other words, the transitory bout of steepening we saw on Thursday and Friday is likely to be just that - transitory. Here's Bloomberg's Brian Chappatta, from his week ahead preview (usually out on Sundays, always free, and always worth a read, by the way):

The U.S. will issue a combined $96 billion of two-, five- and seven-year notes this week, the largest slate of fixed-rate coupon sales since 2014, according to BMO Capital Markets. After a stretch dominated by Federal Reserve speakers, the offerings are likely to refocus traders on the prospect of ever-larger auctions to cover swelling budget gaps. 
That outlook will be hammered home next week, when the Treasury releases its latest financing estimates for the current and upcoming quarters. With trillion-dollar deficits just around the corner, the department’s forecasts could very well be market-moving.
And this is where this discussion gets interesting if you step back and think ahead. I've talked a lot over the past six or so months about the dangers inherent in piling fiscal stimulus atop a late cycle economy (see here and here, for instance). There's likely to be a sugar high for economic activity, but that comes at a cost; literally, in the sense that the current round of expansionary fiscal policy is deficit-funded.
As you're probably aware, the latest CBO forecasts show the deficit hitting $1 trillion two years earlier than previously expected as a result of the tax cuts and extra spending measures.
The tax cuts and the spending are likely to juice the economy in the near term, but it's doubtful they will pay for themselves via growth effects over the longer haul. According to the IMF, the U.S. fiscal position will be worse than that of Italy, Mozambique and Burundi by 2023:
(Source: IMF)
Needless to say, the stimulus risks stoking inflation and thereby forcing the Fed to hike more aggressively than they otherwise might. Here's an excerpt from a new piece by Brookings:
The U.S. economy remains in robust shape, with growth in GDP, industrial production, and investment holding up well. In tandem with strong consumer confidence and employment growth, wage and inflationary pressures have picked up slightly, although less than would be typical at this stage of the cycle. The U.S. is engaged in a perilous macroeconomic experiment, with the injection of a significant fiscal stimulus even as the economy appears to be operating at or above its potential.  
The Fed is likely to lean hard against potential inflationary pressures as this stimulus plays out. Export growth has been buoyed by a weak dollar and strong external demand, but the U.S. trade deficit has still risen over the past year.
As the Fed hikes to ward off inflation pressures, those hikes will of course drive short-end rates higher, thereby supporting the dollar and underpinning demand for the long-end (between favorable rate differentials and the safe haven appeal of U.S. debt, Treasurys will be an attractive asset even as the fiscal outlook for America worsens and even as the administration's trade doctrine amounts to a weak dollar policy by proxy). This dynamic will lead to more flattening in the near to medium term.
But this presents a palpable (and likely underappreciated) set of concerns. The buildup in duration and the perpetuation of the bond trade more generally creates an ever larger tail risk.
What you have to ask yourself is where the bid for the long end is going to come from when the U.S. finally does enter a recession against a backdrop where America's fiscal position has ventured into uncharted territory and the dollar suddenly loses support from a Fed that will be forced to cut rates to counter the downturn. Here's Deutsche Bank's Aleksandar Kocic, from a note out Friday:
In contrast, in the current cycle, the main driver of the flattening trend is essentially the strong USD – as long as the currency remains stable, the sponsorship for the US long end is likely to be uncontested. This becomes problematic when the USD begins to weaken significantly and that can come on the back of either higher inflation or possible recession or a general weakening of the economy. Fed hikes in this case act as a stabilizer – rate hikes are both supportive for currency and potentially prevent higher inflation. 
Nevertheless, persistence of the current trend is a cause of buildup of tail risk. As we are expecting a continuing fiscal easing and deficit spending in the future in the environment of economic expansion, when the recession kicks in, Fed would have to cut rates. The logical question is: who will sponsor the long end of the US curve in an economy with potentially weaker currency? Long yields would likely fail to rally or could even sell off in an easing cycle. The persistence of Fed hikes and curve flattening could become an incubator for vicious steepeners in the future.
See what I mean? The current environment is conducive to the continual sponsorship of the U.S. long end as Fed hikes are supportive of the dollar even against the deteriorating fiscal outlook. Those same hikes serve as a check on inflation. This could encourage crowded positioning (i.e., the buildup of tail risk) which in turn raises the stakes further in the event the economy finally falters, forcing the Fed to cut rates, thereby allowing inflation to materialize and potentially undercutting the currency against a backdrop where the fiscal picture is the worst it's ever been.
In that scenario, the bid for the long end of the U.S. curve may evaporate completely, leading to dramatic steepening and opening the door for a supercharged version of the spike in cross-asset volatility we saw in early February during the brief inflation scare that accompanied the above-consensus AHE print in the January jobs report.

 The Pension Crisis Gets A Catchy Name: “Silver Tsunami” 

Pensions really are in crisis, but the story is so full of large numbers, obscure projections, and dry terms like “unfunded liabilities” that not many people are paying attention.

The same is true for a lot of other big trends out there, which is why those sounding the alarm eventually settle on pithy/scary (if not always accurate) terms to get people’s attention. Global warming, for instance, or nuclear winter.

Now the pension crisis may have found its hook:

‘Silver Tsunami’ hits as pension costs devour California school budgets
(San Francisco Chronicle) – What happens when state funding improves, but local school budgets get worse? And how did we get into this situation in the first place? 
It’s simple. School systems are getting hammered by the rising costs of pension and health care commitments. Meanwhile, they are being pinched by external factors including declining student enrollment, increased competition and frozen federal funding. 
California is not an anomaly. Districts throughout the nation are facing the same squeeze. 
So why isn’t anyone paying attention? Three main reasons: 
Money is boring: And only boring people like chief financial officers talk about money and use phrases like “unfunded liabilities.” Interesting, cutting-edge people talk about “disruptive innovations” like personalized learning, or anything with the word “maker” in it. 
Money is politically messy. Everyone wants funding for their favorite education project. In this zero-sum world, no one wants to talk about making tough choices.  
Even fewer want to discuss sensitive topics such as pension and health care liabilities. 
Education finance has never been part of our nation’s education wars. Most of the opinion makers in education are like the Great Houses of Westeros in the HBO series “Game of Thrones.” They are much happier fighting each other to the death about issues like unions and charter schools than focusing on the more powerful forces that could destroy them all. 
In “Game of Thrones,” that force is the White Walkers. In education, it’s the “Silver Tsunami” — the tens of billions of dollars in pension and other post-retirement benefits guaranteed to retirees. 

In the olden days (before the mid-2000s), these budget problems seemed very far away.  
But over the past decade, millions of Baby Boomers have retired. Suddenly pension and retiree health care costs were at hand. 
Most state and local officials failed to plan for these increased costs. During good times, they sweetened already generous benefits. During bad times, such as the Great Recession, they reduced the already inadequate amounts they were socking away. 
The size of these unfunded liabilities is mind-boggling. Nationally, the estimate is $1.4 trillion. In California, it’s $97 billion for teachers and other school employees as of 2015-16. To put this into perspective, total venture capital investment in educational technology since 2010 was $2.3 billion. 
In 2013, California state leaders attempted to address the shortfall by increasing payments from districts into the pension fund to $1,600 per pupil in 2023-24 from $500. This increase will only pay for part of the state pension obligation. Billions of dollars more will come directly from state coffers and never reach education budgets. 
Just when you think it couldn’t get worse, California has more than $92 billion in unfunded health care liabilities. By 2030, Los Angeles Unified School District, serving more than a half-million students, is projected to spend half its budget on retiree pension and health care costs. Hundreds of other districts could make dramatic budget cuts or even go bankrupt. 
District and charter leaders are beginning to talk about the impact of these rising costs. Unfortunately, everyone else is making things worse. Unions, foundations, and nonprofits still live in a world where an improving state economy was a reason to advocate for salary increases or fund the latest program. 
That world is gone. Winter is already here. Unlike the fantasy world of Westeros, there are no magical solutions or heroes coming to save us.

With 10,000 or so baby boomers – many of whom are public sector employees – turning 65 every day, pension imbalances will explode in the coming decade. That means life gets harder for pretty much everyone who drives, needs police protection or has kids in school. Which in turn makes politics even more unstable and unpredictable than currently.

At the same time, the weakest pension plans and their cities will be forced into bankruptcy, leading to panic among the not yet bankrupt and – now we’re getting to the systemic risk – the owners and potential future buyers of the bonds cities and states issue to keep afloat. When the muni market dies, so does much of the rest of the US financial system.