On Thursday, 4 August 2011 – European markets fell sharply, the FTSE falling nearly -3.5% and the Dow Jones stock exchange falling 512 points (-4.3%). These are late 2008-early 2009 levels (the height of panicky season). Lets have a look at the key factors:
Americans Leading by Example
The US federal debt ceiling-fiscal austerity hybrid package which President Obama signed at the last minute on 2 August saw a simple procedural task do a depressing level of damage. The hugely fractious debate highlighted deep fissures at the political level with two distinct (and polar opposite) economic viewpoints dramatically colliding (one favours drastic cuts to federal spending, the other favours a streamlined but strong federal role). The perception that Republicans and Democrats are ideologically at war makes a compromise US economic strategy (on the only issue that really matters – jobs) now increasingly unlikely (if not utterly impossible) in the politically charged atmosphere running up to the Presidential election in November 2012. This, on top of dwindling consumer spending means the new austerity plan to slash public spending while the economy hovers above recession might be a heavy handed action at the wrong time. The likely result may be the feared ‘double-dip recession’ as investors run for the hills and seek short term gains in emerging economies, returning after the election (fingers crossed).
The other PIIGS – Italy and Spain
In the rank of worlds largest economies – Spain is 8th, Italy is 12th. The markets/investors know all too well that whatever sticking plasters EU leaders conjure up, the EU-27 (including the eurozone-17) need to convince the market they’re serious about the problems and ready to solve them (a trait currently lacking). Something with economic teeth is urgently needed, backed up with far more cash and political solidarity than leaders have yet mustered. The figures do not tell a simple story. Spain has 20% unemployment with over 40% youth unemployment but has a very reasonable debt to GDP ratio (total output) of 75%. Italy has 8% unemployment with 28% youth unemployment with a severe debt to GDP ratio of 119% (2nd only to Greece).
The ‘Is it Over Yet’ Plan – 21 July 2011
On 21 July, EU leaders met amid optimistic hopes for a BIG plan – a catch-all future focused ambitious united idea to address not only current problems in Portugal, Ireland and Greece but only on possible emerging difficulties in highly indebted Italy and Spain – economies that are literally TBTF (Too Big To Fail). Alas, no such luck. The plan seemed heavily fixated on the short term and on Greece, the immediate problem and failed to live up to current realities. Market reaction has mirrored this and events have rapidly moved since. Investors have soured significantly on Italy and Spain. We know this because yields on Italian bonds (Italy’s cost of borrowing – like an interest rate on its loans) rose to 6.2%, with yields on Spanish bonds rising past 6.3% heading to the 7% level where Greece got bailed out. It was as if the summit never happened.
Lame Duck Leaders
European nations which haven’t had a general election since the onset of the crisis in 2008 seem set for near revolution (at least at the ballot box). Incumbent parties were defeated across the EU with particularly sensational results in Finland and Ireland. The political dimension and perception of democratic legitimacy is particularly important with huge aid packages and tough political decisions to be made to reassert credibility to the markets. An Italian austerity package worth €48bn seemed paltry compared to the spending cleaver realistically needed. Remarks by Italian PM Berlusconi on Wednesday (3 August) promising sweeping reforms failed to convince anyone. This isn’t a major surprise. In Italy, Berlusconi is scandal ridden (to put in mildly) with upwards of 75 survived scandals in his 17 accumulated years in charge with his political fortunes now seen to ebb and flow with the economic winds. In Spain, the deeply unpopular PM José Luis Zapatero has called early elections for November 20th – but he will not be the Socialist candidate for PM.
With the Greek government barely surviving, PM Papandreou is leading a wanderly wagon government likely to collapse at the first bump in the road (likely a negative report from the EU-IMF in September). German Chancellor Merkel’s coalition is fraying at the edges with support from the opposition Socialists likely needed to pass vital EFSF legislation in the Autumn. The legitimacy of these leaders to take swift action on austerity programmes, on passing reforms of EFSF through parliament or negotiating any new EU plan is hugely questionable. These days, for aspiring leaders or incumbents credibility/respect from the markets = severity of action. How severe can (wo)men made of straw be?
The ECB, as outlined in the 21 July agreement (see earlier post) has tried to plug the gap by buying Spanish/Italian bonds (i.e. rising demand for these bonds and trying to artificially support them, keeping their borrowing costs from rising), but this seems not to be terribly effective, notably with the big sell off on 5 August. To make matters even more unpredictable a new ECB President Mario Draghi (An Italian) is due to succeed Jean Claude Trichet at the end of October with a potentially different approach.
Don’t’ Forget – We Still Have a European Banking Problem
The US can happily bypass the politicians and use the Fed (Federal Reserve, US Central Bank) to fiddle around with monetary policy and print dollars something the austere inflation obsessive ECB doesn’t like. Fiscally, the US has shown itself well able to take hard decisions in a crisis. One example, TARP (Trouble Asset Recovery Programme), the brainchild of Former President Bush’s Treasury Secretary Hank Paulson, was $700bn of a ‘bazooka’ to directly target the rot in US banks and stabilise the US banking system. It worked. The ECB has tried to intervene with European banks but those banks are blighted with PIIGS debt. This means many German, Belgian, Dutch, French and British banks have their survival pegged to the PIIGS ‘debt monster.’ When it rears its ugly head, investors panic and European bank shares plummet.
The ECB is trying to lend money to European banks to help then as the money they have to lend shrinks but a panic will make this a tall order if things continue to worsen. The EFSF (the ‘big pot’ European rescue fund) is only €440bn – which is seen as inadequate. A ‘market calming’ level would be at least upward of €1tn but the 21 July Summit avoided addressing the size of the pot, only addressing what the money could be used for. On Thursday, 4 August 2011, Commission President Barroso called for a “stronger expanded fund to resolve the crisis [as] Euro-area financial stability must be safeguarded.” The problem? Its political near-impossible. Any change in the format of the EFSF (including the minor July reforms) require the assent of all 27 EU national parliaments. Germany, the anchor of the euro and the EU’s lender of last resort, has already said no to a bigger pot. They’re not keen on footing the bill.
The main issues boil down to the following:
- Fears of ‘Double Dip’ recession in the US as political atmosphere becomes increasingly fractious and ideologically opposed to spending
- Fears of (continuing) sovereign debt crisis in the PIIGS (and, and a result, a banking crisis in the rest of the EU) without proper action being taken to reduce the debt piles themselves
- European Bailout ‘Pot’ (EFSF) is too small by about €600bn. Investors know this.
- Germany appears (to investors) reluctant to step in and take control (it is realistically the only country that can now calm the European markets)
- Political Uncertainty 2011: Personnel changes are at least possible in 4 key positions – Spanish PM, Italian PM, Greek PM and ECB Head (A-political but a politically charged role)
- Political Uncertainty 2012: Personnel changes are at least possible in 2 key positions – US President (effective January 2013) and French President
- Unknowns – Possibility of early German election? (If Socialists needed to pass EFSF reforms, might Merkel cut and run…or be forced?)