Eurozone Meltdown Brewing?

November 16th, 2011
in contributors

by Guest Author Art Patten, from Symmetry Capital Management

Editor's note: This was written over a week ago before the current bond contagion news (GEI News tonight – November 16).

Though most eyes are focused on the latest political turmoil in Greece, economies in the rest of the European Monetary Union (EMU or eurozone) are showing signs of increasingly severe weakness.

As we’ve previously argued, the government debt crises in the EMU can be contained as long as the European Central Bank (ECB) stands in to backstop the whole mess by buying government debt (as it alone has the power to create net new euros). However, it will take far more concerted and difficult-to-coordinate efforts to prevent the eurozone from sliding into recession (which in turn makes preventing a financial crisis more challenging). Barring a sharp recovery in credit markets, the EMU economy now looks set to contract by at least 4% in 2012.

Follow up:

Recent data are confirming this view, as eurozone purchasing manufacturer indices (PMIs) —including for Germany, the prevailing economic paradigm’s darling—looked absolutely abhorrent last week. German construction figures were awful today, and productivity figures for the European Union (the EU, which includes both EMU nations and countries that do not use the euro as their official currency) are now in territory last seen during the 2008 recession. A chart of German PMI looks like a tired swimmer chained to a bunch of cinder blocks. Yet amazingly, the swimmer continues to complain that the blocks aren’t yet heavy enough.

Eurozone Composite PMI (Source: Markit)

If a full-blown EMU debt crisis erupts, which is still a very real possibility, that figure could be five times worse; if accompanied by a currency crisis as well, it could be ten times as bad.

Because the EU and eurozone’s institutional arrangements (1) lack a central fiscal body with the authority to implement stimulative measures, and (2) restrict activist policies by the ECB, the entire framework has a pro-cyclical bent, which means more pain ahead even if a financial crisis is avoided (which becomes increasingly difficult as fears of a slowdown intensify). This is likely to go on until a critical mass of people have finally had enough, and politicians and bureaucrats are frightened enough to take them seriously.

But the looming problems in Europe have little to do with Greece, and everything to so with Italy, Spain, Belgium, France, and eventually Germany.

Despite the hooplah over a new framework for Greece, bond investors are continuing to drive yields up (i.e., prices down) on Italian government debt. Italy is now uncomfortably close to an interest rate level capable of triggering a debt-default spiral. The fact that the world’s fourth largest issuer of government debt is now a non-sovereign with 100% external liabilities (because it cannot create new euros) should put serious fear into the hearts of investors (it has already done so for central bankers, apparently).

10-Year Italian Govt Bond Yield (Source: Bloomberg)

Spanish government bond yields are also higher (and prices lower) since summer.

10-Year Spanish Govt Bond Yield (Source: Bloomberg)

Risk aversion has also spread rather dramatically to the core EMU nations of Belgium and France.

10Y French Less 10Y German Govt Yield (Source: Bloomberg)

And the cost to insure against a default by the German government has spiked dramatically since summer.

German Govt 10Y Credit Default Swap in $ (Source: Bloomberg)

The distinction between “core” and “peripheral” Europe is becoming increasingly irrelevant, an outcome virtually guaranteed by the EMU’s institutional framework. And thus far, it’s required an unbroken string of better-than-bi-monthly EU summits and untold time and effort from the private sector and its regulators just to prevent Greece from taking down the eurozone (and possibly global) payments system. Will Europe have the necessary stamina and flexibility to effectively deal with a much larger crisis? It’s unlikely to receive much help from abroad either; consider that the G-20 proved itself worse-than- useless at its just-adjourned summit, with vague offers of help and still-pronounced infatuation with fiscal tightening, despite an apparent worldwide shortage of aggregate demand.

It could well be that we’re witnessing the beginning of the end for the prevailing macroeconomic paradigm. Unfortunately, before it can be drastically improved, we’ll have to endure yet more tinkering, such as nominal GDP targeting by central banks. But eventually, we will hopefully be able to lay at least some of our era’s innocent frauds to rest and replace them with principles that better reflect reality. The most important one is that a sovereign currency-issuing government does not fund itself through tax revenues or borrowing; taxation simply enforces the widespread acceptance and use of its currency. From that one fact, several important observations follow:

  • Such governments are never fiscally constrained; the only economically relevant constraint on deficits (via spending increases, tax cuts, or central bank operations that add to the net stock of financial assets) is inflation.
  • Current government deficits and debt (whether interest-bearing, such as Treasury securities, or not, such as money) do not impose any burden on future generations, unless they lead to inflation at a high enough level to severely undermine investment and future productivity.
  • For productive saving and investment to occur, a sovereign government, via its treasury and/or central bank, must run deficits, as that is the only sector of the economy (the restricted ability of export activities aside) capable of adding net financial assets.

Compare those to the faulty inverse propositions guiding policymakers worldwide:

  • Governments must finance their expenditures via taxation and borrowing (which assumes that net additions to the stock of financial assets ’just happen’).
  • Current deficits lead to an expansion of government debt which must be paid off by future generations in the form of higher taxes and/or fewer public goods and services.
  • Government must add to savings by saving, i.e., by running balanced or surplus budgets over the long-term (which fails to recognize that this is a de facto argument for contracting the supply of net financial assets, i.e., deflation).

And it’s staggering how many academic and political reputations are chained to these errors. As Warren Mosler has pointed out, there are legacies being trashed—The Emperor Wears No Clothes, writ large.

In the meantime, the U.S. Congressional super-committee has yet to release anything promising, the Chinese government is continuing its attempts to tame inflation and crush its overheated residential property sector, and credit markets are flashing serious economic and market warnings. Blissfully unaware, most major stock markets have exuberantly extended their historic October rallies into November.

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (SCM) is a Pennsylvania registered investment advisor that offers discretionary investment management to individuals and institutions. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, or to engage in any investment strategy. Past performance is not indicative of future results. This material does not take into account your personal investment objectives, your personal financial situation and needs, or your personal tolerance for risk. Thus, any investment strategies or securities discussed may not be suitable for you. You should be aware of the real risk of loss that accompanies any investment strategy or security. It is strongly recommended that you consider seeking advice from your own investment advisor(s) when considering any particular strategy or investment. We do not guarantee any specific outcome or profit from any strategy or security discussed herein. The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such. All views and positions are subject to change without notice.

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