Eurozone Risk: Time to Pull Out Major Policy Moves

Context
There is nothing fundamentally new to say about the Eurozone. Back in 2010 when a portfolio management group asked me to make a presentation on the Eurozone to help them see through the maze and get a clear picture, I ended my presentation by saying “the Euro won’t fall now, but we will still be talking about all this in 5 years”… and here we are!
 
Large economies of the Zone have major labor market issues that are structural by nature and require major reforms. Countries have separate fiscal policies and tax collection, a country-specific-focus of most banks, different languages, no automatic “built in” fiscal transfers to absorb “asymmetric shocks”, and there are no “Eurobonds” that would aggregate risk into one debt instrument, thus helping weaker states (although this “Eurozone credit backing” was implicit before 2008)… and on and on and on… In short, the Eurozone is not an “Optimal Monetary Zone”, far from it.
 

A quick recap of the monetary zone issue
The Eurozone is stuck with debt-deflation dynamics: prices tend to fall, public and corporate debt loads are high, hence the real burden of these debts tends to increase and paralyze the economy further. Now the ECB has embarked on major policy moves that have avoided outright debt-deflation, but much more needs to be done, and not just by the ECB.
 
The 2008 shock only made the structural fault lines come out. Like a couple that has a weak relationship, all is well when times are good – it is when times get rough that you see how strong and healthy the union really is. Let’s see if we can clarify how things are and what is likely to happen…
 
The ECB
The central bank is doing what it can. The issue is that the extra liquidity that is being pumped into markets comes right back to the ECB in the form of reserves, even with negative rates on excess reserve deposits and interest payments to banks that borrow from the ECB. Why?
 
There are essentially 3 reasons for the lack of effective money supply expansion, even in the presence of monetary base expansion:

1. The low-growth context makes credit expansion essentially impossible. You need expansion to absorb money and credit, because we are in a credit money system, credit expansion = effective monetary expansion (inflation); credit contraction = effective monetary contraction (deflation). This is because we are not (for now) actually doing physical helicopter drops of money ballots (equivalently: printing money and sending free checks to households), which would indeed pump up money supply and inflation.
2. The banks are under-capitalized and bank managers are nervous, especially about lending to places where credit and liquidity is needed: Italy, Spain, Portugal, and Greece. This means that excess savings are simply deposited in reserves. In countries with a more unified banking system (with banks having branches in all regions of the economy), the excess savings of a region would go (at least a bit more) to other regions directly via the same bank, which is a structural specificity of more functional monetary zones, such as the USA or Canada. What would help would be a massive recapitalization of banks by governments and the ECB (who could take temporary stakes on future profits to make the process more acceptable).
3. In many countries, households and businesses are stressed about stagnation and labor market conditions. Although households in the major economies of the Zone are much less leveraged than in the USA in 2008 (this is good news), people and businesses refuse to take on extra debt, hence you can push all the central bank liquidity you want, it will simply “float around” in financial markets in various forms – it won’t “land” in the real economy. In other words, the central bank has low “traction”: the wheels tend to spin in the mud.

Do negative rates charged on excess reserves help? Yes. Do positive rates given to banks that borrow from the ECB help? Yes. But these policies are limited, because if rates on reserves become too negative, banks will have to charge clients for their deposits, and people will start hoarding physical cash if rates become too negative, which would complicate things a lot.
 
What did the USA do?
The USA was stuck in the very same spot in 2008-2012: lack of demand for credit, stagnation, deflationary forces, increasing excess liquidity, etc. What did they do? The same thing the ECB is doing. But the structural setup is very different, so the ECB has more trouble getting traction, and it has an official mandate of “close to, but BELOW 2% inflation”, which does not help in the current context.

(Quick personal rant: we all need to get over this 2% inflation mania, it's like OCD problems... go see a therapist for help! I know the whole "inter-temporal credibility and inflation bias" thing and all the monetary theory stuff (I know, I teach this!), but perhaps we are all a bit excessive on this... moving on...)
 
The US government and the Fed purged the private sector of a lot of bad credit, which accelerated the process of normalization. This was messy and, let’s be honest, ugly in terms of democracy and “fairness”… but in the end, lack of action in the name of fairness or ideology ultimately falls on the little guy who loses his job and on the general population stuck in stagnation and a lost decade or 2.
 
The “messy process” worked for the USA, and the general outlook went from very bad to pretty good within less than a decade. I firmly believe and I stand by this, so you can quote me on this: when in doubt, OVER-stimulate (by a lot), and add to the process the required structural reforms that are pro-growth, pro-employment, and good for financial and economic stability… it is LESS expensive in the long run and benefits ordinary people the most. The problem often hinges on the political wiggle room to do so and past fiscal irresponsibility that has decreased current breathing room.
 
In the USA after 2009, unemployment started dropping in most regions and households deleveraged a lot… for 8 years! During those 8 years, the lack of domestic demand due to private sector deleveraging was partially replaced by government spending (deficits) and exports facilitated by a generally weaker USD in world markets. The purging process is almost over for the USA.
 
The good news is that most Eurozone households are far less leveraged, so the problem is not likely to persist due to massive household deleveraging. The bad news is that the lack of political coordination causes paralysis in major moves that are required to really get going and turn the page on these hard times. Jobs and production need to be clearly encouraged by sweeping changes in policies, regulation, and high-level communications of politicians. Bad loans that plague Italian banks need to be purged, even if the process is messy, and something needs to be done to get the economy out of this classic case “Paradox of Thrift” and policy paralysis (other than the ECB).
 
What is likely to happen and what to watch for?
What I think and what “should be done” doesn’t matter and is not useful for managing money or risk, right? So what is likely to happen going forward and what should we watch out for? My general take remains unchanged relative to my “Global Markets Outlook” document (free on the Market Outlook page of my website).
 
The Eurozone is likely to muddle through and slowly get better. A surprize exit from the Zone would be catastrophic for the global economy and markets. The likelihood of this seems low for now, but on this specific aspect, you never really know unless you are VERY close to information sources. If it happens, even if it was just a small economy like Greece, the global impact would likely be large in the short-medium run due to market mass psychology effects.
 
My 2 cents is that there will be no exit within the 2016-2017 period, and it is only based on my evaluation of the cost-benefit analysis for the “potential exit countries” (I am ignoring the UK issue entirely here).
 
On the hypothesis that there will be no country exit, what could we expect?

1. More monetary expansion and a possibility of another phase of euro depreciation.
2. A slow, grinding growth pattern.
3. Lots of asset demand in safe haven markets and countries.
4. A generally good context for Germany, since it has the monetary stimulus without labor market problems.

 
What to watch out for is political unity and reforms, labor market conditions, continued ECB willingness to act aggressively, as well as the sources of systemic risk, such as Italian banking sector risk, credible rumors of exit, capital cushion in large financial institutions, liquidity conditions in key markets that require lots of rollover activity, and others.
 
This is not a thorough overview of everything in the Eurozone mess, as it is a simple blog post, so even if there is lots more to say, I will stop here to let you move on with your day! My general take on global markets is available on the Global Markets Outlook document on the Market Outlook page. I will update some outlook evaluations regularly.
 
I hope you enjoyed this post and that things are a bit clearer now! Feel free to comment, share, and to contact me. Cheers!
 
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