Barron's | SATURDAY, APRIL 28, 2012
How Europe is "Unfixing" Its Problems
By CARL B. WEINBERG
The troubled economies on the periphery of Europe are getting into deeper trouble. Growth has slowed, unemployment has risen, indebtedness has gone up, and borrowing costs have climbed sharply.
This article was prepared by the Eurocrisis Discussion Group at the Department of Economics, New York University, a group of economists that has meetings throughout the spring. Individual participants are named at the end of the article.
As the European debt crisis emerges from a brief remission, we confront a simple question. Are the steps taken thus far by the European governments and the IMF "fixing" the euro zone? We fear that, instead, they are "unfixing" it.
More than two years after the onset of the crisis, we would have expected to see embryonic improvement, at least, in the broadest economic indicators. We did not. So we pose the obvious question: Are efforts by the European governments, the European Central Bank and the International Monetary Fund enough to repair the weakest European Monetary Union economies and to stabilize their finances? Are we too impatient, or are the governments, the ECB, and the IMF just making things worse?
Working from IMF and government data and forecasts, we have analyzed the health of the economy and public-sector finances in each of the periphery countries based on four indicators: economic growth, unemployment, debt burdens, and borrowing costs.
We found that almost all the indicators had deteriorated since the start of the crisis in 2010. In fact, they are predicted to worsen even more this year, despite remediation programs imposed by EMU governments and the IMF. Almost without exception, national debt across each of the periphery countries is higher now as a share of the economy than before the crisis broke, and is projected to rise again this year. Borrowing costs, as gauged by 10-year government bond yields, have risen as well. And they show no sign of abating, with borrowing costs for the Spanish and Italian governments rising as we write.
Unemployment rates are at or near record highs and rising, particularly for the young. GDP growth has slowed, stopped, or even reversed into a decline. In absolute levels, the countries' economies have not yet recovered from the 2008-09 global downturn and financial crisis. They are contracting again.
By these simple metrics, the programs are "unfixing" troubled European economies rather than "fixing" them. The strategy of lending even more money to countries that have exhausted market sources of credit -- and saddling them with severe fiscal austerity programs to boot -- is not working by all accounts.
Compare these observations with the experience of the U.S., where prompt remediation of the crisis in the banking sector -- temporary recapitalization using public funds -- catalyzed a quick bounce-back from catastrophic financial failure. Two years after the fall of Lehman Brothers, the U.S. economy had already resumed economic growth. While the recovery is still tentative, fragile, and too slow, unemployment is falling consistently, and even home sales and auto sales are advancing. Today, U.S. banks are lending again. The growth of credit is funding new investment by small businesses, bolstering their working capital.
Two years later, how is the euro zone faring? Banks are still undercapitalized relative to the risks they face on their loan portfolios and on their sovereign-bond holdings. The banks will need to raise an additional 115 billion euros ($152 billion) to meet new capital-adequacy ratios of 9% by June, according to estimates by the European Banking Authority. About 70% of this total will have to be raised by lenders in the periphery countries. The IMF estimates that if banks cannot tap private or public funds to recapitalize, they will have to divest themselves -- collectively -- of about $3 trillion in loans and other assets to bring their capital adequacy up to the bar.
Meanwhile, banks are reported to be facing capital flight. Massive ECB liquidity provisioning since December now ensures that no bank in the euro zone will fail for a lack of cash. This has temporarily calmed markets. However, liquidity doesn't make a bank more solvent. As traders and investors absorb that idea, fear of financial crisis has been rekindled. No clear path to public support for bank recapitalization has been established. It is not assured, in any way, that no bank can fail. Without the confidence that banks are sound, the system becomes dysfunctional.
Credit in the euro zone is contracting under the weight of these multiple burdens. This credit crunch is the main reason the euro-zone economy is contracting, not growing.
Fixing Europe's troubled nations quickly is in everyone's interest. Because of the way politicians are going about it, the price tag for doing this is already high. The cost can only go up as more countries -- like Spain and Italy -- come closer to losing access to capital markets. Repairing troubled economies is a cost that will subtract from income and savings in even the strongest: Germany is on the hook to pay 27.1% of the cost of stabilizing the periphery nations.
How can the problems be fixed?
First, focus on economic growth, the obvious remedy for all of Europe's problems. Stronger growth would lower fiscal deficits and debt burdens by boosting tax revenue, by reducing public spending on income maintenance and job creation, and by raising the denominator of the debt ratio. Deficit and debt reduction over time is essential, of course. The challenge is to balance the urgency for fiscal reform against the cost of austerity on economic growth.
Then, take a page from the U.S. playbook. Recapitalize banks as quickly as possible using public funds to buy newly issued equity shares. Force all banks to participate, whether they need new equity or not. This all seems expensive, but it is less costly than bailing out governments. Note that most of the money the TARP (Troubled Asset Relief) program spent on capitalizing banks has been repaid, with profit, to the U.S. Treasury. If the euro-zone banks were adequately capitalized, they could withstand big losses on their bond portfolios and remain "safe" in the eyes of their customers, investors, counterparties, and regulators.
Finally, learn a lesson from the Latin American and Greek experiences -- that restructuring is inevitable to restore a troubled borrower. It must be done sooner rather than later if big haircuts are to be avoided. Had all of Greece's debt been restructured as long-term bonds in March 2010, Greece's financing burden would instantly have become manageable, without any haircut on private-sector creditors. Spain has €74.3 billion in bonds maturing between now and April 30, 2013. If they were restructured today into 30-year self-amortizing bonds, principal payments would average less than €2.5 billion a year.
EMU governments, however, aren't taking this advice. Banks remain undercapitalized, and they are cutting lending to regain capital adequacy. Worse, EMU governments insist on lending more money to already overindebted nations -- a bad idea. Salvation is seen in self-abusive policies, like fiscal austerity, at a time when economies are shrinking.
European governments and international agencies have devised "stabilization funds" or "firewalls" they say will "ring-fence" possible contagion of the global financial system from all current and any conceivable fiscal or economic crisis. The EFSF and ESM are authorized to wield financial "firepower" of more than €1 trillion, but these facilities are almost entirely unfunded: They are armed with promises, and not with pools of hard cash such as those TARP had at its disposal in the U.S. Funding these entities will create enormous drains on capital markets and disrupt the flow of funds to private investment, with catastrophic consequences. Unfunded, they offer no assurance to anyone.
Equally, the $430 billion of new funding for the IMF, obtained last week at the Spring meetings of the Fund, are also just promises to lend bank reserves to the IMF. If these monies are ever needed, implementing the new arrangement will monetize government debt on a huge scale, possibly enough to trigger inflation around the world. That, too, will be disruptive to capital markets, particularly U.S. Treasuries.
As investors as well as economists, we worry about systemic failures in banking systems throughout the euro zone's periphery. We worry about breakdowns in the social and political fabric that not only unites euro-zone economies but also binds together individual nations. The May 6 elections in Greece may demonstrate how fringe parties can gain control of nations in times of severe economic hardship -- hardship that, in the eyes of the local populace, has been induced by foreign-imposed austerity.
If voters see that the only consequence of the austerity from Brussels is to bind economies to further hardship, European politics will reject centrist solutions. With no growth in sight, we can expect to see fringe politicians flourish on a tide of anti-EU sentiment. This was evident in the rising turnout for extreme parties in last week's presidential elections in France.
THIS ALL MAY SEEM REMOTE TO READERS in the U.S., but it is not. On the upside, U.S. stocks may benefit from a wall of money fleeing Europe looking for a safe haven. The dollar will get stronger on these flows. That will be bad for exporters, but good for importers, who will enjoy wider profit margins. U.S. companies and banks may be able to steal business from hobbled euro-zone banks, both in Europe and around the world.
Fund managers can expect continued increases in yields in Europe. Even safe-haven securities, like German government bonds, are not safe: Germany's public finances are vulnerable to its obligation to be the biggest player in any euro-zone bailout.
U.S. government money is not going to be a part of the solution. The Obama administration cannot contemplate using U.S. cash to help woebegone Europeans out, and it refused to participate in the IMF's latest request for new resources. Europe's troubles will not be a big issue for the U.S. election, as long as the Treasury does not add cash to the euro zone's "firepower" or to the IMF's resources. Americans will vote on their own bellies, not on the woes of foreigners.
CONTRIBUTORS TO THIS REPORT, IN ADDITION to Carl B. Weinberg, include Maria Hernandez de Benito, Xiao Jun Chen, Ju Young Kim, Liz Landau, Owen Marmaduke, Alfredo Salvo, Andrew Scarponi, and Xaiojun Chen. All opinions reflect the collective and independent views of the authors, and not those of New York University or its Economics Department. |
