(by Alasdair Macleod) With the Eurozone having being displaced from the financial headlines
by the American presidential election, you might have briefly thought
that its problems had gone away. They haven't.
It's just that the public is expected to absorb one major story at a
time. And now that the presidential election is done and dusted, Europe
is rapidly returning to the headlines. This is not desired by the
powers-that-be, who desperately need us to believe things will get
better with a little patience.
Behind the scenes, in order to prevent a systemic crisis, the
authorities (through the European Central Bank) have been hard at work
keeping a lid on interest rates for Spain and Italy, which act as
everyone's market bellweather. Their strategy focuses on the hope that
high bond yields are just a lack of 'animal spirits' – and if only they
can be reignited!
Time is working against all countries in the Eurozone because the good are being dragged down by the bad.
You don't have to be an economic genius to understand that the
perpetual uncertainty over the Eurozone's future has led to a widespread
freeze on industrial investment and development. Industrial production
is collapsing at an accelerating rate, falling 7% year-on-year in Spain
and Greece, 4.8% in Italy, and 2.1% in France. The downtrends for
industrial production are readily apparent in the chart below:
The businesses that are doing well (and there are some) are those
businesses with strong balance sheets and solid export order books for
non-Eurozone markets; unfortunately, they are concentrated in countries
like Germany, Holland, Finland, and Austria. They are not located where
they can contribute to economic progress in Spain, Italy, Greece, or
France, and so they are not adding to the tax revenue desperately sought
by those governments.
Despite the recent deal worked out with Greece, the old cliché about
kicking the can down the road is close to becoming no longer possible.
Deferring the inevitable is only a political option so long as there is
no immediate damage from doing so. But this is no longer true in the
Eurozone, where political procrastination is now identifiably
responsible for social unrest. It's not just the trade unionists in
revolt; now it is the middle classes as well. Doctors and teachers in
Greece do not get paid anymore, and it is going that way in Spain, with
regional governments surviving by simply not paying their bills.
Government is destroying society, proving the falsity of the heretofore
accepted belief (in Europe, anyway) that government makes society
better. But then, anyone who has bothered to read Hayek's The Road to Serfdom will not be surprised.
What was not anticipated in Hayek's masterpiece is the divided state
that is emerging. Greece is part of a larger EU and Eurozone bureaucracy
and cannot achieve statist ends by turning her citizens into serfs. The
government itself is subservient to higher authorities and is now
having that medicine applied to it by its peers. Every visit by the
Troika (collectively the European Central Bank (ECB), International
Monetary Fund (IMF), and the European Commission) screws the Greek
government further towards its own serfdom.
Keep in mind just one thing: Greece is utterly broke and cannot
escape that fact. All of the posturing by the three Troika members is
designed to avoid facing this reality. The political elite drive this
party line and rigidly conform to it. However, there is increasing
unease among powerful elements in the background, and in particular,
sound money advocates in the Bundesbank are deliberately pushing for
different solutions than those pursued to date.
Jens Weidmann, who is the Bundesbank's chief and its representative
on the ECB's Governing Council, is remarkably outspoken on this issue.
In a recent interview with the Rheinishe Post, Weidmann pointed
out that the ECB and other national central banks in the Eurozone are
now Greece's largest creditors and cannot take a haircut on Greek debt.
Furthermore, they cannot write off this debt, since that would amount to
monetary financing, which is forbidden under Eurozone rules. So, he
concludes, the ECB is trapped.
This intervention is important, because – unusual among the world's
central banks – the Bundesbank is viewed by the German public as the
protector of the currency against the politicians. The German economy is
traditionally driven by small savers, who are secure in the knowledge
that the Bundesbank won't let them down by printing money. While this is
perhaps a stereotypical view, a hangover from the days of the
deutschemark, it is still true with respect to public attitudes. And
this is important because there is greater public trust in the head of
the Bundesbank, Jens Weidmann, than in any politician, including
Chancellor Merkel. We must listen to Weidmann, not Merkel.
Returning to Greece, forward-looking markets have already written it
off, but getting there is not easy. On 11 November, by a slender
majority, the Greek Parliament agreed to the latest austerity demands
from the Troika, in the belief that the Troika will come up with
urgently needed cash. This is cash for an economy that is tanking with
its industrial production collapsing. Deposits have flown from the
banks, which, without the ECB's recycling of funds both through the
TARGET2 settlement system and by taking in yet more worthless Greek debt
as collateral, would themselves default. Tax revenues, insofar as they
can be collected, are simply vaporizing. In the words of the classic
Monty Python sketch, this parrot is dead, expired, and everyone knows it.
Despite this, the Troika caved in (to ironic laughter from the press)
on 13 November by giving Greece a further two years to get its
government debt to GDP under 120%.
The concern, obviously, is that Greece is a dry run for Spain and
Italy. It is also, as I argue below, a dry run for France, which is in
terrible shape and deteriorating rapidly. This is why the protector of
German savers, Herr Weidmann, is worried. He is signalling that the
precedents set in dealing with Greece will ultimately destroy Germany.
In my last article for PeakProsperity.com,
I argued that Germany, not Greece, should and will leave the Eurozone,
perhaps taking Holland, Finland, Luxembourg, and Austria with her. It
has always been clear that this is the last thing the political elite
would consider, but unless Mrs Merkel reconsiders her position, she will
be overruled by the Bundesbank, and perhaps also her own finance
minister, Wolfgang Schäuble, who is known to be extremely concerned.
Anyway, let me throw in a little ray of sunlight for Germany (or is
this the light an oncoming train in the tunnel?) For some reason that's
not entirely clear, the outstanding TARGET2 claims by the Bundesbank on
the other Eurozone national banks actually fell in October. The updated
chart is below:
That's the good news. The bad news is that the previous down-tick (in
December 2011) was in the wake of a drop in Spanish bond yields from
over 7% in mid-2011 to a low of under 5% last January. This time,
Spanish yields fell from 7.5% three and a half months ago to 5.4% a
month ago. Italian government bonds have followed a similar pattern, as
shown in the chart below:
It is perhaps logical to link changes in TARGET2 balances with
changes in sentiment in Spanish and Italian bonds. These bond yields
show signs of bottoming out, which is clearly visible on the chart. The
only reason these bond yields have fallen to these low levels is because
the ECB forced them there. But when these yields rise, which they
probably will because there is little doubt the ECB's manipulation
cannot succeed for very long, the accumulation of TARGET2 imbalances on
the Bundesbank's book will quickly exceed €1 trillion.
And there is a further problem. One of the reasons French ten-year
government bond yields are only 2.1%, and have even been briefly
negative for her six-month bills, is that some of the capital flight out
of Spain and Italy has been deposited in French banks, only to be then
lent on to the French government.
But France, as I argue later in Part II of this article,
is itself a basket case, only not yet widely recognised as such because
it has benefited from this capital flight from Spain and Italy.
At some stage, probably in the next six months, these accumulated
deposits in the French banks will, in turn, seek a safer home elsewhere –
and where else but in the German banks? And so the Bundesbank faces the
prospect of a second wave of capital flight and escalating TARGET2
imbalances.
Of course, this would not matter if it was certain that no one was
leaving the Eurozone, and the TARGET2 system was constructed on the
assumption that no one ever would. One could argue that Greece leaving
would not be too much of a problem, other than the precedent it would
create. This is why it is so important to keep Spain and Italy in the
system.
In Part II: Europe's Mexican Standoff we explain why the answer to the question of Who will ultimately pick up the tab?
when a Eurozone member leaves is not at all clear. In fact, the
"stability" of Europe right now hinges completely on no one leaving (or
defaulting).
After all, TARGET2 is a settlement system with offsetting cash
creation and destruction carried out by the national central banks on
delegation from the ECB. But nonetheless, it is understandable that the
sound-money guardians at the Bundesbank are increasingly alarmed at the
progression of events.
To borrow from Dirty Harry, it leaves those tied to Europe's future pondering a seminal question: "Do I feel lucky?" Well, do ya?