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Europe's Road to Nowhere, Part 2


Over the next few months, the eurozone faces a number of challenges, including the implementation of the new arrangements, possible further downgrading of nations, refinancing maturing debt, and meeting required economic targets.


If the pattern elsewhere in Europe continues, it is unlikely that Italy will be able to stabilize its public finances. The sharp drop in demand from cuts in government spending and higher taxes will result in an economic slowdown, which will result in continuing deficits and increased debt.

In the third quarter of 2011, Italy's economy contracted by 0.2%. The government forecast is for a further contraction of 0.4% in 2012. The government forecasts may be too optimistic. Confindustria, the Italian business federation, forecasts the economy will contract by 1.6% in 2012.

Stronger countries within the eurozone are also affected. German export orders are slowing, reflecting the fact that the EU remains its largest export market, larger than demand from emerging countries. Germany exports to Italy and Spain total around 9% to 10% in 2010), higher than to either the US (6% to 7%) or China (4% to 5%). Lack of demand for exports within Europe and from emerging markets combined with tighter credit conditions may slow growth.

Voting Intentions

The risks of political and social instability remain elevated.

Greece faces elections in April 2012. The polls indicate a fractious outcome, with the major parties unlikely to gain majorities with significant representation of minor parties. An unstable government combined with a broad coalition against austerity may result in attempts to renegotiate the bailout package. Failure could result in a disorderly default and Greece leaving the euro.

The French presidential elections, scheduled for May 2012, also create uncertain. The principal opponents to incumbent Nicolas Sarkozy either oppose the euro and the bailout (the National Front led by Marine Le Pen) or want to renegotiate the plan with the introduction of jointly guaranteed eurozone bonds (the Socialists led by Francois Holland).

The European debt crisis is also creating political problems in Germany, the Netherlands, and Finland, especially among governing coalitions. The risk of unexpected political instability is not insignificant.

A downgrade of Germany's cherished AAA rating or any steps to undermine the sanctity of a hard currency (by printing money or other monetary techniques) will force increasing focus on the costs to Germans of the bailouts. Germany's commitment to date is 211 billion euros in guarantees, 45 billion euros in advances to the IMF, and 500 billion euros owed to the Bundesbank by other national central banks – around 25% of GDP.

The increasing risk of losses may even divert attention away from the 2012 European Soccer Championship where Germany is drawn in the "Group of Death" with the Netherlands, Portugal, and Denmark.

Road to Nowhere

In the short term, Europe needs to restructure the debt of number of countries, recapitalize its banks, and refinance maturing debt at acceptable financing costs. In the long term, it needs to bring public finances and debt under control. It also needs to work out a way to improve growth, probably by restructuring the euro to increase the competitiveness of weaker nations other through internal deflation.

Such a program is difficult and not assured of success, but would provide some confidence. At the moment, Europe does not have any credible policy or workable solution in place.

One persistent meme is that Europe has enough money to solve its problems. This is based on the eurozone members' aggregate debt-to-GDP ratio of around 75%. There are several problems with this analysis.

The debt is concentrated in countries where growth, productivity, and cost competitiveness is low, which is what caused the problems in the first place. The relevant wealth is in the hands of a few countries like Germany that appear unwilling to bail out spendthrift and irresponsible neighbors. A substantial portion of the savings is also invested in European government debt directly or in vulnerable banks, which have invested in the same securities.

The total debt of the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) plus Belgium is more than 4 trillion euros. A write-down of around 1 trillion euros in this debt is required to bring the debt levels down to sustainable levels (say 90% of GDP). In the absence of structural reforms and a return to growth, the write-downs required are significantly larger. This compares to the GDP of Germany and France, respectively, of 3 trillion and 2.2 trillion euros.

In addition, the stronger nations may have to bear the ongoing cost of financing the weaker countries' budget and trade deficits. This does not appear economically or politically feasible.

Europe now resembles a chronically ill patient, receiving sufficient treatment to keep it alive. A full and complete recovery is unlikely on the present medical plan. Europe resembles a zombie economy, which functions in an impaired manner with periodic severe economic health crises. The risk of a sudden failure of vital organs is uncomfortably high.

In their song "Road to Nowhere," David Byrne and the Talking Heads sang about "a ride to nowhere." Byrne sang about "where time is on our side." Europe's time has just about run out. A failure to properly diagnose the problems and act decisively has put Europe firmly on the road to nowhere. It is journey that the global economy will be forced to share, at least in part.

No positions in stocks mentioned.

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