Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Monday, 29 April 2013

The European Exuberance Conundrum


The Euro and European sovereign bond yields continue to bemuse. The headlines are by and large negative but the inexorable hopium-fueled climb continues. Apart from cheap money, the three shots of hopium being imbibed at present in Europe seem to be:
  1. Italy has formed a “reform minded” technocratic government
  2. The doctrine of austerity has been dealt a blow allowing growth oriented policies to be put in place
  3. Even if all else fails, the ECB won’t
It would be great were these true. Alas, hope springs eternal.

Italy and “reform”
Italian politicians failed to decide on a president and backroom political machinations led to a “technocratic” government, i.e. a government of vested interests, by vested interests and for vested interests. Investors hoping for deliverance (and smoking the Economist’s hopium are likely to be disappointed). First, this is a government formed not to reform but to perpetuate the power of the elite by excluding the mavericks of the 5-star movement. As Greece and the coalition led by New Democracy has shown, it only succeeds in kicking the can down the road. Unfortunately, Italy is not Greece and it would be extremely costly to perpetuate the charade. Second, this is not the elected Romano Prodi government of 1996-98 which committed the original sin of reforming just enough but no more to get Italy into the Euro. Third, the present situation is far removed from the success of 1996-98. Those reforms were made when the global economy was in a phase of “irrational exuberance” unlike the current comatose state with central bank life-support. Moreover, the public wanted to join the Euro which provided impetus to Prodi’s reforms. Now the reforms which investors and austerians wish to foist onto Italy are deeply unpopular. Political trouble looms even as investors decide that 4% for ten years is more than adequate for this leveraged super senior Eurozone tranche.

Less austerity, more growth
The increasing pushback against austerity shows that realisation has finally dawned, perhaps too late just like the Titanic’s order of full-speed astern. First it is still mostly the southern Europeans making the case to an unyielding Germany. Second, it is highly doubtful that the dosage of austerity will be meaningfully reduced especially before the German election. Third, data from northern Europe points to weakening economies. Unemployment went up to 6.4% in recessionary Netherlands, it is also increasing in the moribund Finnish economy and even the mighty German engine is sputtering as shown by contractionary PMI data. Recessionary times seldom lead to acts of generosity especially from the morally righteous who believe in austerity. Fear of meltdown will ensure adjustment periods are lengthened and loan terms extended but southern Europeans looking for fiscal support may have better luck finding that pot of gold at the end of the rainbow.

The ECB put
The bazooka keeping the vigilantes at bay is the OMT, a policy of great advantage but no one to know what it is since the ECB refuses to publish details. This certainly helps in dealing with the German Constitutional Court challenge. After all, how can OMT be illegal when there are no details to judge upon? The true details if and when published are likely to disappoint since investors are presuming that OMT is fiscal support through the monetary backdoor. More likely it is the old, failed SMP with a new name since anything aggressive will be immediately challenged judicially and politically. Remember the famous promise of “breaking the vicious sovereign-bank loop” through direct ESM capitalisation of Spanish banks without burdening the sovereign?

The props are hollow and the probability of a cataclysm keeps increasing as Europe stagnates and drifts apart. Even as North and South blame each other, southern Europe continues to deteriorate with unemployment rising to record levels (Spain and Greece both at 27.2% with youth unemployment around 60%). Worse, the number of unemployed is the highest since records began for the “core” economy that must not be named for it cannot be ESMed and OMTed (Hint: Its 10-year bonds yield 1.75% given the "strength" of the economy - 2012 GDP growth was 0%, deficit was 4.8% and debt-GDP north of 90%).

Low growth and high unemployment, especially youth unemployment, are key ingredients for social upheaval. Further there has been a massive increase in distrust of a dithering and out-of-touch EU in the six largest EU economies (4 largest Eurozone ones). More than half the people in Germany (59%), France (56%), Italy (53%) and Spain (72%) tend not to trust theEU as an institution. This is manifesting itself through populist, Eurosceptic and/or extremist political movements which further reduce the scope for compromise between elected national governments.  

The die seems to have been cast but ignored due to hope, fear of missing out and the accompanying perennial belief of getting out in time.

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