What Is The Risk The Euro Crisis Will Reignite?

The euro zone crisis is not back -- at least not yet.

Recent movements in global markets following concerns about Portugal’s Banco Espirito Santo really had as much to do with market nerves after a long spell of repressed volatility as it did with the state of the bank’s balance sheet. Despite the current calm, everyone knows that volatility will return one day, and no one wants to be caught on the back foot when it does arrive. So the initial response is to hit the “sell” button and then ask questions.

Beyond this context, there is a lack of certainty in the market about which way bond yields for the so-called “peripheral” euro zone countries are heading in the near term -- and what exactly the risks associated with holding them really are. Riding the yield compression, in the case of the Portuguese 10-year bond from over 7 percent to under 3.5 percent was a one-way-bet no-brainer once the impact of Draghi’s July 2012 speech became crystal clear.

But now yields have started to tick up again, so the advantages of holding in anticipation of further declines become less obvious, while the risks continue to mount. In many ways, the situation is analogous to yen depreciation and the Bank of Japan. The first leg was easy, as the yen fell into the 100 to 105 to USD range. But now it is stuck there, and the debate has become a “will she, won’t she” on further BoJ easing.

It is clear the recent European Central Bank decision to launch Targeted Long-Term Refinancing Operations has disappointed. TLTRO's may do something to help ease access to credit in the south in the mid-term, but they will hardly be effective in combating deflation. In particular, we may need to wait more than six months to see any net liquidity impact, since the September and December allocations coincide with earlier LTRO repayments, leaving what Pantheon Macroeconimcs’ Claus Vistesen calls “a potentially worrying ‘air-pocket’ over the next six months where the central bank’s balance sheet continues to contract, making the verbal commitment to easing increasingly difficult to rely on as a sole back-stop."

Will we really have to wait till 2015 to see any significant step to try to stop the deflation rot?

Digging deeper, and beyond fears about what the coming ECB bank stress tests may turn up, the simple passage of time in itself could complicate things. The recent round of  numbers has had everyone busily revising down their 2014 growth forecasts, and it is obvious that even if outright deflation is avoided inflation will be very, very low. In fact whether or not the Euro Area slumps back into outright recession or not seems to depend more on Vladimir Putin than on the ECB at the moment,

But the key point to take away from all this is that nominal GDP over the next couple of years may barely increase, with the knock on consequence that sovereign debt levels in the most indebted countries will surely be jolted onwards and upwards. This is important since all official sector projections have these levels peaking either this year or next, but now these estimates will surely need to be revisited.

Second quarter GDP data was horribly bad. France's economy stagnated, but more worryingly for policymakers Germany relapsed (minus 0.2 q-o-q), leaving Spain as the only one of the "big four" to put in a positive growth performance (0.6 q-o-q). While the immediate drag on short-term growth may well be the impact on sentiment of a crisis on the frontier between Ukraine and Russia,  the Euro Area  is now clearly stuck in some form of longer term secular stagnation. The daylight just around the next recovery corner argument rings hollower and hollower with each successive loss of momentum.

"Europe is becoming Japanese" is an expression you hear more and more. People saying this normally point to the fact that German 10 year bund yields have now gone under 1% (and hence have started to look like 10 year JGBs).

But behind this argument lies some sort of version of "reverse causality". In Japan JGB yields have been driven to very low levels by central bank intervention, with the BoJ now buying a very large share of all new issue. The ECB isn't buying Euro Area sovereigns, the markets are in anticipation of QE.  So to talk about the Japanification of Euroa Area yields is a little misleading. Bond purchasers and their models are PROVOKING this downward lurch, not weak growth or deflation. To push Mario Draghi into QE markets would need to move back into risk-off mode on periphery assets. As long as the bond markets remain well behaved Draghi will do as little as possible, as I will discuss below.

Another argument used to justify the "Japanisation" of the Euro Area idea carries much more clout, and that is the one being used by Paul Krugman based on working age population dynamics.

"If you’re worried that secular stagnation might be depressing the natural real rate of interest — the rate consistent with full employment — and you think that demography is a big factor, Europe looks really terrible, indeed full-on Japanese."

The basic idea is that working age population dynamics play a big part in determining movements in aggregate demand and hence inflation (see my secular stagnation summary here). This idea received support from a research paper published at the start of August by a group of IMF economists - "Is Japan’s Population Aging Deflationary?" (authors Derek Anderson, Dennis Botman and Ben Hunt). The first part of the abstract runs as follows:

"Japan has the most rapidly aging population in the world. This affects growth and fiscal sustainability, but the potential impact on inflation has been studied less. We use the IMF’s Global Integrated Fiscal and Monetary Model (GIMF) and find substantial deflationary pressures from aging, mainly from declining growth and falling land prices. Dissaving by the elderly makes matters worse as it leads to real exchange rate appreciation from the repatriation of foreign assets. The deflationary effects from aging are magnified by the large fiscal consolidation need."

Bottom line, despite all the denials from Mario Draghi that the Eurozone is not another Japan there are plenty of grounds for thinking that it will be.

So Which Way For The ECB?

Evidently members of the EU Commission, ECB governing council members, and senior political leaders in Berlin, Amsterdam or Paris are neither theoreticians nor intellectuals. The secular stagnation hypothesis is at this point more akin to a theoretical research strategy than a workable template for policy-making, and policymakers are understandably reluctant to take decisions on the basis of what is still largely a hypothesis. As the editors of a recent book on the topic put it in their introduction: "Secular stagnation proved illusory after the Great Depression. It may well prove to be so after the Great Recession – it is still too early to tell. Uncertainty, however, is no excuse for inactivity. Most actions are no-regret policies anyway". As they suggest the risks here are far from evenly balanced. If countries like Japan, Italy and Portugal are suffering from some local variant of one common pathology, then normal solutions are unlikely to work, and matters can deteriorate fast.

Naturally the ECB can go down the Abenomics path, and institute large scale sovereign bond purchases even while the Commission turns an increasingly blind eye to higher deficit spending at the country level. But it is far from clear that Abenomics works (see here) and if it doesn't what happens to all the accumulated debt?

On the other hand time always has a cost. Letting things drift further means letting debt levels rise, and risking testing market patience and this becomes especially important in the cases of Italy and Portugal. The longer time passes the more difficult it is going to be for anyone to convince themselves that the debt of these countries is sustainable.

So there may come a point after which the Germans simply will not allow Draghi to buy Italian bonds without a prior haircut (see my "Italian Runaway Train" here). OK, they've said they won't do more PSI, but they've said a lot of things, and the cost of irritating investors is limited when you have a regional current account surplus and a central bank buying bonds.

Maybe the costs of the Euro "widowmaker" trade will be borne by all those eager bond purchasers who thought nothing could possibly go wrong. I am sure German politicians would decide a loss of credibility on PSI would be less costly to them than getting German taxpayers on the hook for current Italian debt levels. Especially in a country where they are now proudly announcing they have reduced government debt for the first time in more than 50 years. So in this case, maybe the turkeys just did vote for Xmas.

The thing is, despite the meeting between Draghi and Renzi (who may also be a turkey by Xmas) nothing substantial is going to happen in Italy. The government is under no pressure to ask for help (and doesn't even feel it needs it), and Draghi won't act before things change. Gridlock - with rising debt.

Naturally in the short term the “Mario Draghi ultimately has my back” feeling will still prevail, but with markets continuing to finance debt levels that any official study will soon have to recognize as unsustainable lack of proactive policies from the ECB will only fuel concerns that the size of the pill may become just too big for the bank to persuade Germany comfortably swallow, leaving the specter of private sector involvement to once more rear its ugly head. How do you tell people who have just sacrificed hard to get their debt under control that they are now about to help "pardon" 50% of someone else's. It simply doesn't make sense.

*************************************************************

These arguments are developed at greater length in my new book "Is The Euro Crisis Really 0ver? - will doing whatever it takes be enough" - on sale in various formats - including Kindle - at Amazon.

The Catalan Vote: Why It's Time To Start Getting Worried About Complacency In Madrid

When Barack Obama told a CNBC interviewer last autumn that Wall Street ought to be "genuinely worried about what is going on in Washington" in reference to the US government shutdown he raised more than a few eyebrows. Normally political leaders try to calm and reassure markets, so this attempt to stir them up on the part of the US President was, in its way, something of a first.

Last May the Financial Times issued a similar warning in an editorial with a clear message: right now you should be more worried than you are about what is happening in Madrid. According to the newspaper, “secessionist demands have created a rolling crisis involving Catalonia and the national government in Madrid,” a crisis which it warns could end in a “head on collision” if the issues being raised are not addressed.

The issues have not been addressed, and  there is now  a  provisional date for that woeful collision to occur: the 9 November this year, the date chosen by the Catalan parliament for the holding a popular (non binding, not a referendum) consultation under a new law which will receive parliamentary approval on 19 September. The original intention of the Catalan parliament was to hold a referendum on the region’s future authorized by Madrid. With that intent parliamentary representatives took a proposal last spring to the Spanish parliament. The reply was a polite but near unanimous “no” since Spain’s parliamentarians took the view any such vote could be considered “unconstitutional”.

As Mariano Rajoy pointed out, given the way the Spanish Constitution is currently worded neither he, nor even the Spanish parliament, have the power to authorize such a vote. The Spanish prime minister’s view was also endorsed recently by the country’s constitutional court, who ruled that the proposed referendum would be unconstitutional under the terms of the constitution as it stands. The court however added an important rider to the judgment, a rider to do with the political problem of legitimacy. If in a discrete part of the national territory, the court suggested, a significant majority of the population are not satisfied with the current arrangements, and these arrangements are not changed,  then a constitutional crisis ensues.

Thus the issue moves from being a purely juridical one to a political one, and any eventual solution - even if this means accepting Catalan independence - needs in essence to be political. Effectively the court threw the ball back into the politicians’ court: if the constitution doesn’t permit a vote it can be changed, if there is the political will to do so. Amending the constitution didn’t seem to be such an insurmountable obstacle at the height of the sovereign debt crisis, when agreement was reach between the various parties in a matter of days to place constitutional limits on the level of government debt, a fact which does not escape the attention of those Catalans who feel themselves in urgent need of the right to a vote.

This is also what the FT had in mind when the editorial argued “it is disingenuous” for Mariano Rajoy “to hide behind the Spanish constitution”. Sooner or later democracy will out. This is why the newspaper argues the Spanish government needs to urgently formulate some sort of counter proposal, along the lines of the so called “third way”: an approach going beyond the current arrangements but falling short of full independence. The core of such a proposal, the paper argues, would be an improved fiscal arrangement, and more autonomy.

In the opinion of the present author these proposals look fine on paper, but arriving at any sort of agreement on them seems highly unlikely. In the first place, Spain’s ongoing economic issues make the financing of any new fiscal agreement extremely problematic. The economy may be showing signs of recovery, but it is a weak and fragile one, and the aftermath of the country’s property bust will cast a shadow of at least a decade over the country’s economic future. In addition there is no easy “win-win” solution available, since letting the Catalans keep more of their own money will undoubtedly mean someone else will receive less. Who will that someone else be? A glance at the political arithmetic shows that the major Spanish party closest to considering the third way is the socialist PSOE. But PSOE relies on votes from the country’s most populous region – Andalusia – and this would surely be one of the areas most negatively affected any substantial fiscal change.

More autonomy sounds nice, but what exactly would it look like? Would it allow the region, for example, to opt out of laws which are highly unpopular in Catalonia like the recent abortion one or the proposal to make bullfighting form part of the national heritage? And what about the identitarian issues which are really what lie at the heart of the current tension? From the Spanish point of view, the most contentious of the Catalan demands is their claim to have their identity as a nation included in any rewritten constitution. Any addressing of this long standing grievance would seem to open the door to solving another, that of having national sports teams to compete in international competitions. Are Spaniards – not simply Madrid politicians – ready for this?

Then there is the language. Far from the impression being given that Spaniards are getting more and more comfortable with linguistic coexistence the situation seems to be quite the opposite, with moves to restrict the use of the language in schools having taken place in the regions of Valencia, the Balearic Islands, and Aragon, in each of which there are significant Catalan speaking communities. Even in Catalonia proper the central government is currently trying to implement an education reform which restricts the autonomy of the Catalan education minister to decide matters of language policy. It is hard to see in any of this a reflection of a will to improve relations.

It seems to me that such feelings of national identity affect both Spaniards and Catalans. They are strong and deep seated, on both sides, and far more important than the economic ones. The difficulty is they cannot be changed either in committee or overnight. I repeat, is there any real sign of a desire among the Spanish population to make the sort of attitude changes which a successful implementation of a third way would imply? President Mas visited Prime Minister Rajoy in the Moncloa in July to discuss the situation. He presented a list of 23 issues about which they could talk. To date the Spanish Prime Minister has not replied. He seems content simply to chant the mantra "there will be no vote". But as the Constitutional Court pointed out you cannot generate political legitimacy by only explaining what won't happen.

Naturally this "no" to the possibility of voting has come to the forefront in recent days with the publication of an opinion poll showing that the "yes" vote might win in Scotland.

As for the Catalans, we have yet to discover what it is they really want. This is what the demand for a vote is all about, so that the wishes of Catalans can be registered in a fashion which goes beyond the innumerable opinion polls. Determining what people actually want is a basic prerequisite so that the democratic process can then go to work. In the meantime they will simply look on in envy on the 18 September as Scots exercise their basic right.

What then happens next? The Catalan parliament will on 19 September pass into law a formula which will allow opinion seeking, non-binding consultations to be held under Catalan rather than Spanish law.  It is not clear at this point whether the Madrid government will challenge this law. Possibly they won't, since it is probably not unconstitutional. Then the Catalan parliament will pass as second decree law convening a consultation with an already announced question for the 9 November.  Madrid have already made clear that they will not permit this question to be asked and will take the matter to the Constitutional Court.

Which brings us to 9 November itself: if it is not possible to have a vote then Catalonia’s President Mas has suggested he might call plebiscitary elections. The purpose of these elections would not be – as some suggest – to authorize the parliament to declare UDI, but to establish the size of the majority in favor of a vote. The newly constituted parliament will then have the responsibility for deciding what to do next.It would be a mistake to think that these elections - if held - would be the end of the matter. They will take the collision onto a new level and generate a very high degree of uncertainty about where things are going from that point on.

So although the world will not change on November 10, and even if there are elections instead of a vote on independence the outcome could well produce a definitive sea change about how Catalans view their relations with Spain. They may well mark a “point of no return”. So to go back to where we started. Right now global markets and most of the international press are being pretty sanguine about the situation, when – as President Obama suggested in the case of the US government crisis – perhaps they shouldn’t be. Perhaps they should be worried about the complacency in Madrid, and remember that one of the principal ways of letting something unexpected happen is to assume it won’t.