17th June 2010
Eurozone economy: the long and painful squeeze
1. Austerity measures across Europe
The Seoul G20 agreement on nothing exemplified the rift between the Keynesian
economic policies followed by the Obama administration since early 2009 and the post-
keneysian policies i.e. austerity packages followed in Europe for the past few weeks. As
reporter by Bloomberg:
Policy makers are diverging on prescriptions for sustaining the global recovery, with U.S.
Treasury Secretary Timothy F. Geithner calling on Japan and European countries with
trade surpluses to boost domestic demand, while Europe’s representatives have said
reining in budget deficits was the top priority.
The US is still running a large trade deficit and Europe is enjoying a trade surplus, mainly
thanks to Germany. Interesting enough, some European leaders (French ones in
particular) were, until recently, calling on Germany to stimulate domestic demand: on
June 7th, Angela Merkel, the German chancellor, responded by a definitive nein! with the
EUR 86 billion austerity package to be spread until 2014. To avoid to be too harshly
punished by markets France followed suit today with a EUR 100 billion (50/50 spending
cut and additional tax collection).
Altogether, austerity packages announced in the euro zone since early May
represent approximately EUR 230 billion by 2013, quite a number but is it really
enough to at least stabilize the situation? From my calculation, the PIGS + main euro
zone countries have to save in the region of EUR 300 billion between now
and 2013 to reach the 3% deficit/GDP threshold if one believes the EU GDP growth
forecasts over the period. We are getting nearer, but still EUR 70 billion are missing,
and this assumes that the implementation will be perfect...
Let's assume that all goes well and all euro-zone countries are back to 3% (which I do not
believe one minute and not only for PIGS countries- for example how Ireland could divide
its deficit by 4 in 3 years or Spain by 3) and therefore find EUR 100 billion a year during
the 3 years to 2013, it means that the euro-zone still would have added nearly EUR
1 trillion debt, an increase in the debt/GDP ratio from 80% in 2009 to 92% in 2013, not
In addition, nothing will have been done to reduce the competitivity gap
between Northern Europe and Southern Europe. All the measure adopted are
aiming at avoiding the straight default of several countries and an immediate
collapse of the banking sector across the euro-zone.
But this is not tackling the fundamental issues and merely gaining some (and not a lot)
The solvency issue is not dealt with, but it is clear that Germany calls the
shots (for the time being), and all countries will have to follow its path or markets will be
shut down for funding their financial requirements.
As discussed in the previous point, deficits are being addressed to go back to the
Maastricht criteria of 3% debt/GDP. I note that nothing is said about the second criteria: a
maximum of 60% debt/GDP. Indeed, 3% deficit/GDP is a deficit and therefore increases
the amount of debt that countries have to take on.
According to Markets & Beyond calculations, fiscal deficits post austerity packages will
amount to a cumulative EUR 955 billion for the 3 years ending in 2013, i.e. EUR 955
billion additional debt to reach EUR 8.5 trillion or 91% of GDP. Within this stock of public
euro-zone debt, we could see some countries negatively impacted (Italy and France in
particular) if PIGS countries need to tap the EUR 860 billion rescue packages (Greece +
The question is therefore how countries can reduce their debt. Let's review first
a very simple equation (Borrowed from John Mauldin's letter):
Domestic Private Sector Financial Balance + Governmental Fiscal Balance – the Current
Account Balance (or Trade Deficit/Surplus) = 0
By Domestic Private Sector Financial Balance we mean the net balance of business and
consumers. Are they borrowing money or paying down debt? Government Fiscal Balance
is the same: is the government borrowing or paying down debt? And the Current Account
Balance is the trade deficit or surplus.
The implications are simple. The three items have to add up to zero. That means you
cannot have both surpluses in the private and government sectors and run a trade deficit.
You have to have a trade surplus.
Let's make this simple. Let's say that the private sector runs a $100 surplus (they pay
down debt) as does the government. Now, we subtract the trade balance. To make the
equation come to zero it means that there must be a $200 trade surplus.
$100 (private debt reduction) + $100 (government debt reduction) - $200 (trade surplus)
But what if the country wanted to run a $100 trade deficit? Then that means that either
private or public debt would have to increase by $100. The numbers have to add up to
zero. One way for that to happen would be:
$50 (private debt reduction) + (-$150) (government deficit) - (-$100) (trade deficit) = 0.
Remember that we are adding a negative number and subtracting a negative number.
Bottom line. You can run a trade deficit, reduce government debt and reduce private debt
but not all three at the same time.
Another equation has to be looked at due to its implications (also borrowed from John
∆ GDP = ∆ Population + ∆ Productivity (∆= change in)
It means that in face of a declining population (the case for a number of European
countries) you have to increase your productivity even more to keep your GDP growing.
I wrote several time that the current crisis is a brutal adjustment to over-
indebtedness (public and private): As a family's or country's debts grow, the carrying
cost or interest expenses rise. At some point, the interest expense consumes an ever larger
portion of the budget. Increasing the debt increases the interest expense eventually to the
breaking point. There are limits and we have reached these limits in several countries.
3. Reduce deficits
European countries have realized that there is no way out of the mess politicians
created over the past 20 years but reducing fiscal deficits. It is worth mentioning that
in today's austerity package, France will cut EUR 15 billion in planned keynesian inspired
economic growth measures: Keynes is definitely dead on this side of the Atlantic under the
pressure of bond vigilantes and Germany.
This will cut growth (you cannot withdraw hundreds of billions from the economy and
hike taxes with no consequence on GDP and employment).
From the first equation, it is however possible to offset the reduction in
governments' fiscal imbalances via exports and a deficit increase by the
private sector. The competitive devaluation of a currency (or monetizing a currency) is a
classical way to improve a trade balance (since the end of Bretton Wood, the US has
consistently manipulated the dollar to its advantage). This is not panacea, but probably the
least worst choice at this juncture.
Within Europe there is an additional problem: euro-zone uncompetitive
economies cannot devalue their currency. In addition, all PIGS's countries have
large trade deficits (from 9.4% for Portugal in 2009 to 14.3% for Ireland). And Spain has
an over-indebted private sector and huge unemployment: Spain is the next shoe to
True, the euro has declined vs all currencies from its November 2009 high (~ 20% drop)
and it is translating into a better extra euro-zone trade balance which has improved since
the beginning of 2010, mainly to the advantage of the traditional exporters, Germany
being at the forefront.
However, within the euro-zone, the competitive devaluation of the euro is
neutral. Looking at the trade balance structure of the PIGS, in 2009 between 41%
(Ireland) and 63% (Portugal) is intra- euro-zone trade; the scope for reducing deficits
via an improvement of the terms of trade is therefore limited, beyond the fact
that these countries do not have much to export outside agricultural goods, hence time
needed to allow them to climb the value chain.
4. Spain: the next stop on the crisis line
Whilst Spain had a deficit/GPD relatively benign at the start of the financial crisis, it is
spiraling following huge fiscal deficits.
Why Spain will be the next shoe to drop:
• Uncompetitive economy: the worst euro-zone track record for unit wage costs
(~+50% since 1998 vs ~8% for Germany); wage costs should fall by circa 30% to
reach the German level.
• Structural and large trade deficit: 11.2% in 2009. Spain's exports account for
merely 6% of GDP vs
• Large unemployment and increasing: 20.1% in Q1 2010 and 19.5% for the 20-
29 age group (I also read 40% for the 18-25 age group).
• Debt /tax receipts approaching a dangerous zone at 185% in 2010.
• Large refinancing in July: EUR 31.5 billion. In addition 43% of the Spanish
debt is held by foreign investors (EUR 240 billion) Q4 2009.
• The total net international investment position is -93.5% of GDP at the
end of 2009 (-82.2% for Greece)meaning that Spain pays interest to foreign
investors and the proceeds is not reinvested in Spain to the same magnitude as it
would be with domestic investors (it is why the situation of Japan, despite it huge
debt/GDP, is less worrying short term with over 90% of its debt held by domestic
• Hang over in the housing market: 1.6 million unsold properties in Spain, six
times the level per capita of the United States whilst prices only dropped by
• Total public/private debt in Spain has reached 270 percent of GDP.
• Fragile banking sector (The central bank seized CajaSur - savings banks are full
of mortgage debt) with the interbank market shut to them. Last month, Spanish
banks had to fund themselves with the ECB at the turn of €85.6bn – double the
amount lent before the collapse of Lehman Brothers in September 2008
and 16.5% of net eurozone loans offered by the central bank. Today, Spain
announced that they want stress tests for Spanish banks to be disclosed, a step
towards transparency to alleviate market conjecture.
• Funding is frozen for most of the private sector.
• Spain's external debt has reached EUR 1.5 trillion (174% GDP), most of
it on short term maturities, with EUR 600 billion due this year.
All this is resulting into a sharp increase in the cost of funding of Spain as
evidenced by Tuesday's auction where yields on one-year debt reached 2.45% compared to
0.9% as recently as April and a surge in the cost of CDS (Credit Default Swaps) close to
250 basis points, not far from the high reach June 7th. The positive note is that Spain can
finance itself on markets as exemplified by today's successful bond sales (EUR 3.5 billion).
Officials across Europe are in denial, in a remake of what happened to Greece.
As noted by Fitch in their 32 pages report:
"To maintain debt solvency Spain must squeeze public spending: yet this policy
undermines the chances of recovery which itself causes further loss of confidence"
Since Spain cannot devalue the euro to immediately improve its competitivity, it has to
reduce wages, risking to trigger a slow death by debt deflation.
The choice is either reflation accepted by the ECB (which seems to be the case, at least for
the time being) or Spain will be forced out of euro-zone, setting off a catastrophic chain-
reaction through north Europe's banking system. The third choice is a debt moratorium
for 10-15 years to give time to Spain (and other countries) to adjust their competitiveness.
Jacques Attali in a recent book "Tous ruinés dans dix ans", proposes to set-up a European
Agency that would issue debt in the name of Europe and guaranteed by all euro-zone
members. This would imply an automatic solidarity amongst countries avoiding the
unprepared cacophony we have heard for 6 months (the result of a flawed euro-zone
construction). However, this would add an other level of debt issuance where each tax
payer in each euro-zone country would eventually be responsible for. Refinancing all
existing debts at the country level via such an Agency would be a solution to avoid the
punishing financing costs of the PIGS countries; it would however mean that Northern
Europe would subsidize Southern Europe and therefore Southern Europe should give
away some sovereignty to ensure that appropriate reforms are conducted and budgets
respected. There is a long way to get there and time is running short.
Interestingly enough is the CDS spreads for France: it have gone up steadily to reach a
level more than double what it was late March. Even more striking, France is the only
country of the euro-zone where the spread vis-à-vis Germany is at historic high.
For quite a while, I mentioned that France is in a worse shape than face value, and after
Spain, I believe that it is France that will be under pressure as much as Italy, if not more.
The second leg of the financial crisis is unraveling with the sovereign debt
crisis in Europe: we are at the beginning and not at the end.
The ECB will continue to monetize the PIGS sovereign debt which it will not sterilize
despite what has been announced, to shore up French and German banks which together
hold EUR 455 billion of Spanish, Portuguese and Greek debt according to RBS.
A combination of euro zone economy slow down during H2 2010 and in 2011 compared to
previous forecasts combined to substantially higher funding costs for PIGS countries, a
freeze of the interbank market for PIGS's banks make a sovereign debt rescheduling
inevitable. I do not understand how politicians believe that 20 years of lax monetary policy
and over-indebtedness that followed can be solved in 3-4 years in a weak economic
environment and structural reform to be implemented: time is needed and insolvency
must be faced instead of living in constant denial.
I re-iterate that Europeans will suffer a markedly decrease in their living
standards for probably at least 10 years. In any case, in an open world where goods,
people and money are free to move, how Europeans could believe that they could sustain
the competition from Asia and Latin America without adjustment? The West as a whole
has transferred a massive amount of wealth over the past 10 years to Asia and
the Middle East, representing trillions of dollars that were then lent to the West to
consume beyond their means: today, we have to pay the bill, and it is very expensive.
I continue to stay clear from the banking sector and I am considering re-entering euro
shorts (probably when we get closer to the Spanish refinancing) together with financial
shorts. I remain long gold, commodity and energy stocks. I am contemplating getting into
consumer stocks in Asia.
For the rest, the S & P 500 support level held well which is positive. However, any
meltdown (which is a real possibility until euro-zone politicians admit that the EUR 860
billion package did not solve the solvency problem of PIGS countries) within the euro-zone
would trigger shock waves to other markets, and among them commodity driven ones and
the US are the most fragile.
Bloomberg: IMF Says Risks to Economy Have Risen ‘Significantly’
The New York Times: Merkel Introduces German Austerity Package
Deutsche Welle: German austerity plan faces widespread criticism
VOX: The PIGS’ external debt problem
Royal Bank of Scotland (RBS): The €2 trillion debt exposure to Greece, Spain and Portugal - 24
The Daily Telegraph: EU denies EUR 250 billion liquidity plan for Spain
Banco de España: Summary economic indicators