Wednesday, February 13, 2013

The European Kool-Aid Machine Is Still Working

Despite the drumbeat of defeatism from English-speaking economists, and despite three years of disappointing economic results, the Eurozone persists in the execution of its original "Plan A", adopted three years ago:
1. Balance eurozone government budgets by raising taxes and reducing expenditure.
2. Improve external competitiveness with internal deflation and market reforms.
3. Stabilize debt ratios through fiscal consolidation and the (eventual) resumption of economic growth.
4. Prevent speculative attacks and restore market access with credible long-term policies, backstopped by the ECB and the ESM.
5. Remove "exit risk" by the ECB's pledge to buy government bonds in the event of stress.

Now is an opportune moment to assess where "Plan A" stands with respect to probability of ultimate success. At present, all of the troubled countries (except Cyprus) are either in compliance with Troika agreements, or are otherwise implementing (or pretending to implement) fiscal consolidation and structural reform.

The bond market's reaction to progress to date has been positive, with yields declining and limited issuance resuming for a number of peripheral countries. The ESM has not had to make new loans (besides Greece), and the ECB has not had to intervene in the bond market. In the hierarchy of world crises, Europe appears to be moving to the back-burner, outside the spotlight of daily headlines and TV news bulletins.

Is there anything wrong with this picture? Yes, it's completely delusional. The eurozone's financial arithmetic continues to head inexorably in the wrong direction. 

The ECB's zero growth policy (ZGP) is slowly bankrupting the peripherals as their debt grows while their economies and government revenues shrink. The political pressure gauge is the unemployment rate, which has already entered the critical "red" zone for some of the peripherals. The human cost of the ZGP is immense and has not yet fully manifested itself in the political process. Zonal unemployment is now 12%, and zonal GDP is shrinking (yes, the whole zone).

But this is not an acknowledged problem for the eurozone, because employment is not an ECB mandate. Unemployment and growth are irrelevant to the European assessment of the success of Plan A. As far as the ECB is concerned, Plan A is a big success.

Let's agree for the sake of simplicity that the central problem for the eurozone is the growing risk of peripheral government bankruptcy, and that the best index of government solvency is the level and trajectory of the Debt/GDP ratio. This ratio can be forecast as follows: Debt + projected fiscal deficits + bank recapitalizations - debt write-offs = future Debt. GDP + nominal growth = future GDP.

What do we see? We see D continuing to rise due to declining government revenue and inflexible government expense, resulting in large and persistent fiscal deficits. On top of these operating deficits is the cost of unending banking system recapitalizations due to government and private-sector defaults. We see flat nominal GDP growth due to low inflation, lack of export competitiveness and inadequate domestic demand, exacerbated by fiscal austerity. 

Thus, D continues to rise while nominal GDP is stagnant (and shrinking in real terms). All measures of government creditworthiness have steadily declined since 2007. Credit ratings are being pushed out of investment grade as new risk thresholds are breached. (In Europeland, sovereign downgrades are irresponsible, unwarranted, and strongly discouraged.)

Other than further debt forgiveness by unhappy creditor governments and institutions (see: Bundestag), there is nothing visible on the horizon to reverse this process of government insolvency as manifested by the upward slope of the D/GDP ratio. The ECB remains satisfied with ZGP, and studiously ignores its enormous human and economic costs.

The current debate within the ECB governing council is not how to stimulate growth and bring down unemployment, but rather how to exit from further stimulus, since the crisis is over. The perversity of such thinking is remarkable in its indifference to evidence of failure. How much contrary data will it take to prove to the Germans that shrinking economies don't repay debt? (They have a selective memory about German history during the 1920s.)

This year, the eurozone disaster must inevitably grow from a purely economic crisis into a political one as well. The peripheral governments face multi-year depressions and their social safety nets and their "social models" are becoming badly frayed. 

Most of the peripheral countries are politically immature with fragile institutional legitimacy. Most of them have undergone multiple regime changes over the past century and few of them have been successfully democratic for longer than a few generations. Few of them have weathered a protracted depression under a democratic regime. Each country has a political inflection point, which will be reached as depression continues. Greece and Cyprus are already politically fragile.

The peripheral states are being stress-tested both economically and politically by the ECB's zero growth policy. As long as the ECB persists in running this sadistic contest, the odds of political failure will steadily increase, and may already be irreversible for certain countries. Europe is not Japan; it is much worse.