Apologies for being late today. Kids!
It’s the eve of the 19th EU summit and as I type Angela Merkel and Francois Hollande should be getting started on their pre-summit meeting. I don’t think there is doubt in anyone’s mind that although we have seen 18 before it, this summit is of particular importance. Hollande and Merkel had a few words to say before their meeting:
“Many are looking to Europe,” Hollande said: “We want to affirm its consistency, its strength, its unity and its solidarity.”
Merkel said the two-day EU summit starting in Brussels Thursday will be “of very great importance for the future of Europe.”
“The situation is serious and we have an obligation to build a strong and stable future Europe,” she said.
“Significant progress has already been made regarding the growth pact,” she said, referring to a plan to invest up to 130 billion euros ($162 billion) in kickstarting eurozone economic growth.
“I hope it can be adopted tomorrow,” Merkel said.
“We need more Europe, we need a Europe that works, the markets are expecting this, and we need a Europe whose members help each other,” she added.
Fine words, but it is actions that tell the truth and in that regard recent history tells a very different tale.
As I mentioned yesterday if the growth pact in its current form is the only thing to come out of the summit then I suspect the rest of the world will see it as a massive failure. Spiegel published an article yesterday crucifying the pact as nothing more than window dressing and an attempt to make it appear as if the summit actually achieved something:
Yet summit participants know themselves that the resolution is little more than a bit of window dressing for voters and financial markets. The pact contains nothing new, according to an internal analysis undertaken by one member state. It is only being agreed to, the analysis continues, so that the new French president can save face. During his presidential campaign, Hollande demanded efforts to stimulate the economy.
“It is all just old wine in new bottles,” agrees Daniel Gros, director of the Centre for European Policy Studies, a Brussels-based think tank. “Politicians just want to show that they are taking the desires of the electorate seriously.” But, he adds, the effect on the economy will be virtually nil.
In the meantime Spanish yields are creeping back up again which has lead Mariano Rajoy to issue a pre-summit warning that his country is in serious trouble without short-term resolution:
Spanish Prime Minister Mariano Rajoy has said Spain cannot afford to finance itself for long at current rates. Spanish 10-year government bonds have been trading at yields above 6.8%, coming close to the 7% considered unaffordable.
Mr Rajoy was speaking ahead of this week’s European Union (EU) summit.
“The most urgent subject is the subject of financing,” he said. Spain has asked for funding for its banks, but the country has not been bailed out.
I’m not sure why Rajoy insists on claiming a €100bn loan isn’t a bailout when it most obviously is. I suspect that it is because of the stigma attached to such a thing along with the conditions that come with it. The Spanish Prime Minister has been insisting for weeks that, in terms of the sovereign, this is free money but that is completely untrue at this stage. If you have any doubts on that you only need to read the statement from the Eurogroup concerning the matter:
The Fund for Orderly Bank Restructuring (FROB), acting as an agent of the Spanish government, would receive the funds and channel them to the financial institutions concerned. The Spanish government will remain fully liable and will sign the Memorandum of Understanding and the Financial Assistance Facility Agreement.
The Eurogroup reiterates its confidence that Spain will honour its commitments under the Excessive Deficit Procedure, and with regard to structural reforms, with a view to correcting any macroeconomic imbalances as identified within the framework of the European semester. Progress in these areas will be closely and regularly reviewed in parallel with the financial assistance.
Spain will request technical assistance from the IMF, which will support the implementation and monitoring of the financial assistance with regular reporting.
Surely that is clear enough.
In the meantime it appears that the ECB is also becoming increasingly concerned about the expected lack of political action from the summit with the rumour that ZIRP, and possibly NIRP, is on the way:
European Central Bank President Mario Draghi is contemplating taking interest rates into a twilight zone shunned by the Federal Reserve.While cutting ECB rates may boost confidence, stimulate lending and foster growth, it could also involve reducing the bank’s deposit rate to zero or even lower. Once an obstacle for policy makers because it risks hurting the money markets they’re trying to revive, cutting the deposit rate from 0.25 percent is no longer a taboo, two euro-area central bank officials said on June 15.
The ECB uses three interest rates to steer borrowing costs in financial markets. The main refinancing rate determines how much banks pay for ECB loans, while the deposit and marginal rates provide a floor and ceiling for the interest banks charge each other overnight.
If the deposit rate was cut to zero or lower, it would discourage banks from parking excess liquidity with the ECB overnight, potentially prompting them to lend the cash instead. Almost 800 billion euros ($1 trillion) is being deposited with the ECB each day.
On the other hand, a deposit rate cut could hurt banks’ profitability by lowering money-market rates, potentially hampering credit supply to companies and households and reducing banks’ incentive to lend to other financial institutions.
Let’s be clear about this. The ECB’s own banking surveys clearly state that the lack of credit expansion is a demand side issue. Here is the statement on supply:
According to the April 2012 bank lending survey (BLS), the net tightening of credit standards by euro area banks declined substantially in the first quarter of 2012, both for loans to non-financial corporations (for which they declined to 9% in net terms, from 35% in the fourth quarter of 2011) and for loans to households (for loans for house purchase they fell to 17% from 29% in the fourth quarter of 2011 and for consumer credit to 5% from 13% in the fourth quarter of 2011). This drop was much more pronounced than anticipated by survey participants at the time of the previous survey round and mainly reflected milder pressures from cost of funds and balance sheet constraints, in particular as regards banks’ access to funding and their liquidity position.
Looking ahead to the second quarter of 2012, euro area banks expect a further decline in the net tightening in credit standards for loans to non-financial corporations (NFCs) (to 2% in the second quarter of 2012) and for housing loans (to 7% in the second quarter of 2012), and a broadly unchanged level of net tightening for consumer credit (6% for the second quarter of 2012).
And now demand:
Euro area banks reported a sizeable fall in the net demand for loans to NFCs in the first quarter of 2012 (-30%, from -5% in the fourth quarter of 2011). This brought net demand for such loans to a significantlylower level than had been expected in the fourth quarter of 2011, with the decline driven in particular by a further sharp drop in financing needs for fixed investment. Likewise, the net demand for loans to households declined further in the first quarter of 2012 (-43% from -27% in the fourth quarter of 2011 for loans for house purchase and -26% from -16% in the fourth quarter of 2011 for consumer credit), in line with the expectations reported in the previous survey round for housing loans and below the expectations reported for consumer credit.
This is classic balance-sheet recession behaviour. Many areas of Europe have seen a significant loss of private sector wealth caused by the GFC and associated asset price declines. In response to this the private sector has adjusted behaviour in an attempt to pay down debts because their asset to debt ratio has fallen so rapidly. In these regions lowering interest rates does not cause increased lending. In fact, if the US is any guide, it spurs de-leveraging because people take the opportunity to refinance at lower rates to pay down debt faster.
Households in struggling economies do not have the capacity to take on more debt and therefore business in those areas have no reason to invest in increased production because their will be no customers willing to purchase the goods. In order to create increased economic demand, and therefore national income, the private sectors balance sheet needs to be cleaned up first.
In a environment of stagnant or falling internal consumption in a near zero interest rate environment this can be achieved in three ways:
- an increase in economic activity caused by external demand
- lowering of the government burden on the private sector
- a write-off of the existing debts
Spain’s government is studying tax increases to rein in the budget deficit, including scrapping a rebate for homeowners that Prime Minister Mariano Rajoy introduced six months ago to meet a campaign pledge.
The government needs to plug the deficit as data showed the central administration’s shortfall for the first five months approaching the full-year target and the Bank of Spain said the recession deepened in the second quarter. The government in Madrid may eliminate the tax rebate for mortgage holders and create environmental levies, Deputy Budget Minister Marta Fernandez Curras said yesterday.
On the third point, we continue to see Europe enact policy that ensures that banks never have to realise the costs of their poor lending decisions and the burden is shifted back onto the non-financial private sector. The Spanish bailout is yet another example.
So, in my humble opinion, Europe has become a mix of ineffectual monetary policy on top of misguided fiscal policy. The only thing that can possibly drag Europe out of its economic quagmire at this point is strong co-operative political will.
Need I say more?