Europe has no levers for growth

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

On the first point, as you may have noticed from recent PMIs, external demand is falling. On the second point, we continue to see the opposite from national governments:

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?

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  1. There is always Option 4, of course – The Syrian Solution. That captures all 3 of the existing options. GDP growth from creative destruction.

  2. I loved Hussman’s quote in the fin Rev today:

    This is like nine broke guys walking up to Warren Buffet and proposing each can issue ‘Warrenbonds’

  3. Touche Janet,

    I have just come back from a holiday where I was in Ireland, Italy, Greece and Spain.
    Everything is quiet on the Western Front I have to report as apart from Italy nobody is manufacturing anything…tried finding souvenirs made in the country we visited..all made in China even the rosary beads in St Peters Rome.
    In Greece tour operators wanted cash only same with Italy and got good prices for tours as everyone is now a tour guide..,except for Spain where in Barcelona and Madrid they are all pick pockets…considering their situation all those countries were expensive to eat out and hotel rates also high with very ordinary service or not enough staff…Plain to see that the countries that now manufacture nothing are being the hardest hit……

    • Jumping jack flash

      “… tried finding souvenirs made in the country we visited..all made in China even the rosary beads in St Peters Rome”

      It is unviable to make them anywhere else because everywhere else demands high wages and refuses to accept competitive global market prices for their labour.

      These countries aren’t actually doing anything to enable them to justify paying these high wages either, such as tariffs, as an example.

      “Plain to see that the countries that now manufacture nothing are being the hardest hit……”

      That is extremely interesting. What does Greece produce? Spain? Not much.

      Italy at least makes expensive cars, shoes and handbags.

      Actually, I bought some IR proximity sensors the other day that were made in Italy. I was very surprised.

      • Italian manufacturing is some of the best in the world, and their strength. But as DE has been analysing/warning for awhile now, its on the decline and wont be enough to save them.

        It serves as a warning to those (including me, guilty as charged) who think that if only Australia switches to a high end manufacturing sector,everything will be fine. There’s more to it obviously.

        If only the Italians went back to the lira…and the Germans back to the mark, you wont see as many Audis and BMW’s anymore – just lot’s of Fiats!

        • rob barrattMEMBER

          True about Italy
          My partner gave her Fiat Punto to my son (the ultimate nightmare owner) 5 years ago – it’s still running.. a tribute to Italian engineering.

    • rob barrattMEMBER

      ‘made in China’ – I was in Venice a little while back, one of the small shops selling Murano glass had a sign up saying ‘our Murano is not made in China’ – whoops..

      • Yeah I was in Venice also and walked from Venice train station to St Marks and came across lots of Asian shop keepers all selling handbags and trinkets that had Made In Italy stamped or labels on them. I told one Chinese guy that they were made in China and he got really pissed off…I have been to China many times as the company I worked 25 years for relocated there and I have saw in China handbags,sunglasses there with those same Made In Italy labels.I spoke to one Italian lady who makes her own stuff and she explained that the issue of fake goods is a huge problem in Venice..My wife bought 2 souvenirs from her and we did see her little workshop….Did not notice this in 2004 on my last visit to Venice..Cheers to all MB people, I love this blog

  4. rob barrattMEMBER

    Mind you, we do need to keep things in perspective regarding debt. Greece (population 11.3m) needs to pay back a $160bn, Queensland (population 4.6m) owes $100bn. Greek politicians would be proud of us.

    • Actually current Qld debt is $62 bn and forecasts had a surplus in 2015 before Newman. Rosy growth forecasts probably, but Costello’s assumptions to get to $100bn by 2018/19 are probably even more inaccurate.

  5. From an FT article:
    But [Merkel] made it clear that she did not intend to move on short-term remedies until she was confident of [her principal eurozone partners] commitment to more fundamental reforms.

    From a BS article:
    Hollande said that both he and Merkel wanted to “deepen the economic and monetary and, tomorrow, political union to achieve integration and solidarity”.

    From earlier reports we know that Rajoy is prepared to cede some budgetary control to what he calls a supra-national “fiscal authority”.

    Monti has said that he’s prepared to keep the EU Summit going until Sunday evening in order to get an agreement on short-term actions.

    Perhaps there is still an outside chance of a “move on short-term remedies” at this summit?

    • They should just cut to the chase and invite Bernanke and Draghi to these summits. They are the only people that are preventing the markets from capitulating. If either of them announced that there will be no more easing as long as THEY live, the party would implode.

  6. Is there any serious case as to why bank shareholders and bond-holders shouldn’t just take the hit.

    It’s almost surreal how easily this is just pushed over to taxpayers.

  7. Angela Merkel used the word growth in one of her sentences. Wow! Didn’t realise she had it in her.But as mentioned by DE in the article, it’s all about walking the talk at the end of the day.

    All we’ve seen so far is slash this and austerity that.

  8. I totally agree with you DE. MMT tells us high debt can inhibit growth, and the EU are in the zone. All the EU debt re-financing over the next few years will bring more stress, and who is going to buy this debt? I expect yields to go much higher before long. Just Spain/Italy need a re-finance Eur 1.4 trillion over the next two years.

    S&P warned back in May that globally companies need to re-finance USD 46 trillion over the next few years, and many of those companies are in Europe.

    This is not over even if they agree on a political and fiscal union.

    It seems to me that we might be seeing a crisis to flush out weaker member states and then get a strong core that could succeed, but I expect a credit event to bring that on.

  9. “I’m not sure why Rajoy insists on claiming a €100bn loan isn’t a bailout when it most obviously is.”

    It’s a question of trying to save face.

    If one thinks about it, it’s the same with Hollande: all the talk about the growth compact is pure BS, put there so that Hollande can claim Merkel isn’t the only voice.

  10. Lighter Fluid

    DE, regarding the numbers quoted in the ECB banking survey, a 43% drop in demand for household credit sounds like a full-blown debt-deflationary depression. Is this really correct? If so I’d seriously be worried.

    Reading the link suggests these percentage values are ‘net percentage of banks reporting a positive contribution to demand’, so things might not be as bad as the number first makes it sound.

    Is there any data on actual aggregate new loans (nominal or as a % of GDP) for the eurozone that a Keensian could sink one’s teeth into?