Monday, October 1, 2012

Europe stares into the economic abyss


We've spoken many times about Europe's economic problems.  Frankly, I'd expected them to blow up into a terminal disaster for the Euro before now, but the powers that be over there have postponed the inevitable by printing money like there's no tomorrow (clearly taking lessons from the Fed, I guess) and desperately trying to stick their fiscal fingers into the holes in the financial dikes that surround them.

They're running out of space and time.  Jeremy Warner highlights the core problem for Germany, Europe's strongest economy.

It’s plainly not going to matter ... if a big trade and capital imbalance develops between the north-east of England and the South East, if only because there is a unified banking and fiscal system to intermediate. If there is a sudden rush of deposits out of the North East to the South, it makes no difference to the banks involved; their net position in terms of assets and liabilities is unaffected.

Yet when these flows are between nations with different banking and fiscal systems, then there is potential for big trouble. Go back to the origins of the eurozone crisis and, in broad outline, this is what occurred.

Throughout much of the first eight years of the euro’s existence, there was a steady improvement in German competitiveness against the eurozone periphery, resulting in a growing German current account surplus. This imbalance in trade was largely financed by German banks, which were, in effect, lending the periphery the money to buy German goods. German credit also financed major construction and credit booms in some periphery countries. Periphery governments were equally profligate, if not worse, in spending on the German credit card.

Then along came the financial crisis, German banks stopped lending to the periphery and, worse, started withdrawing their credit as fast as they could. With no good use for the money back in Germany, the resulting surplus is placed on deposit with the Bundesbank.

Meanwhile, back in the periphery, the local banking system is left with a steady loss of funding but, because credit cannot quickly be called in, the same amount of lending. To fill the funding hole, the periphery bank borrows instead from the European Central Bank in return for collateral. The ECB, in turn, will obtain the money from the Bundesbank surplus.

What’s occurred is a money-go-round. Deposits leave the periphery banking system then via the Bundesbank and the ECB end up back where they started.

You can see why some economists might think that the net effect is inconsequential. In the round, the German exposure doesn’t change. All that’s occurred is the liability to repay the deposits has been swapped from the private to the public balance sheet. But to put it like that unduly trivialises the problem, for to socialise responsibility for the bad debts of the periphery with German taxpayers, which is essentially what’s happened, is no small matter.

But it is certainly true that one way or another – whether through the banking system or the Bundesbank – Germans were always going to be on the hook for all that bad lending. When the debtor borrows too much, the creditor always pays.

. . .

Where things have got out of hand, however, is that on top of this withdrawal of credit by the German banking system, there has also been a frenzied flight of domestic capital from the eurozone periphery. Much of this money has ended up in Germany, or other perceived havens. On top of their own bad lending, Germans are therefore also assuming liability for the bad lending of the periphery nations themselves. This will continue as long as investors think there is any risk of break-up.

Nor does it end there. Via the German banking system, the flight of capital finds itself squeezed, because of ultra-low German bond yields, into the rest of the eurozone core, including France. A country which, in truth, has far more in common with Spain and Italy than it does with Germany thereby ends up with German interest rates, encouraging it’s newly installed president, Francois Hollande, to believe the markets are sanctioning him to make the economy even more uncompetitive than it already is. While everyone else is being frogmarched into austerity-oblivion, France is haring off in the other direction.

Even assuming that by some miracle, the eurozone periphery manages to claw its way back to competitiveness, the madness of the euro is only setting itself up for an even worse crisis further down the road.

There's more at the link.

That "frenzied flight of domestic capital from the eurozone periphery" has been of epic proportions.  In his latest newsletter, John Mauldin makes the scale of the problem horrifyingly clear.

Greece doesn't want to leave [the Eurozone] whilst there is still even a remote chance of being given billions more in loans that they have zero intention of paying back (after all, why would you walk away from the guy throwing money at you until his bag was empty?), whilst it appears to have finally dawned on Europe that Greece has them over a barrel in the sense that if they were to leave, not only would billions in loans disappear ... but it would precipitate a Europe-wide bank holiday and escalate the bank run that has been in progress for over a year now.

If Greece were to leave the EU, then all Greek banks would need to be shut in order to return to the Drachma, and if you closed all the Greek banks, it would make it apparent to those last few blissfully ignorant savers still keeping their savings in Spanish banks (to pick but one imperiled European country completely at random) that the exit of a weak country from the euro—an outcome Greek PM Antonis Samaras described as "not an option" as recently as this week—was decidedly an option, and that would necessitate either closing Spanish banks too in order to stop capital flight to the safety of German deposit accounts accelerating further or imposing strict capital controls Europe-wide (which is hardly in keeping with the spirit of the union). Of course, if you then close Spanish banks ...

. . .

There really is no such thing as a "manageable" exit for anybody right now, I'm afraid. European countries are lashed together on board a sinking ship, and that fact is slowly dawning on them ...

. . .

The realization that Spain is the key to the entire European house of cards is slowly dawning on the denizens of Europe, and it's a sobering thought indeed ...

. . .

This week Bloomberg reported Spanish bank deposits declined by 224 billion euros or 10% in the twelve months ending July 31st. That is equal to more than 20% of Spanish GDP ... There can be no doubt that the run on Spanish banks has been ongoing, massive, and most likely devastating.

. . .

The dreadful unemployment situation in Spain has been talked about in abstract terms for almost 18 months now, but things are decidedly not improving ... The number of employed workers in Spain is falling by an average of just over 3% per month. To put that in perspective, that is the equivalent of roughly 600,000 workers dropping out of the US workforce every thirty days.

. . .

Spanish real estate prices have been falling for years. According to official data released this past Friday, the decline in house prices has accelerated. They fell 14.4% year on year in the second quarter – the fastest rate since the real estate bubble burst in 2007. This is what one should expect given the unimaginable “run” on the Spanish banks. Real estate is the principal collateral behind Spain’s untenably high ratio of private non-financial debt to GDP, and it is collapsing.

. . .

But perhaps the single biggest problem with Spain is not the housing market, nor the busted banking sector, nor even the chronic unemployment. No. The biggest problem Spain presents to the world is the lack of credibility in the official statistics it releases amidst rumours of massive unpaid bills and insolvency in many of its regional governments.

. . .

Here's the simple truth:

Spain, like Greece, cannot be trusted to publish accurate economic statistics because the stakes are way too high and the true numbers likely far too shocking.

. . .

As always, forget the talk, ignore the rhetoric and discount words like "manageable," "impossible," "not an option" and "believe me." Beneath all this lies a set of fundamental mathematical equations, and last time I checked, the laws of mathematics weren't something that could be subverted.

There's much more at the link.  I highly recommend reading Mr. Mauldin's whole article.  It's well worth it.  (I also recommend that you subscribe to his free newsletters, if you don't already do so.)

Friends, looking at those numbers, it's hard to understand why Europe's financial chickens have not yet come home to roost.  By kicking the can down the road, trying desperately to buy time by printing money and pulling political stunt after political stunt, Europe's leaders are merely ensuring that when the crisis finally arrives, it'll be much worse than it would have been if they'd confronted it squarely from the beginning.

I'm not a prophet.  If I gaze into a crystal ball, all I see is glass.  Nevertheless, it doesn't take supernatural powers to foresee what's just over the horizon in Europe.  My great fear is that when it happens, the crash will come so suddenly and so swiftly that it'll destroy the good along with the bad.  Remember the Weimar Republic's hyperinflation?  The cost of living index rose from 41 in June 1922 to 685 in December, a more-than-sixteen-fold increase in a mere six months - and it didn't stop there.  Wikipedia illustrates the effect of this inflation on currency convertibility as follows:




To illustrate Weimar's hyperinflation another way:  "In 1919 one loaf of bread cost 1 mark; by 1923 the same loaf of bread cost 100 billion marks."

Given the rampant printing of fiat currency going on at present (both in Europe and in the USA), there's no reason to believe that the same thing couldn't happen again.  I believe it might happen sooner than we think . . . and with results just as devastating to present-day Europe and the USA as the inflation of the mark was for Weimar Germany.

Emergency food supplies may be primarily intended to help us cope with a physical disaster of some kind, but they might also be all we can afford to eat in a high-inflation environment.  They may also be all that's available for a while if the price of fuel goes through the roof and the trucks stop running.  All the more reason to make sure we've prepared as best we can!

Peter

1 comment:

Mikael said...

While I'm glad to live in a european country with ordered finances, that didn't adopt the euro, it's still going to be a bumpy ride, as we are an export country, and our currency is being heavily strengthened by comparison, so our ability to compete will be severely hampered when other currencies take nosedives.