Wednesday, July 16, 2014

The Difficult Road Ahead In The Eurozone

This article provides an analysis of the economic problem in the eurozone and concludes that the only way out of the problem is to engineer a "Goldilocks Economy".  Rapid growth would be bad for the banking system and so would very slow growth.  The only workable solution is one with moderately low growth.  That is because the banking crisis is the real problem in the eurozone.  The other problem is Treaty on Stability, Coordination and Governance which limits policy options on the periphery.

The eurozone crisis was blamed on irresponsible sovereign debt and austerity was the chosen solution to sovereign debt problem.  Austerity would reduce public debt levels and inspire confidence.  That has not worked.  Greek debt as a percent of GDP was 105% in 2008.  Today it is 175% and GDP has dropped by 25%.  Over the same period Portugal's ratio has increased from 62% to 129%; Spain's has risen from 36% to 93% and Ireland's ratio has increased from 25% to 123%.  Consumer confidence is down and business confidence has not risen in the eurozone as a whole.  Moreover, unemployment levels outside of the export driven Northern nations remain at high levels.

It was politically easier to blame public debt for the economic problems in the EZ than to focus on the problems in the banking sector.  The banks were loading up on sovereign debt and borrowing short term by using the bonds as collateral.  They used the borrowed funds to make long term loans at higher interest rates.  This source of liquidity dried up when sovereign bonds lost their AAA ratings.  The ECB provided liquidity through its Long Term Refinancing Operations (LTRO).  Banks could borrow from the ECB at 1%.  For example, Spanish banks could borrow at 1% and purchase Spanish bonds the paid 7%.  That helped to restore their balance sheets by replacing bad loans with profitable assets.  The ECB also promised to purchase sovereign bonds if necessary.  The prices on sovereign bonds rose rapidly and interest rates declined.  For example,  the interest rate on French 10 year treasuries is lower than that of US 10 year bonds.

The banking recovery is at risk if the economy grows rapidly.  The ECB would have to increase interest rates to combat the risk of inflation.  That would lower the value of the sovereign bonds that helped to restore their balance sheets.  Consequently, the banks must find ways to make profitable loans in period of only moderate economic growth.  That is the "Goldilocks Dilemma".  The economy must grow at a lukewarm rate so that banks can work their way towards solvency. 

The Treaty on Stability, Coordination and Governance places limits on fiscal policy.  Austerity is built into the treaty.  High levels of unemployment in the periphery nations will be around for a long time according to this analysis.

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