EDINBURGH – In recent weeks, talk about a budding recovery in the eurozone has gained traction, with key indices pointing to expansion in the core countries – data that many are citing as evidence that austerity is finally working. Money-market funds from the United States are returning, albeit cautiously, to resume funding of European bank debt. Even Goldman Sachs is now bullishly piling into European equities. But is a recovery really underway?
Cynics recall that a European recovery was supposed to take hold as early as the fourth quarter of 2010, and that every International Monetary Fund projection since then has predicted recovery “by the end of the year.” Instead, GDP has collapsed, with the Spanish and Italian economies expected to contract by close to 2% this year. Portugal’s economy is set to shrink by more than 2%, and Greece’s output will fall by more than 4%.
Moreover, unemployment in the eurozone has skyrocketed to an average rate of roughly 12%, with more than 50% youth unemployment in the periphery countries implying a long-term loss of talent and erosion of the tax base. And, despite the spike in unemployment, productivity growth in the eurozone is decidedly negative.
More significant, over the last year, the public debt/GDP ratio rose by seven percentage points in Italy, 11 in Ireland, and 15 in Portugal and Spain. If the sine qua non of recovery via austerity is the stabilization and reduction of debt, the cynics’ case appears to have been made.
Against this background, the return of US investors to provide short-term dollar funding for European bank debt smacks of a desperate hunt for yield that relies on European Central Bank President Mario Draghi’s promise to do “whatever it takes” to save the euro. As for Goldman’s equity play, as bond-market guru Bill Blain put it, “the words ‘buy cheap, sell a bit dearer on the up, and then dump and run’ spring to mind.”
In fact, any talk of recovery is premature until the losses incurred by austerity are recouped. As it stands, every country that has implemented an austerity program without imposing losses on private creditors has more debt now than when it started. For example, according to official estimates, Spain’s public debt, which amounted to only about 36% of GDP when the crisis began, has almost tripled – and the actual figure may be much higher. More telling, the countries that cut expenditure the most experienced the largest bond-yield spikes and the most significant debt growth.
The explanation for this is simple. When a country gives up its monetary sovereignty, its banks are effectively borrowing in a foreign currency, making them exceptionally vulnerable to liquidity shocks, like that which sparked turmoil in Europe’s banking system in 2010-2011. The government, unable to print money to bail out the banks or increase export competitiveness through currency devaluation, is left with only two options: default or deflation (austerity).
Austerity’s underlying logic is that budget cuts, by reducing the debt burden and restoring confidence, ultimately enhance stability and support growth. But, when countries pursue austerity simultaneously with their main trading partners, overall demand plummets, causing all of their economies to contract and, in turn, increasing their debt/GDP ratios.
But the problem with austerity in the eurozone is more fundamental: policymakers are attempting to address a sovereign-debt crisis, though the real problem is a banking crisis. With Europe’s banking system triple the size and twice as leveraged as its US counterpart, and the ECB lacking genuine lender-of-last-resort authority, the sudden halt in capital flows to peripheral countries in 2009 created a liquidity-starved system that was too big to bail out.
As holders of euro-denominated assets recognized this situation, they turned to the ECB for insurance (which the ECB could not deliver under its previous president, Jean-Claude Trichet, whose leadership was defined by his commitment to maintaining price stability). Investors’ subsequent efforts to price in the risk of a eurozone breakup – not the volume of sovereign debt – caused bond yields to spike.
But the financial-market turmoil fueled a panic among eurozone leaders, leading them to misdiagnose the malady and prescribe the wrong medicine, which has served only to generate new symptoms. While Draghi’s promise, embodied by the ECB’s “outright monetary transactions” program – as well as its long-term refinancing operation and emergency liquidity assistance program – has bought time and lowered yields, the eurozone’s banking crisis persists.
Eurozone leaders must recognize that spending cuts will do nothing to stabilize the balance sheets of core-country banks that are over-exposed to peripheral countries’ sovereign debt. Until Europe rejects austerity in favor of a growth-oriented approach, all signs of recovery will prove illusory.