A Specter Overhanging Europe


Moritz Kraemer; Michala Marcussen, CFA; Liam Halligan; and Hans-Werner Sinn.

There is an unpleasant specter overhanging Europe, according to a panel discussion on EU Debt and Prospects for Growth: A Fairly “Grimm” Tale? at the 68th CFA Institute Annual Conference: the specter of outside investors looking in at the lingering debt crisis.

Many Europeans display a tolerance, incomprehensible to observers, of melodramatic Greek–German posturing and Italian sleepiness on overdue structural reforms that some deem necessary to safeguard the system. But if Europe is to retain the confidence of international investors, the normalization of such dramas and inconsistencies can’t continue. The clock for radical reform is ticking and time is running out.

Moritz Kraemer, chief rating officer at the credit agency Standard & Poor’s, began a wide-ranging discussion by admitting the European recovery remains weak compared with that of the United States, despite every European country desiring growth. In part, this is because of worsening demographics and a lack of structural reforms. The quicker recovery in the United States and elsewhere was because these nations didn’t require all the reforms now holding back eurozone countries. “Italy is an example of a country unable to structurally reform itself,” said Kraemer. Across southern Europe, Kraemer highlighted the need for more leadership to bring a reform agenda forward. High unemployment rates in these countries may well mean further stress on the social fabric.

Financial Times economist Martin Wolf had earlier told the conference audience of the need to admit that quantitative easing (QE) is never going to be reversed. Kraemer agreed, remarking that QE and unconventional monetary policy (asset purchases) by definition have to stop when the European Central Bank (ECB) owns all of the bonds in the eurozone. The current plan is to stop buying in September 2016. Tapering talks have already begun.

On Greece and the prospects of a “Grexit,” Kraemer pointed out that the country had defaulted before, although the difference now is in the structure of the creditors. “I cannot see the contours of a solution coming out,” said Kraemer, criticizing the “Troika” institutions — the International Monetary Fund (IMF), the European Commission, and the ECB — as ineffectual. It seems, at least for this observer, difficult for the ECB to maintain the impression of Greek solvency, claiming Greece is just temporarily illiquid, if the system of emergency liquidity assistance, in addition to monetary policy operations, no longer works.

“What kind of crisis do we have in Europe?” asked Hans-Werner Sinn, professor of economics and public finance at the University of Munich. Is the dysfunction in European economies a Keynesian demand crisis or something else? For Sinn, it is the result of a bursting inflationary credit bubble in southern Europe. “Southern countries simply lost their competitiveness compared to Germany,” the economist suggested. Another alternative is that some inflation is encouraged by central bankers. “We have to deflate the south or inflate the north,” said Sinn.

The author of a recent book, The Euro Trap: On Bursting Bubbles, Budgets, and Beliefs, Sinn suggested that high interest rates in the future could increase incentives to carry out reforms, whereas so far QE had the effect of easing the pressure on countries to reform. On structural imbalances between eurozone countries, Sinn suggested that if Germany had been allowed to inflate (and southern Europe had not), then differences within the eurozone could have been equalized in as few as 10 years. Instead, we have the current situation. “QE was the last chance for southern Europe to regain competitiveness,” said Sinn. Reforms in Europe must now mean wage cuts, but “nobody is saying this here.”

“Germany has always been happy that the European Central Bank did the dirty jobs,” said Sinn. It is quite possible, at least according to Sinn, to have the default of the Greek government without domestic bank insolvencies. But when the emergency liquidity credit exceeds the lines of credit required, then the Greek government will have to pay its bills with IOUs. Only a big rescue program directly for the banks themselves could resolve such a desperate situation in Greece. It is the ECB council that is in control of actual lending limits. For Sinn, the ECB can give liquidity assistance but cannot prevent domestic Greek banks from going under with current limits.

Michala Marcussen, CFA, head of global economics at Societe Generale Corporate and Investment Banking, provided a harder-edged banker’s view of the landscape. “I’m struck by how much agreement there is in Europe,” said Marcussen, referring to needed structural and fiscal reforms. “Underlying structural reform is required and time for Greece is running out.”

On the question of whether QE is about to be reversed, Marcussen evaluated the downsides of QE continuing so long and the danger of building up excesses and asymmetries in intersecting monetary and fiscal policy. For example, “you get to a point where you see wage inflation coming back,” said Marcussen. “Using monetary policy as a fiscal policy tool, you are generating wealth transfers, with each central bank getting to keep profits from asset purchases.” Dangerously high asset values was another concern manifested in “compressed down term premia, probably minus 200 bps,” said Marcussen. In short, we stand at an interesting moment when a long period of weak growth is the last thing needed.

For Marcussen, a well-functioning economy is not just about wages, it is also about educational levels and reform of judicial systems to make them effective and business-friendly. Products and service markets must work smoothly and effectively. Simplification is key. “I take a Nordic view of things,” said Marcussen, pointing to the Scandinavian flexi-security model. “Our only policy tool should not be just pushing wages down.” Marcussen also noted the relatively speedy recovery in Ireland as an exemplar for Europe: “What worked for Ireland was underlying flexibility and structure.”

International Financing and Currencies

With so much at stake, all the panelists agreed that more functional heavyweight international financing is essential for Europe. The idea of introducing eurobonds prompted some lively responses. “Eurobonds would be a stronger disciplinary force,” said Marcussen. “To outsiders, the current defaults would then seem more like Californian defaults.” While Kraemer contended, “we already have them in all but name.” For Sinn, the IMF’s assistance to creditors is often propping up incorrect exchange rates. “If we strengthen these cooperative systems, then money is there to help weakling economies, but this maintains the wrong exchange rates. The alternative is to allow the currencies to adjust so that we don’t have large current account imbalances,” he said. Referring to the indebted US economy and its (not insignificant) trade deficit, Sinn asked, “Can you imagine that the United States will ever pay their money back? I can’t, and it’s the same with southern Europe.”

Concluding with a discussion on the strong dollar’s precarious role as the international reserve currency, the panelists turned to competitive devaluations among currencies and disunity within currency blocks. “Devaluing cannot be a solution owing to the distributional issues in devaluation between debtors and creditors,” said Kraemer. What is dangerous is that we have deflationary tendencies. “In the future, we may have competitors to US dollars,” said Marcussen. Yet within the euro block, “Poland has wages half of those in Greece,” said Sinn. Moderator Liam Halligan wrapped up by noting that “the eurozone is about to blow up. Now is not the time for talking shop on theory.”

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Photo credit: W. Scott Mitchell

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