Sent: 20-12-2011 10:50:03
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Europe - The Year of Muddling Through
The year is winding up without any resolution to the biggest handicap markets have faced in decades. European leaders are choosing which is worse, staying together or separating. Neither offers a solution to the ongoing market malaise. Muddling through without a catastrophic bank failure in the year ahead will be a job well done.
An accurate New Year forecast always seems hostage to the unanticipated tsunami, collapse of a seemingly impregnable investment bank or terrorist attack. This might be the year we have our best chance of anticipating successfully what will dominate market outcomes. Europe stands out.
Other things could happen - a war with a nuclear emboldened Iran, Chinese policymakers putting the brakes on growth too aggressively, a crumbling Pakistan state being taken over by tribal warlords, a power struggle within a more belligerent North Korea, a misstep on the US presidential trail - but nothing seems to have the potential of Europe to so unnerve markets for a prolonged period.
There are some positive risks. The US economy appears finally to be beating expectations about how strongly it will grow. For all the risks to global growth, the International Monetary Fund continues to forecast that the world economy will grow in 2012-16 faster than the average in the last 10 years and at a rate that would have been readily embraced at any time in the last 50 years.
The developing economies will continue to account for a larger proportion of output and demand. Looked at from that perspective, Europe matters less but it remains a large, even if declining, chunk of global demand as it faces three seemingly insurmountable economic problems:
- how to prevent bondholders capturing an indefinitely growing share of economic output at the expense of an increasingly impoverished and restive population;
- how to ensure major banks are capitalised well enough to survive the year and, beyond that, fulfil their roles in an advanced functioning economy; and,
how to avoid a massive contraction in economic activity in 2012 and 2013 as the size of government budgets are reduced.
The first problem can only be averted with a contraction in government spending or such a large capital loss for Europe's financial institutions that asset values are hurt and economic growth is jeopardised.
The second problem is being addressed through emergency measures when a bank threatens to topple over a financial precipice. This leaves financial institutions managing contracting balance sheets day to day and unable to fulfil their economic roles in support of economic activity either because they lack an adequate capital base or fear the risk of lending when other banks are so shaky.
Against the background of the first two, the third problem seems a lost cause. The traditional medicine for a heavily indebted nation - restoration of competitiveness through currency depreciation - has been ruled out.
For many analysts, a common currency is such a fatally flawed idea that a break-up of the Euro area must be part of any solution. So far, the UK aside, European governments have decided that staying together is preferable. None of the problems will be solved in staying together but, they reason, solidarity would be a less disastrous course than splitting up the monetary union.
Already, funds are flowing out of banks in peripheral economies. Corporates are moving funds to safer institutions in less risky locations. Any suggestion that Greece, for example, is about to quit the euro would almost certainly lead to a run on Greek banks as people sought to protect their savings. The same would play out in Spain, Italy, Ireland and anywhere else. Dropping out would result in the banking system in these countries being ruined. Political unrest and economic depression would ensue.
Letting the peripheral economies keep the euro with France and Germany going back to the Deutschemark and Franc might avert panic among the citizenry but might so reduce the competitiveness of the larger economies that they would struggle for years to recover. In any case, euro bondholders would be looking pretty sick in this scenario, too, so that the threat to banks in the major economies would not be averted.
International investors have instinctively looked to the European Central Bank to come up with a solution. This is due to more than 20 years of training by the US Federal Reserve.
Through the stock market crash of 1987, the failure of Long Term Credit Management, the Al Qaeda attack on the World Trade Center towers, the 2001 U.S. recession and the sub prime crisis in 2008, the U.S. Federal Reserve has propped up markets. World markets came to count on Alan Greenspan and, more recently, Ben Bernanke to save the day.
Europe's central bank is proving an entirely different beast when it comes to solving the current debt crisis. Not only are the personnel individually less inclined to intervene to support financial markets, the legal powers of the European institution are more circumscribed than those of the U.S. Fed.
There is a basis for Europe to muddle through as a new fiscal union is put in place and just enough is done by way of emergency measures to prevent catastrophe. Europe is one of the world's largest economic regions. As a group it can pay its bills. Leaders in the north may not like the income redistribution effects but that comes with any political union. China, Australia and the USA all face the same income distribution issues from disparities in regional growth.
The leaders of France and Germany will extract everything they can in return for the sacrifices they make. The balance of power in Europe will never be the same again. Germany and France will achieve the political ascendancy they have craved for centuries.
Meanwhile, the refusal of the ECB to bail out the banks as readily as the US Fed might have done could prove a silver lining. Investors will have to accept lower asset values. Lower growth will ensue. Political leaders will be short lived. But investment markets will not become hooked on ever larger doses of liquidity to keep them aloft.
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