Different Folks, But Increasingly, The Same Strokes

While one can look at the plotted path of German GDP and see it as different from France and Italy one can also look at the paths and see a lot of similarity. Topographically the series look much the same. But just before the financial crisis German GDP surged higher, then it tracked the decline in French GDP in the crisis, step by step, but when recovery came, Germany was there leaping out to the lead where it has stayed.

And for a while that has been the story.

But that is the story no more. Increasing the real story is the topographical similarity. That is compelling; not the departure in the GDP growth rates. Weakness in the rest of the Zone is wearing down Germany as surely as the glaciers scraped out the Great Lakes with their historic slow movement and as sure as simple flowing water created the deep gorges of the Grand Canyon. Sometimes the seemingly benign force can overpower the seemingly immoveable object if it is persistent enough. And that is now the operative story in the euro Zone as the stalwart German economy is being chipped away into mediocrity by the persistent weakness and cloying needs of its smaller neighbors.

Germany is still out performing Italy and France (and others) to be sure, but weakness in the Southern region of the Zone in particular is taking a toll right now and piling up German obligations for the future. Speculation on Germany is whether it can hold things to another weak growth quarter or whether it will succumb to a negative GDP quarter in Q3. Surely that call is a thin a reed to grasp and not worth the effort.

The Circle Game

The Zone’s problems remain. Greece dodged a bullet this week by raising funds in the markets; its recent bond auction was ‘successful’ but only by getting Greek banks to buy its bonds. That is truly pulling yourself up by your bootstraps, a phrase usually meant to laud hard work; but in this application it is focusing on the impossibility and utter foolishness of the attempt. When these bonds are pledged by the Greek banks to the Greek central bank and the Greek central bank petitions the ECB for funds on its name in order to advance them to its banks against this same collateral the fools’ game will be in full swing. How long can this go on? Is this sweet success, Suck-cess or simply unbridled excess? It depends on you viewing point. What works for Greeks antagonizes Germans.

ECB's Angle on LTRO is Obscure

The ECB thinks it has some fire-power in using LTRO purchases under the mandate of dysfunctional markets. This week Greece at least found a way to funding paradise without getting the ECB involved in a controversial LTRO, instead it got the ECB entangled through a back door. It may be that monetary policy is not ‘functioning’ since the ‘transmission mechanism’ for short term rates’ ability to impact longer term rates is not effective. But, of course, this channel is not ‘effective’ for exactly the opposite reason- that markets are functioning.

The disparate behavior of national bond markets is no anomaly. It is a well- thought-out result. For the ECB to use the notion of dysfunction to justify trying to push bond yields lower in Italy and Spain and elsewhere would be as productive as trying to submerge a cork by periodically whacking it with a hammer.

Understanding Europe's Problems/Symptoms

I prefer the analogy that sees Europe as being like a patient with a fever. A fever has a cause but the fever itself can get so high that it can become the most clear and pressing danger to a patient’s health. Sometimes the emergency lowering of the fever by using cold water and ice is an important expedient. But when that is done you must address whatever it was that caused the fever to start up or it will return. This analogy applies to the EMU region. It has countries with symptoms so excessive that the symptoms have become the main short term problem. And if these symptoms (high bond yields/missed fiscal targets) are not dealt with the various patients’ fates might be sealed for the worse. But using special short term help will not be enough. And therein lies the rub.

Greece has blown though assistance plan, after assistance plan. When does ‘more’ become too much? It is true that if you give Greece more help with temporary measures it might not take the longer terms steps that are required to bring health and the ‘fever’ could come back as has happened in the past, time and time again. So who, given Greece’s track record, wants to take that risk? Here is where the analogy broadens out. Greece has a disease that could spread- either way. Help it too much and others might expect the same help for themselves. The disease of slothfulness would spread. Help Greece no more and its fever could reach a bursting point and thrust Greece into a sort of economic coma that would eject it from the Zone, then a different transmission process of risk and paranoia would begin.

In this eventuality, all struggling nations would come to fear they would suffer the same fate as Greece and a speculative run would appear that would be hard or impossible to stop- and expensive.

So letting one country out of the Zone or forcing it to exit, could be an act that would force out many more and that could create much more chaos and more financial loss. This is why the game goes on and on. No one can decide where to cut the cord. So Greece malingers not because Greece is so important but because what it represents is so very critical.

EMU: The Procrastination Nations

The national debt and banking sector problems in the Zone are only getting worse as the Zone fails to come to terms with its unpleasant reality. The Germans can see it. But Merkel’s only reaction is to try to force a fiscal union on the belief that a fiscal union with sharp teeth will stop the runs in various countries. But this is a fix that does not fix the underlying cause of the fever, the competiveness loss. The Merkel plan simply assumes that a country, once backstopped, will put its shoulder to the wheel and make up for 30% or 40%, and in some case less, of competitiveness erosion that has occurred since the Zone was formed. How a nation does this and how long it takes to complete the job and what conditions are like in the meantime are not subjects for polite discussion or for pondering by anyone with political aspirations in any of these nations that are in need this adjustment.

The One Clear Need

The clear need in Europe is to remedy competiveness losses that have occurred as well as to solidify a new workable constellation of price competitiveness parities. The way to this is through currency depreciation. But that admission is an admission of failure for the Zone. It is failure even for the ECB although it has managed to meet its (gross) regional inflation pledge. The problem with the fiscal fix strategy of Merkel is that it stoppers the bottle with half the contents still on the floor. There is a still a real mess to clean up and the plan for fiscal consolidation gives some countries a bottle that is only half-full.

One Clear Gap

Fiscal fixes do not solve the problem of competitiveness losses. And this is the issue no one in Europe is discussing. Germans pretend that other countries can be ‘fiscalized’ into the Zone and will bite the bullet by doing what it takes to restore their competitiveness in order to stay in the Zone. Past fiscal transgressors simply want more bail out and want to be recognized for the pain they have suffered and are suffering and they do not want to look at the future at all. Some plead that they are ready for adjustment but want to cling to past unsustainably high standards of living – effectively denying that they will adjust. In the end this is why growth keeps getting dragged down in the Zone. The rich are not big enough or rich enough to finance the gaps that have emerged without suffering debilitating feedback effects. Too many Zone members do not want to suffer the drop from what has been an excessively high standard of living to make the needed repairs. But a failure to make this adjustment means that they will need an endless subsidy.

Meanwhile Europe weakens- In the UK the claimant count rose in July but its ILO smoothed rate of unemployment has edged lower. The Olympics have given the UK a nudge ahead and we may have to swim though several months of data before the true tide of UK growth shows its hand. Maybe things really are getting better there, but the same store sales did not seem to show it this month… perhaps we should withhold judgment.

In France Hollande ran on a platform of tax the rich and no new layoffs. But there have been auto plant closings in France and now France is facing a real budget crunch. How does the pro-growth Hollande deal with a growing budget problem in an age where blowing off your fiscal targets is no longer tolerable or not tolerable unless you are Greek…

So you can see where this leads. Failure to get the weak to adjust simply causes their disease to migrate to what were once the stronger countries. Just as Hollande cannot find enough rich to tax to balance his budget, neither can the Zone tap Germany endlessly without consequence. And that is why Europe must act. It must decide on the nature of the triage required. Triage is part of the Zone’s survival solution. The notion of saving the Zone ‘as is’ is sheer folly. Greece is the ice berg to the EMU’s Titanic. But unlike the Titanic, the euro-Zone has options. But options erode; in the financial markets they expire. The Zone needs to act while its options still have value.