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Posted by: Andrew Bell
Tuesday 1st November 2011
The past 18 months have seen a blur of inconclusive and fractious conferences on the problems of Europe’s single currency. Having enough summits to create a ski resort, perhaps that is what Europe’s leaders should do: “Downhill all the way”?
Repeated meetings over the summer sought a lasting settlement on Greek debt, to create a robust firebreak against sparks spreading to other countries with impaired credibility but better fundamentals and to render the banks resilient to losses from their holdings of Greek and other sovereign bonds in the Eurozone.
Finally, in October, the outline plan for a deal has been agreed, which appears adequate to remove the downside risk of an accelerating fiscal and banking crisis, which underlay much of the markets’ volatility over the summer. Greece’s creditors take a “voluntary” haircut of 50% of the value of their claims, the banks’ have to rebuild their capital ratios to a higher (9%) threshold and governments will eke out (leverage up) the resources previously agreed to support the Eurozone periphery’s struggling borrowers.
Markets had already taken a more positive view of the likely European outcome, since there were greater signs of urgency in addressing a more comprehensive agenda than featured in the July “final deal”. The previous hard-line view in Germany morphed from being bone-headed to merely hard-nosed, recognizing that the cost of picking up the pieces if the Euro broke up was likely to be much greater than the cost of subsidising its continuation. However, despite the Summiteers broadly adequate words many details remain to be filled in, with past form warning of the risk of backsliding or mistakes in execution of the measures agreed.
A further key risk is that there is nothing to address weak economic growth and losses in competitiveness by peripheral economies, which drove the markets’ ebbing confidence in the sustainability of their fiscal positions. Either Germany and the rest of the core need to reflate/inflate more than the periphery (rebalancing the changes in relative competitiveness) or the Euro needs to weaken relative to other trading partners. Unless these happen, the periphery will have to regain competitiveness by lowering costs (deflation) or improving productivity, neither of which has an immediately positive effect on budget deficits.
Investors have been willing to take a more sanguine view of the on-going saga, since economic growth outside Europe has turned out better than expected. Pessimism became so rife that even anaemic growth would have been a relief and, in the US at least, the signs are that growth in the autumn was better than this. In emerging economies, there are signs that the monetary tightening cycle is drawing to an end. This had been needed to cool overheating demand and counter the inflationary impact of higher commodity prices. Policy in emerging economies is tipping from combatting inflation to promoting growth, which will be helpful in offsetting the adjustments underway in developed economies.
So, can investors come out of their foxholes now? The answer may be yes but remain watchful - the outlook does not warrant unbridled optimism. Equity markets recently sank to levels which appeared to place a higher probability on a global recession and financial disaster happening in Europe than now seems likely. This has allowed investors to recover some of their summer losses during October. The headwinds of debt reduction in developed economies and unresolved policy tensions in Europe remain nonetheless.
This is a time when strong political and economic leadership would be welcome. These qualities are in short supply around the two fault lines of the world economy. European politicians appear to understand what is needed but not how to be re-elected if they do it and in the US there appears a greater desire to pin the blame for events on political opponents than to make sensible compromises which would be likely to help the economy. In the words of Disraeli, speaking in 1872:
“It was not difficult to perceive that extravagance was being substituted for energy by the Government. The unnatural stimulus was subsiding. … Some took refuge in melancholy, and their eminent chief alternated between a menace and a sigh. As I sat opposite the Treasury bench, the Ministers reminded me of those marine landscapes not unusual on the coasts of South America. You behold a range of exhausted volcanoes; not a flame flickers on a single pallid crest; but the situation is still dangerous: there are occasional earthquakes, and ever and anon the dark rumblings of the sea.”
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