Europe: Past The Point Of No Return – OpEd

“Eurozone banks’ demand for European Central Bank funding surged to a two-year high on Tuesday, as fast spreading sovereign debt worries left lending markets virtually frozen and  the ECB the only available funding option for many institutions.” – Reuters, Nov 22, Frankfurt

The European Central Bank continued to buy Italian bonds on Tuesday in an effort to calm markets and slow the flight of capital from Europe. Yields on Italian and Spanish debt continued to rise increasing the cost of borrowing for the debt-stricken states. At the same time, the cost of borrowing euros in the interbank market  remained at elevated levels while credit market stress gauges (Libor) reached their highest point since July 2010. What started out as a brushfire on the perimeter (Greece) has now turned into a raging inferno that threatens to consume the eurozone. Here’s an excerpt from Roubini Global Economics Newsletter:

“Italian debt dynamics have become unsustainable in light of much-weaker-than-expected growth prospects and elevated borrowing costs. Following a sharp loss in market confidence and a buyers’ strike, we expect Italy will be forced to restructure its sovereign debt.

The environment of heightened political uncertainty in Italy has rendered it incapable of tackling the current challenges….

We believe Italy is past the point of no return and will be forced into a managed debt restructuring as early as 2012.” (“Italy: Too Little, Too Late”, Katharina Jungen, Mark Willis, David Nowakowski and Megan Greene, Roubini Global Economics)

While banks have access to “unlimited” funding from the ECB, struggling countries like Italy and Spain must depend on unpredictable central bank purchases of sovereign bonds in the secondary market (Securities Markets Program). EU sovereign debt is not explicitly guaranteed by the ECB as are US Treasuries which are backed by the “full faith and credit” of the US Treasury. Capital flight from the EU bond market proves that investors are more worried about default than inflation. What they want is some assurance that they’ll get their money back, whether it is worth less or not is secondary. The ECB refuses to provide that guarantee which is why the crisis continues to worsen. This is from Businessweek:

“Spanish borrowing costs surged to the most in at least seven years as the nation failed to sell the maximum amount of 10-year bonds on offer at an auction….

“This has been the worst week of the European sovereign debt crisis,” Nicholas Spiro, managing director of Spiro Sovereign Strategy in London, said in an interview with Bloomberg… “The contagion is spreading like wildfire. There are no real private buyers for Italian and Spanish debt.” (Businessweek)

Liquidity continues to dry up as banks park more of their funds at the ECB. This has triggered a lending freeze that will lead inevitably to recession in 2012 if not earlier. Money markets have also tightened the spigots, reducing the flow of money to EU banks by nearly one-half in the last year alone. The signs of a full-blown credit crunch are now visible everywhere. Even so, Germany continues to block the one solution that could ease conditions and calm the markets, allowing the ECB to backstop sovereign bonds.

Jens Weidmann, member of the ECB and head of Germany’s Bundesbank, summed up the German approach like this:

“(The ECB) would overstretch its mandate and call into question the legitimacy of its independence by accepting a role of lender of last resort for highly indebted member states,” Weidmann said.

EU banks have now borrowed more than $500 billion from the ECB “but data shows that two thirds of that money is being deposited back at the ECB” (Reuters)

This is an indication that the repo markets –where banks get funding for short-term loans–is no longer functioning properly. Thus, the banks are exchanging collateral with the central bank for money but leaving the money at the ECB expecting conditions to get worse.

According to Bloomberg:

“Foreign bank deposits at the Federal Reserve have more than doubled to $715 billion from $350 billion since the end of 2010 amid Europe’s debt turmoil, buttressing the dollar’s status as the world’s reserve currency….

People are hoarding cash because they see that there’s some difficulty in the U.S. dollar funding market” as banks shed euro-denominated assets, Charles St-Arnaud, a foreign- exchange strategist at Nomura Holdings Inc. in New York, said in a telephone interview Nov. 14.” (Bloomberg)

So, bond yields are rising, the credit markets are in turmoil, and the ECB has settled on a policy that paves the way for catastrophe. What’s next? Here’s more from the Roubini report:

“We do not expect Italy to be able to react in time to tackle its debt problem with an adequate fiscal consolidation and structural reform plan. The high degree of political uncertainty has rendered the country unable to tackle the current challenges, as a result of which markets have lost all confidence in Italy…..

For the next few years… Italy and the smaller peripheral countries would implement painful reforms and hope for growth, with varying degrees of success. Failure in a few years’ time would call for further restructuring, and by that time the lifeboats for a demise of the EZ might be in place as well.” (“Italy: Too Little, Too Late”, Katharina Jungen, Mark Willis, David Nowakowski and Megan Greene, Roubini Global Economics)

If Italy blows, then the eurozone will face a disorderly breakup that will end in a multi-year Depression punctuated by growing social unrest.

Didn’t anyone see this coming? Didn’t anyone anticipate that a monetary union devoid of traditional political and fiscal institutions (eg–An executive, a congress, a judiciary, a treasury dept, a bond market) would encounter problems that would prove to be insurmountable leading to the ultimate dissolution of the union?

As it happens, the majority of economists that were questioned in a Reuters survey in 1998 (before the euro was even launched) accurately identified the problems the union would face. Here’s an excerpt from Reuters that helps clarify the point:

“More than a dozen years ago when the single European currency was born, Reuters polls of economists show they were well aware of many of the flaws that threaten the euro today….

“I was aware of the problem that you have a monetary union without a fiscal union, and I wrote about the issues that low interest rates for the periphery will likely get them into a boom, but what happens when the boom goes bust?”

Economists picked three scenarios as most likely to threaten the existence of the euro zone: a decision to withdraw by one of its members; national resistance toward greater political union; and the danger that a one-size-fits-all monetary policy creates economic havoc….

The euro zone periphery’s budgets were a worry well before the single currency was launched….A July 1998 Reuters poll showed 34 out of 42 economists backing the presidents of the European Central Bank and Bundesbank in their belief that the fiscal policies of some countries were too loose before euro adoption.

Respondents were also asked to name the countries they thought had fiscal policies that were too lax in the run-up to the euro’s launch. Topping the list were Ireland, Spain and Italy.” (“Euro zone flaws were clear before its launch: Reuters polls”, Reuters)

Can you believe it? The majority of experts were able to predict the whole disastrous scenario before the first euro was ever printed, right down to identifying the particular countries that were most likely to pose the biggest problems.

So, why did the policymakers shrug off their warnings and charge ahead anyway?

Well, because that’s what the corporatists and big finance wanted; a single market with low transaction costs. Lower costs mean bigger profits, and that’s the name of the game. Unfortunately, bigger profits are no guarantee of system viability. Currently, the eurozone is in meltdown-phase, because the existing system doesn’t work and there’s no way to fix it without greater political integration.  So far, there’s no movement on that front at all.