Volume 62, Number 12
After two days of detailed discussions on the European debt situation this week, our major impression is that the Europeans are enjoying a brief respite from Greek anxiety as the LTRO has temporarily solved their problems – or, more accurately, kicked the can down the road one more time. There is strong conviction inside the Euro zone that Greece now will not have to leave and that problems in other countries, especially Spain, can be handled. Italy, Portugal and Ireland are all making progress on austerity – which makes the Germans happy, but weakens the Euro zone economy. Spain alone is balking at meeting its tough targets – but it is making progress, which heartens the lenders. Bottom line, there is no imminent chance of default – but this strikes us as the lull between Bear Stearns and Lehman – with Spanish spreads now the canary in the coal mine.
The reality of what is going on behind the LTRO is that there has been a substantial run on the European banking system. A huge portion of all deposits have been shifted into Germany (and more into the Netherlands and Finland, also AAA rated) as Euro zone savers seek safe haven. Note that the loans which were originally backed by these deposits still exist and with few changes in real world economic policies they are not getting better. The German banks who have received the deposits are not lending out the money. Rather they are depositing it at the Bundesbank, which deposits it at the ECB, which then lends its back to the original banks that are now short of deposit funding. The LTRO lets deficit banks pledge their shoddy assets for fresh ECB loans, and the ECB plays don’t ask, don’t tell on market value. Bottom line, the investors think they have moved to a safer banking system (temporarily lifting confidence), but the Euro zone banking system is a whole, not a collection of separate countries. If the Spanish debt now held by the ECB via LTRO fails, the Bundesbank eats 30% of the loss, the Banque de France 20%, Italy 15% and so on.
The banks in countries without AAA ratings are now being starved of new deposits – all of which are going to German banks. So there is no loan growth to stimulate their economies – or cause inflation. Germany is still seeing strong loan growth, but increasingly the new debt is filling in for lost earnings as the economy slows. With no federal fiscal stimulus – which no one in Europe except Germany (and Finland) could fund — there is little impetus for European growth, so the bad loans will fester. The only possibility for monetary stimulus is another round of QE or LTRO, but given the size and three year term on the recent round, no one expects another soon. It looks to us like Europe will remain mired near zero growth and over time unemployment and bad debts will rise as companies fail due to continued weak sales. As in the US, there will be little reason for new hiring even if your competitor fails. Rather firms will fatten margins and build fortress balance sheets. The economic situation will take months to develop into a new crisis, but it seems a one way street. Bottom line, Europe looks like the US with a two year lag.
To us it seems clear that even the hard core conservative/monetarists in Germany are all in on the Euro zone. They are far more supportive of new bailouts than they were six months ago. This is largely because the German economy has swung from domestic led growth, buoyed by inflows of cheap money, to contraction as foreign austerity crimps their export markets. Bottom line, if the conservatives are in, it is hard to expect a rejection from the German populous. Yes, they will work hard to extract maximum control in redesigning the fiscal programs of the other Euro zone nations – as they tried in Greece — but they are running into headwinds as many countries bridle at German pressure and intervention into areas of sovereign control. The Germans may continue to ask for more austerity than seems reasonable – precisely the same mistake the French made with regard to German reparations in the 1920s and early 1930s — however, but we do not believe they will abandon the program.
Most US press on Europe is UK dominated, and the cries for Euro collapse are still quite shrill from the London crowd. They collectively tell a story of imminent and serial default that does not seem likely. It is very similar to the calls in the US for a widespread walking away from underwater mortgages, which has never happened. Indeed, it is the UK which finds itself on the outside, having followed the Reinhart-Rogoff off tackle play for surviving a debt crisis – the UK devalued 25% against the Euro early on – but they got no benefit as their main export market, continental Europe, has foundered. Now new calls for austerity in the UK leave them backing into QE for reasons of competitive devaluation and reflation.
Bottom line, we see the Euro zone as in a temporary holding pattern, with not enough growth to make their bad debts any better, but no imminent pressure for default from any country. The wound will fester for a while before new troubles later this year. Ultimately, the European solution requires the Germans – the only strong hands on the continent — to pay up in the short run. Moreover, a significant narrowing of the unit labor cost gap between Germany and the rest of Europe is needed over the longer term. The old system of German over-production, sold to the rest of Europe and financed by the French, like Humpty-Dumpty cannot be put back together again. Europe may avoid a Lehman, but it is just at the start of a multi-year muddle through as they deleverage and find a new economic balance.
US and China Muddling Too
The latest economic data suggest that Europe is joining the US and China in a massive muddle through involving almost two-thirds of global GDP. China’s PMI for March was a split decision, with HSBC’s measure falling to a four month low and the official figure moving to a four month high. We lean toward the low side of the estimates, as the most reliable data on Chinese growth – rail freight traffic and electricity use – both point to growth similar to the early millennium when Chinese growth was about 8%. The slump in China has a lot to do with the slowdown in Europe and a failure of the bounce in the US to produce significant offsetting export sales. Given the relative sizes of the US, EU and Chinese economies, a 1% slowdown in China has about the same effect on total global growth as a 0.5% decline in either of the developed world centers. Thus, the big swing on the world front has been the recession in Europe, which is backing up into Asia. Meanwhile, the strong fourth quarter boost in the US (3.0% real growth) will not be repeated in the first quarter, which is coming in below 2.5%. The US appears stuck in a 4% nominal growth range, with real growth slowing slightly in the first quarter, but inflation accelerating from the modest 0.9% annual rate in the fourth quarter. We see little reason to believe that US growth will break out of this range soon as neither monetary or fiscal policy give a current impetus – and the risk at the start of next year is all on the downside.
The question of whether the winter surge was weather appears to be coming into better focus as both initial claims and the Chicago Purchasing Managers’ Index were on the soft side. Initial claims, which had been threatening to break out on the downside of 350,000, underwent annual revisions in its seasonal factors – which pushed the total back up to 359,000 for the latest week. As before revisions, initial claims appear to be moving sideways over the past seven weeks, breaking the decided downtrend during the warm winter. The headline on the Chicago PMI only dipped from 64.0 to 62.2, but the details were much worse with new orders dropping from 69.2 to 63.3, inventories rising sharply from 49.6 to 57.4, and employment falling from 64.2 to 56.3. Apparently strong auto production is holding Chicago’s levels up relative to national totals, but the softening trend of lower orders and higher inventories is similar to the earlier Philadelphia Fed report.
Finally, it all comes down to income growth – and per capita real disposable income posted a second straight decline in February despite a solid 0.3% gain in wage and salary income. Hiring may be filling up consumers wallets, but the unwinding of stimulus and the rebuilding of government balance sheets is clawing it away. Wages and salaries rose $17.6 billion in February, but reductions in unemployment insurance payments erased -$3.4 billion. Total personal income rose $28.2 billion, but new taxes and contributions to social insurance took $11.6 billion or 41%. The aggregate tax rate is now back to the highest level since when the recession began in early 2008. Despite solid 4.4% growth in wages and salaries over the past year, inflation and taxes have cut real per capita disposable income by -0.4%! Until the government rebalancing is over – years from now – we expect private sector growth will be held back by rising taxes and reduced transfers limiting the US to the muddle through mode now spreading around the world.