By Ambrose Evans-Pritchard Economics Last updated: December 6th, 2011
Standard & Poor's dropped a bombshell at the right moment (Photo: AFP)
Very quickly, Standard & Poor’s is of course right.
The immediate eurozone crisis cannot be solved by punishment measures alone. There needs to be some form of joint debt issuance and a lender of last resort to halt "systemic stress".
It was well-timed to drop this bombshell on Monday night after the Merkozy fudge (though S&P made the decision earlier), since the duumvirate yet again failed to offer any meaningful way out of the impasse.
"Policymakers appear to have acted only in response to mounting market pressures, rather than pro-actively leading market expectations in a way that might have better supported and strengthened investor confidence. We take the view that the defensive and piecemeal nature of this response has helped expand the crisis of confidence in the eurozone."
Spot on.
IMF chief Christine Lagarde was equally dismissive of the Merkozy plan. "It’s not in itself sufficient and a lot more will be needed for the overall situation to be properly addressed and for confidence to return."
As S&P states, a credit crunch is taking hold, partly because of the EU’s pro-cyclical demands for higher capital ratios. Euroland’s incoherent mix of policies are pushing the eurozone into recession and therefore into deeper debt stress.
"As the European economy slows, we believe that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, eroding the revenue side of national budgets."
There has of course been consternation in Germany, usually based on a misunderstanding of how rating agencies operate. They measure default risk, therefore members of a fixed currency union are inherently more risky.
The US and the UK have used QE to inflate away some of the debt, and they have weakened currencies to act as a shock absorber. This is undoubtedly a form of stealth default, but that is not what S&P measures. It deals only with "credit events", and such an event is less likely for countries with a sovereign currency and central bank that can inflate (provided their debts are in their own currency).
Furthermore, shrieking Europols commit the fallacy of comparing levels of public debt and deficit levels with the US. That evades the core problem, that the eurozone’s banking nexus is €23 trillion, or three times sovereign debt. This has become a contingent liability of the governments themselves, especially the AAA core.
"For countries in net external liability positions, including the eurozone’s peripheral economies, we see growing risks to the funding of their external requirements. In our view, financial institutions located in countries in net external asset positions (such as Germany) also face pressure where the quality of those assets is deteriorating. Deleveraging by European banks is intensifying, as they reduce their balance sheets amid worsening funding conditions, look to bolster their capital ratios, and address concerns about deteriorating asset quality among their borrowers. By our estimates, a sample of 53 large eurozone banks from 12 countries will face bond market maturities of an historic record of over 205 billion euro in the first quarter of 2012."
I might add that EMU banks have a loan-to-deposit ratio of almost 1.2 (like Japan before the Nikkei bubble burst), compared to 0.7 in the US. They are much larger in aggregate, much more leveraged, and mostly underwater already on EMU bonds if forced to mark to market. In essence, the whole eurozone is already insolvent. Face up to it.
(Yes, yes, before you all scream over there, Britain is insolvent too by the same yardstick. That is why it is useful to have the magical instrument of a sovereign central bank in such circumstances – and one willing to act – to conjure away the awful truth.)
Euroland’s crisis is not about Greek pensions or Italian labour laws, but about a vast and catastrophically ill-designed edifice of interlocking bank debt and sovereign debt.
You cannot separate the two. The sovereigns are destroying banks, and the banks in turn are destroying sovereigns. The two disasters are feeding on each other. This will continue until there is a circuit-breaker, both to act as lender of last resort and to end the slump.
S&P does not pull its punches on this:
"We will analyze the policy settings of the ECB to address the economic and financial stresses now being experienced by eurozone sovereigns. In particular, we will examine the potential impact these policy settings will have in both staunching the eurozone’s increasing output gap and ameliorating its currently dislocated debt markets."
In other words, Europe has been told that the ECB’s contractionary policies – if continued – will lead to downgrades. The agency is targeting the output gap.
The Europeans are entitled to ignore this as – in their view – the worst sort of New Keynesian and Anglo-Saxon muddled thinking. Fine, but you can hardly complain if you lose your AAAs from an Anglo-Saxon New Keynesian agency.
Take it on the chin, defy the world, and pursue your 1930s policies if you wish.
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