European Affairs

Syriza Challenges the Euro-Austerians     Print Email
By J. Paul Horne – Independent International Market Economist

paul horneGreece’s new government insists on drastic easing of the draconian conditions imposed by the “Troika’s” €240 bn bailouts in 2010 and 2012 [1], plus restructuring of Greece’s €320+ bn international debt burden.  This forces Euro political leaders to  face up to the urgent need for overdue institutional and structural reforms to ensure that the euro, at age 16, remains viable as a reserve currency.
 
But unlike the first two rounds of the Euro debt crisis, altered economic and political fundamentals leave very little time and leeway for them to reach a sensible solution with the Athens government which has, for the first time, a broad-based mandate from Greek voters. If the Troika (the European Commission, ECB and IMF) does not extend the bailout program which expires Feb. 28, Greek banks, reported to have lost 40% of their deposits since Syriza last autumn, could be ineligible for ECB funding to keep them solvent. Moreover, the government may not be able to repay the € 4.3 bn due the IMF in March and € 3 bn in international bonds in June.
 
The latest Greek crisis could also trigger wider financial and economic consequences although, for the time being, these appear to be discounted by politicians and investors alike. Although Greece successfully tapped international bond markets for € 3 bn in April 2014, slippage in reforms such as privatization of state assets are prompting “Creditor North” politicians to take a tough line on continued austerity. But five years of recession and rising unemployment cause “Debtor South” leaders to insist on a more pragmatic approach. The EC economics commissioner, Pierre Moscovici, concurred, telling the Financial Times on Jan. 31: “We all need to be careful about the economic situation in Greece. Our common goal is to enhance growth. For that we need pragmatism and respect for commitments, from both sides.”
 
Financial markets seem confident common sense will prevail again, as shown by relatively little change in the German bund and Greek bond yields since their sharp divergence during the past nine months that was an early indicator of trouble to come. So far, bond markets have not panicked as in 2010-12 when Greek yields soared over 40%, cutting Greece off from foreign capital. (See Fig. 1 below.)
 
Fig. 1 – Greek (right) and German (left) government bond yields diverge again
 
 syriza.graph1
 
 
 
Syriza leaders pledge that they want Greece to remain in the Euro zone although their initial rhetoric suggested they may not fully grasp the financial and political obstacles facing them. Similarly, creditor North governments may underestimate potential financial market turbulence if they reject a pragmatic response to Greece’s demands. Noteworthy is Syriza’s promise to go after the oligarchs who have made the economy so resistant to reform (a move that would be cheered by financial markets). Nevertheless, if the upcoming negotiations between Athens and the Troika founder, “Grexit” from the Euro zone could be the unintended, and very bad, result with profound consequences.
 
We hope Athens understands that “Grexit” is not a realistic option. Greece’s total foreign debt, estimated at € 323 billion (see Fig. 2 below), is about 175% of GDP and growing faster than the economy. It is unserviceable without external financing. If Greece were forced out of the euro and to adopt a new drachma, it would still be liable for the euro-denominated debt. Cut off from capital markets, like Argentina, the new national currency would constantly depreciate against the euro, forcing Greece to renege on its debt. The result would be an even worse depression and higher unemployment and Greece’s position in the European Union, and the security it represents, would be at risk. 
 
Fig. 2 – Greece’s International Debt and Creditors (in € bn)
 
syriza.graph2
 
 
Grexit would have wider implications. It would seriously complicate the ECB’s launch in March of its new Quantitative Easing (QE) program to buy at least € 60 bn a month of bonds until the Euro zone economy starts to recover and inflation expectations turn upward, away from deflation. Before the Greek political situation produced the current crisis over austerity, the ECB was already facing a fundamentally tough situation with stagnant growth and disinflation threatening to turn into recession and deflation. (See Fig. 3 below.) 
 
Fig. 3 – Euro Zone GDP growth (left) and consumer price inflation (right)
 
syriza.graph3
 
Source: http://www.tradingeconomics.com/euro-area/inflation-cpi . Note: GDP growth through 3Q14 and harmonized Euro CPI through Jan15. 
 
Historically low Euro bond yields (on Feb. 2, Germany paid 27 bps (basis points) to borrow for 10 years, France 55 bps, Italy 162 bps and Spain 145 bps) suggest that markets worry the ECB’s much delayed QE may not revive the Euro economy. The years of under-investment since the 2007-2009 financial crisis and subsequent recession, plus slowing productivity growth, mean the Euro zone’s potential (non-inflationary) GDP growth has shrunk to around 1% from over 2% prior to 2007. (See Fig. 4 below.) (It is worth noting that similar trends have slowed U.S. medium-term potential growth to what the CBO estimates is 2.1% , down from the pre-crisis rate of over 3%.)
 
Fig. 4 – Euro Zone capital spending (Gross Fixed Capital Formation - left) and labor productivity growth (right).
 
syriza.graph4
 
 
Another obstacle to the ECB’s stimulus effort is Europe’s over-dependence on banks as the transmission mechanism of credit to the real economy. Unlike the U.S. with its far more diversified capital markets, Euro zone companies and individuals depend for a very large share of their financing on banks. These are, however, under growing regulatory pressure to raise capital and liquidity ratios and reduce their excess balance sheet risks, which makes banks less willing to lend. Although the Euro zone promotes banking union and a sounder banking system (which the ECB now supervises), the practical consequence is that the banking system will limit the economic effectiveness of the ECB’s new QE program.
 
Exchange rate changes are another component of the Greek and Euro economic dilemma. Growing apprehension in FX markets about Europe’s near-recession and vulnerability to deflation led to a capital flight into the German and other Euro core countries’ bonds, pushing their yields down to record (some would say bubble) lows. Low yields, plus concern about the stagnant economy encouraged a capital flight from the euro, notably toward the dollar. Since last summer when the FX rate averaged $1.35 per euro, the euro depreciated 16% to $1.13 by Feb. 2. The best measure of FX competitiveness is the real broad effective trade-weighted (TW) indices of the euro and dollar vs. their principal trading partners. The euro index is down markedly in the past year while the dollar’s index is up sharply. (See Fig.5 below.)
 
Fig. 5 – Euro (blue) Dollar (red) real broad effectiveTrade-Weighted Indices (2010 = base 100)
 
syriza.graph5
 
Source: http://research.stlouisfed.org/fred2/categories/33210  St. Louis Federal Reserve Bank FRED data on 2feb15.
 
The weaker euro is strengthening Euro zone exports, contributing more to European growth; while the stronger dollar is penalizing U.S. net exports, hence overall GDP growth, as already seen in third quarter GDP data. As the ECB implements QE and the Fed, having ended its QE, edges toward raising the fed funds target, we expect the euro to weaken further against the USD and dollar-related currencies. Although a weakening euro helps the economy, if international private (and public) investors sense that Grexit might occur and/or that the ECB may not succeed in stimulating the economy, they might accelerate their flight from the euro to the dollar, a situation that would require policy action on both sides of the Atlantic to save the euro.
 
Austerity vs. Stimulus
 
Creditor North politicians also face the stark new political reality that austerity must be replaced by enough economic stimulus to insure the anti-euro populist rebellion does not get out of hand in other countries such as Spain. “Podemos”, a leftwing populist movement with ties to Syriza, is rapidly becoming one of Spain’s largest and potent political groups. France’s National Front party already challenges the mainstream Socialist Party and center-right UMP for the No. 2 spot. Germany’s rightwing anti-Islamic “Pigeda” and “Alternative for Germany” movements are already troublesome. The long-anticipated social and political backlash against austerity and the euro is happening.
 
Which means the north European “austerians” face a political imperative to accompany the ECB’s monetary stimulus with fiscal stimulus to improve economic growth and employment. Continued austerity risks undermining the political consensus essential to the euro’s survival. In addition, Euro political leaders must get on with institutional and governance reforms. They have procrastinated too long, perhaps feeling protected by ECB President Mario Draghi pledge “to do whatever it takes” to save the euro. But they ignored his repeated insistence that national political leaders must implement painful reforms of budgetary policy, labor and product markets, corporate regulatory regimes and the social safety net.
 
If financial markets perceive that the fundamental problems we have described make Grexit likely, bond traders will also increase pressure on countries perceived as vulnerable because of inadequate progress on labor and product market reforms and fiscal governance. These include Greece, Spain, Portugal and possibly Italy and France, two countries some regard as “the elephants on the euro bond trading floor”. (We note, however, that Italian PM Matteo Renzi pushed through labor market reform and last week succeeded in getting anti-Mafia judge Sergio Mattarella elected Italy’s President despite opposition from Silvio Berlusconi’s Forza Italia party. French PM Manuel Valls is also pushing modest market and pro-business reforms despite resistance from the union-led left.)
 
We have long been optimistic that the market pressures triggering the Euro debt crises in 2010 and 2012 had the virtue of forcing Euro politicians to institute significant institutional reforms aimed at preserving the euro while moving toward the fiscal union needed to complement monetary union. We noted in various reports for The European Institute the significant moves made under market pressure.[2]   These included:
 
+ European Stability Mechanism (ESM) to bail out Euro zone states committing to reforms. The ESM is AAA-rated and just issued € 3 mm of 8-year bonds. (See: http://esm.europa.eu/ ) ;
+ Banking union with ECB is the main bank regulator since Nov. 4, 2014 (cooperating with the national central banks) in the Single Supervisory Mechanism, imposing increasingly tough stress tests on the 130 biggest Euro banks (the results were published Oct. 26, 2014   ; and imposing tougher capital ratios;
+ European Council on Systemic Risk is now functioning under the ECB;
+ European System of Financial Surveillance (ESFS) set up bank, insurance, pension and financial market regulatory authorities in the EU;
+ The Draghi guarantee included the ECB’s Long-Term Refinancing Operations and other types of low-cost funding to Euro zone banks, and now its new QE program;
+ Cyprus & Greece bailout programs saved both countries and included “bail-ins” of international investors;
+ EU-wide deposit insurance for small savers was harmonized and extended; and
+ EU fiscal Compact was proposed in 2010 to coordinate EU and Euro budgetary and fiscal policies, governance and stability. It still must be implemented.
 
CONCLUSIONS
 
Today we remain optimistic that the next weeks of negotiations between Greece’s new leaders and the Troika (with Germany pulling strings in the wings) will result in compromise to extend the bailout program while easing austerity and reducing the debt service burden. Greece will, we think, remain in the Euro zone although it’s probably erratic compliance with the new conditions will keep markets worried. 
 
If, however, our optimism is misplaced, we note that euro-denominated debt is reported by the ECB to total € 14 tn, roughly 127% of Euro zone nominal GDP and a critically large share of international (and central) banks’  assets. If the Greek situation spins out of control, Grexit occurs, and market pressures rise on other Euro states, there could be serious international market turbulence. For those worry about “Black Swan” events, that would be a totally unexpected development with inordinate consequences. Disclosure: I know a Black Swan when I see one. But then it is too late.
 
J. Paul Horne is an Independent International Market Economist based in Alexandria, VA and Paris where he was chief international economist for Smith Barney for 24 years. He retired as a Managing Director of Salomon Smith Barney/Citigroup in 2001 but remains active with the National Association for Business Economics, the Global Interdependence Center and the Société d’Economie Politique in Paris.
 

[1] See “Thank you, Greece, for Saving the euro!” (Jan. 2, 2013): http://www.europeaninstitute.org/EA-January-2013/the-euro-crisis-update-thank-you-greece-for-saving-the-euro.html

[2] See “Bond Vigilantes” approve ECB-EBA stressing Euro banks” (28oct14): http://www.europeanaffairs.org/index.php/component/content/article/243-blog/october2-2014/1942-bond-vigilantes-approve-ecb-eba-stressing-euro-banks-10-28