The unexpected resignation of Juergen Stark, a hardline hawk and a member of the executive board of the European Central Bank, provided the catalyst to another sharp sell-off in the European markets at the end of last week, as fears increased that Greece will be unable to repay its $750 billion or so of financial obligations. Although Stark's resignation was "officially termed" for personal reasons, it is widely believed that Stark resigned because he was opposed to the resumption of the bond purchase program and the potential easing in monetary policy by the ECB. Stark's abrupt departure fueled a sharp sell-off in the Euro as well as European equity markets on Friday, which, in turn sparked a risk-off sell-off in equity markets around the world. In general, market participants viewed the action by Stark as a sign that the ECB would be unable to address the financial problems in southern Europe. However, the loss of yet another inflation-fighting German at the ECB, combined with the statements by Trichet following the latest ECB meeting, could be a hint that the ECB will move away from its sole inflation-fighting mandate and play a bigger role in the crisis management in southern Europe. Likewise, the month-to-date retracement in the Euro from 1.45 dollars to 1.37 dollars may be the start of an important and necessary correction in the highly overvalued European currency.
The ECB is managed by a governing council consisting of 23 members, six members of the executive board and 17 governors of the 17 euro area countries. The executive board runs the ECB's day-to-day business operations. In an odd way, Stark's departure makes it easier for the ECB to expand its role in crisis management. Although the Germans have demanded an independent central bank that solely focuses on inflation, the world has changed the last several years. Moreover, the 2011 departures of the German monetary policy leaders, Axel Weber and now Stark, show that the drivers of monetary policy in Europe have changed. In the coming weeks and months we are likely to see that what the Germans want with monetary policy they might not get. The crisis in Europe, much like the crisis in the U.S. in 2008, placed monetary policy leaders in the position that their policy actions would have fiscal consequences. Germans have opposed expanding the ECB sovereign bond buying program and are likewise, uncomfortable introducing Eurobonds and taking an active role in the debt restructuring of entities such as Greece. Several other European countries are also opposed to owning the debts of their fiscally irresponsible southern neighbors. Many of the ECB policy hawks have been correctly stressing that the rules used to create European monetary union and the Maastricht Treaty have been violated. They are correct but they need to get over it. One of the major faults of the European constitution is that it does not have a mechanism to toss out members even those that have broken rules that were required for original acceptance into the union. Given that the ECB already has bought Greek debt and has several hundred billion in exposure to Greece, Spain and Italy the monetary and fiscal policy leaders in Europe need to develop a workout restructuring process that, in the case of Greece, may require the added help of the IMF.
The Greek crisis deteriorated last week as the CDS market has priced the implied probability of a default in Greece over the next five years at 98 percent. Greece is still trying to drum up support for a restructuring plan that would include a haircut of just over 20 percent, while current market prices suggest that the haircut on Greek debt should be more than 50 percent. The European Union is attempting to enhance the European Financial Stability Facility (EFSF) before the day of reckoning unfolds in Greece. This may still buy some time for Greece; however, as we have stressed for the last 18 months, Greece cannot pay its debts and a workout process will inevitably unfold that includes a mark to market re-pricing of the Greek debt by the financial institutions and central banks in Europe. Likewise, the Greeks (as well as several of the other "club-med" countries) will need to implement significant austerity measures to get their fiscal house in order. With Greek two-year paper yielding north of 60 percent and Greece admitting that they have only a few weeks of cash, it is basically high noon for Greece.
Last week the German courts rejected the challenges to the legality of the EFSF. This provides some cover to German leaders, including Merkel's coalition, to support the expanded role of the EFSF. However, the German court also ruled that future decisions involving loans to EU countries (i.e. Greece) would have to be approved by the German parliament in advance. Given the fact that the majority of Germans are opposed to giving Greece a free ride, this will be a challenging event. Moreover, on September 29th the German parliament will hold a vote to support or reject the expanded role of the EFSF. At this juncture, 25 members of Merkel’s coalition have stated that they will either vote against or abstain from the expanded role for the EFSF. Merkel will have to get votes from the opposition coalition to approve the measure. This, combined with a poor showing in regional elections, could increase political instability in Germany. The net result could be a call for early elections and a coalition change which would also increase the challenges for Greece and the other "club-med" countries.
The ECB policy leaders, as was widely expected, held rates steady at the early September meeting. However, it appears that several of the ECB members are finally beginning to realize that the risks for inflation and economic activity have changed. The ECB reduced its outlook on growth for the balance of this year and next and touted that the downside risks have intensified. Given the limited growth in Germany and France and the rolling recessions that are unfolding in southern Europe, we believe that the downside risks to the ECB's newly revised forecasts are already in the process of being realized. On the inflation front, ECB President Trichet said the risks are now balanced rather than tilted to the upside. In contrast, we believe that the next move on the inflation front in Europe will be a deceleration over the balance of this year. Accordingly, the tightening cycle that began in April and included two ludicrous rate hikes appears to be more than just over. Several leading European stock markets are down about 30 percent this quarter and this deterioration in the markets, as well as weakening economic and debt conditions in Europe, increases the likelihood for a more aggressive moderation in inflation and a policy reversal by the ECB. Many of the countries in Europe are being forced to try to live within their means with austerity measures that include higher taxes and lower government spending which makes monetary policy easing even more imperative. Given that the transition in ECB leadership from Trichet to Draghi will take place on November 1st, a smart move would be for Trichet to push for a reduction in rates prior to the ending of his leadership term this fall. However, caution is warranted as it has been several years since the ECB actually made a smart move. Moreover, it may be too little too late. The real issue in Europe is not about interest rates, but rather financial solvency for several of the club-med countries starting with Greece and its impact on liquidity in the European banking system.
The big question is what the European debt crisis means for the U.S. As we have repeated on these pages for some time, we do not expect Europe to be a part of global growth for some time. Weak demand from Europe hinders U.S. economic activity, but we continue to maintain that growth from developing economies combined with improving U.S. demand (albeit at a very slow pace) will be the driver of U.S. growth. Certainly the Fed by its recent actions, and the Obama administration by its jobs program, are gearing up to inject their monetary and fiscal muscle, but the effectiveness of such actions is likely to be limited. It is clear from the minutes of the August FOMC meeting and recent speeches by several Fed officials including Bernanke that the Fed will continue to provide a highly accommodative monetary policy. In recent weeks speculation for another round of quantitative easing has surfaced. The Fed could take action to expand the maturity of its balance sheet (an operation twist) and should cut the interest rate that it pays on excess reserves. However, a massive increase in the size of its balance sheet does not appear to have enough support among the regional Fed presidents to get implemented. The Fed will maintain an easing bias and will stand ready to do what it can to support the economy. However, the real form of stimulus that is needed is centered on the fiscal side of the equation. Given the budget negotiations battle in Washington and the need to trim our multi-trillion deficit, this will be an extremely hard task as our accumulated $14.5 trillion deficit limits the flexibility of our fiscal policy.
On Thursday, September 8th, President Obama announced a new $447 billion proposal to spur economic growth and jobs. Although the proposal to cut both employee and employer payroll taxes, the extension of the investment tax breaks, and the tax credit for the hiring of veterans should receive some bi-partisan support, the ability to pay for this plan is highly questionable. Moreover, the plans for infrastructure spending, aid to state and local governments, and extended unemployment benefits is likely to be too controversial to be approved. Congress' newly minted Joint Select Committee on Deficit Reduction (aka the "Dirty Dozen") got off to a rough start last week as Senate Kyl (R-Arizona) threatened to drop out of the negotiations due to his opposition for defense cuts. This provides another sign that it will be difficult to come up with a plan to cut $1.2 trillion in government spending in the next 10 years, never mind addressing the President’s goal of a $2 trillion cutback in government outlays to pay for his jobs program. However, as ugly as it appears, we may get some form of a jobs bill/ fiscal policy stimulus compromise as the only ratings that are lower than the approval ratings for Obama are the ratings for Congress itself.
Although the deterioration in business and consumer confidence the last several months could become self-fulfilling, the bean counting for real GDP growth is coming in better than the doom and gloom fears. At this juncture, the current data points to a 2 to 2.75 percent pace for economic activity in 2011:Q3. The employment trends for the last four months have been weak, but they still support the notion of modest economic growth. Despite the fears of what is unfolding in Europe and the continued challenges in the Middle East, supply channel disruptions that hampered economic activity in the first half of the year appear to be easing. Consumer spending and industrial production both posted solid gains in July and this was followed by a rebound in new orders and a bounce in the service sector activity (the ISM non-manufacturing data) in August. The limited direct and secondary exposure of U.S. institutions to the problems in southern Europe may allow for the continuation of low and slow economic activity in the U.S. Moreover, last week’s release of a sharp narrowing in the trade deficit for July (due to strong exports) suggests that a narrowing in the trade gap will also support GDP growth this quarter.