Charting Europe's Crisis - Part 1
With Europe finally regaining its rightful place as the epicenter of the peripheral economic crisis, it is time we shift focus, albeit briefly, from America and its increasing cadre of troubles, to those of the Euro area. Below we present some of the key charts and observations that will frame the imminent [bail out|default] of a whole host of minor EMU and EU countries.
The first, and most relevant data series, is unemployment. And while in the US everyone is well aware of the various seasonal adjustment gimmicks, DOL definition loopholes, and ridiculous birth-death model models which make the final number completely irrelevant, it is useful to note that both the EU and the US are sharing roughly the same "broad definition" (U-3) unemployment rate as a percentage of the labor force. Notable is that while the U.S. equivalent of this metric has allegedly started to improve (even as NSA data indicates the reading is at record recent highs), the European unemployment rate has yet to plateau.
Next, counting to use data from the ECB's Statistical Data Warehouse, we present the Harmonized Index of Consumer Prices, or, in brief, Euro Area Inflation rate. After hitting a low of -0.3% in August of 2009, the most recent reading indicated a +1% rate of inflation. This number is suspect for several reasons as will be shortly discussed.
One reason why one should take the inflation number with a grain of salt is that Unit Labor Costs, after peaking at 4.77 in Q4 2008, have taken a sharp downturn, in essence offsetting any direct gains in the HICP.
Furthermore, as BarCap demonstrates, the rate of decline in Negotiated Wages (both on an absolute and relative basis) in the Euro area is showing no moderation. This is a decidedly deflationary economic reading: absent a firm turnaround in wages, many will say, the case for inflation is baseless and at best will translate into highly volatile and speculation driven commodity prices (both in Europe and globally).
One redeeming feature for a contrarian inflation outlook is the inflection point that appears to have been hit in broad output metrics. With the manufacturing output index starting to trend down after a recent high, the slack in the economy may see some tightening, eventually leading to a rise in final prices.
Combining this data indicates that projected inflation, as represented by HIPC and by the BarCap underlying index, confirms that there will be deflationary pressures on European prices for the next couple of years.
Another consideration when evaluating economic slack is the recent dramatic inversion in current account balances as many of the hardest hit nations (the PIIGS come to mind) will promptly revert from a spending to a saving regime, thus eliminating much of the internal export-led growth by core countries (Germany).
This may well be one of the more critical consequences of the austerity measures that will be shortly adopted by various EMU countries with a high Deficit/GDP ratio. As BarCap notes:
It seems likely that under pressure from the markets, there will be an abrupt narrowing in these deficits – in other words, national saving will need to rise sharply as governments tighten fiscal policy. In turn, this would result in a shortage of domestic demand in the euro area. For example, last year we estimate that the current account deficit of ‘southern Europe’ (on our definition) was around €190bn, ie, 2.1% of euro area GDP (for Q4 09, we estimate that it was still around €50bn, ie, still around 2% of GDP).
To meet this domestic demand gap, Europe will look to Germany. Yet the German household saving ratio has also risen in recent years. On a gross basis (ie, including capital consumption) we calculate that it has risen from a low of 14.7% of personal disposable income in H2 00 to around 17.5% in Q3 09. Admittedly, this is not as strong as the rise of Spain’s, which grew from 9.7% of GDP (on the same basis) to around 19% (SA) in Q3 09, but still significant. In Germany’s case, this is likely to reflect concern about demographics and pension reform. To compensate for the likely shortfall in domestic demand in southern Europe, it will be important for the German household saving ratio to decline. Yet that will be a formidable task.
As well, given the lags in the monetary transmission process, the ECB must seek to anticipate developments in 2011, which is likely to be a year of concerted fiscal tightening (whereas Germany is undergoing tax cuts worth at least 1% of GDP this year, next year it also will tighten, along with the rest of Europe and possibly the US).
Speaking of not just a lagging but outright broken "monetary transmission process", we highlight what could be the scariest chart in this presentation: Europe's Monetary Aggregated M3, which is in freefall.
Inflation may be whatever the ECB wants us to believe it is. However, as in the US, unless the money entering into the economy is circulating properly and receiving the benefit of the money multiplier, it is essentially useless from an inflationary standpoint. And while many lament the passage of banking lending to the private sector in the US, the M3 data indicates that the situation in Europe is in no way different, and will likely get worse before it gets better, especially should a liquidity crisis (not if but when) engulf one of the EMU nations.
The contraction in M3 and bank lending is sufficiently important that the ECB's recent release had a several paragraph discussion on its implications:
Turning to the monetary analysis, the annual growth rate of M3 remained negative in December 2009, standing at -0.2%. In the same period, annual growth in loans to the private sector was zero. These data continue to support our assessment of a moderate underlying pace of monetary expansion and low inflationary pressures over the medium term. Actual monetary developments are likely to be weaker than the underlying pace of monetary expansion, owing to the downward impact of the rather steep yield curve [Prior sentence: The decline in actual monetary growth is likely to overstate the deceleration in the underlying pace of monetary expansion]. Looking ahead, M3 and credit growth is likely to remain [very omitted in most recent release] weak for some time to come.
The prevailing interest rate constellation continues to have a strong influence on both the level and composition of annual M3 growth. On the one hand, the low rates of remuneration on short-term bank deposits foster the allocation of funds away from M3 and into longerterm deposits and securities. On the other hand, the narrow spreads between the interest rates paid on different short-term deposits imply a low opportunity cost of holding funds in the most liquid components included in M1, which continued to grow at a robust annual rate of more than 12% in December.
The zero annual growth rate of bank loans to the private sector reflects a further increase in the growth in loans to households, while the annual growth in loans to non-financial corporations moved further into negative territory. Such divergence remains in line with business cycle regularities. The ongoing contraction in the outstanding amounts of loans to non-financial corporations continues to be accounted for entirely by a strong net redemption of loans with a short maturity. For the sector as a whole, the overall contraction may be due partly to substitution with market-based financing [Previously, the continued negative flows in short-term bank loans to non-financial corporations observed in recent months may partly reflect better possibilities for substitution with different sources of longer-term financing.]
Yet, just like in the US, the number one concern for Europe is the future source of funding in light of increasingly elevated leverage ratios. The most recent reading of government deficit as a % of GDP indicated a near-record reading of over -6%. This is an average representation, with some countries such as Greece, Portugal and Spain representing material double digit outliers, as has been extensively demonstrated previously.
Lastly, the Euro area's Debt as a % of GDP is skyrocketing, indicating that just like the US, Japan, and virtually most countries, any future budget expenditures will need to be financed with external borrowings. Yet if every country is dependant on China as the only source of endogenously created capital (instead of economies like the US' where new money is either originated by printing or by new shadow economy financial "innovation"), now that China is turning off the liquidity spigot, this spells doom for all nations that rely on the benevolence of external creditors to continue funding endless deficits.
It is on this fragile backdrop that the deterioration of the PIIGS is taking place. What is certain is that the increasing funding crisis, which may promptly turn into a liquidity crisis should spread persist in their widening, will soon find a path of least resistance to impair countries previously considered immune from a domino effect such as Germany, BeNeLux and Scandinavia. This is why in our belief the ECB, Germany and all heretofore more fiscally prudent countries are damned if they do and damned if they don't bail out Greece: as one outcome will lead to an escalation in the fiscal crisis, while the other will impair monetary policy for years to come. Europe is faced with a lose-lose proposition. The only real question is whether Europe's (and the Euro's) loss will be US' (and the dollar's) gain or whether investors will soon see America for a comparable hollow economic box, and will shun exposure to the "reserve" currency, instead finally focusing on the commodity economies in Asia, as Nouriel Roubini expects to happen. The next several weeks will surely provide many answers.