Europe Is Still Broken: Evidence & Commentary

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Over the past few months, the perception has been that the risk of a meltdown in Europe (characterized by the loss of market access for Spain and Italy) has grown increasingly remote. The relative calm comes courtesy of the ECB which conventional wisdom has it, began acting "like a real central bank" in September when it announced it was willing to throw eurozone taxpayers' wallets behind theoretically unlimited purchases of Spanish and/or Italian bonds. This promise of course, was meant to discourage so-called "bond vigilantes" (otherwise known as investors who know a bad deal when they see it) from "speculating" on rising periphery bond yields. As it turns out, the effect of the as yet untested Draghi put has been dramatic. Spanish and Italian 10s have tightened by a ridiculous 240 basis points since late July. 

The problem is that a theoretical promise to purchase unlimited amounts of bonds in the secondary market does absolutely nothing to fix the bloc's myriad and endemic structural problems. As Diapason's Sean Corrigan recently noted,

"...nothing much has been done there beyond persuading traders that the line of least resistance lies in not calling Draghi's bluff when he insists that sovereign spreads must not widen."

All of this of course ignores the fact that widening sovereign spreads are the market's way of punishing the fiscally irresponsible in the same way short sellers serve as a kind of check on corporate recklessness. 

In any event, the gullible investing public gets duped by headlines touting "successful" Greek debt buyback programs and "robust" Spanish bond auctions (nevermind the foreboding CACs) and as such, the eurozones ever-present laundry list of problems has been papered over. Make no mistake, the crisis is still alive and well.

In Greece for instance, it should have been abundantly clear from the time the recent debt buyback was proposed, that the program put the country's banks in an absurd situation: if they participated, they would lose the future stream of interest payments on the government bonds they owned, but if they didn't participate, they risked jeopardizing the program and, in the process, their own recapitalization by throwing a veritable monkey wrench in the long-delayed next tranche of international aid.

Sure enough, earlier this month, Ekathimerini reported that as a result of the buyback, the country's four systemically important banks are facing a capital shortfall 1.5 billion euros greater than would otherwise have been the case were it not for the buyback scheme. Relatedly, Reuters said Saturday that the IMF now expects that between 2015 and 2016, Greece will need somewhere between 5.5 billion and 9.5 billion euros to avoid bankruptcy. The problem: as usual, no one knows where the money is going to come from. 

Elsewhere, the ECB's policies have failed to correct the myriad disparities between the core and the periphery, a point made clear in a recent presentation from a Goldman conference in London. For instance, while the ECB's policies have succeeded in increasing the money supply (M3), lending volumes to the private sector have failed to respond:

Similarly, monthly flows data shows corporate borrowing is especially weak:

More specifically, the following charts show a persistent divergence between the core and Spain/Italy in terms of both overall financial conditions (a combination of real 3-month interest rates, real long-term rates, and real trade-weighted value of the exchange rate and equity market capitalization of GDP) and interest rates on business loans:

Lastly, note that Germany is still funding the periphery as illustrated by the fact that TARGET 2 (everyone's favorite bailout mechanism masquerading as a settlement system) claims of the Bundesbank on the rest of the euro have begun to rise again after a brief respite. 

All in all, the ECB has failed to correct or really to even amerliorate the deep, persistent imbalances that are so pervasive across the currency union. Don't expect this situation to improve anytime in the near future. It would seem that a broken monetary policy transmission channel may turn into an EMU mainstay, hindering credit expansion and generally curtailing Mario Draghi's ability to effectively arrest the crisis for the foreseeable future. If you still have doubts as to the intractable nature of the crisis, just look at Goldman's projections for GDP contraction in Spain and Italy in 2013: -1.7% and -.08% respectively. Ignore the parroting of the mainstream financial media... nothing is fixed in Europe. 

Charts: Goldman