The next few weeks consist of some crucial events - perhaps most notably the EU summit of 28-29 June - which create scope for governments to offer fundamental responses to the Euro crisis. Goldman Sachs, like us, expects to be disappointed and are not optimistic that resolution will be achieved in the near-term. Until the Franco-German axis at the heart of the Euro area can agree the terms at which sovereignty is foregone in return for a sharing of the debt overhang (and greater fiscal integration), other countries (potentially including larger more globally contagious nations like Spain and Italy) will be kept in a state that Goldman describes as 'suspended animation' via temporary support measures that contain - but do not resolve - their problems. This bodes ill for their real economic performance.
To Summarize: courtesy of Einhorn's cycle of perpetual doom...
Goldman Sachs Daily Focus: Key dates for the Euro area in the coming weeks - expect to be disappointed
Continued stress in European markets. Turmoil persists in European financial markets. Spanish and Italian bond yields remain at elevated levels, the euro has weakened significantly against the dollar over recent weeks, and equity prices have fallen back to levels last seen at the end of last year. The macroeconomic background offers no respite: with the latest conjunctural indicators (notably the PMI surveys) pointing to a contraction in 2012 Q2, last week we revised down our forecasts for economic activity in the Euro area.
Policy action is needed. Yesterday, in line with our expectations, the ECB Governing Council chose to leave its policy rates on hold. While we see the ECB as ready to act as circumstances demand (with a particular focus on the ability of the Spanish government to raise funds), no further non-standard policy measures were announced. In line with previous pronouncements, ECB President Draghi emphasised that it was up to governments to act: the fiscal authorities need to address what are fundamentally fiscal problems.
The central bank lacks the instruments necessary to confront Europe’s substantial structural and fiscal challenges: we can expect little immediate respite from monetary sources in the shorter term, and any such help would, at best, manage the symptoms of the current crisis rather than treat the cause.
Attention therefore needs to focus on the governments, who hold the relevant policy responsibilities. In the past, governments have proved reluctant to take decisive action ahead of market pressure. We see little reason to expect this to change. That said, there are a number of key events in the coming weeks that are worthy of close attention as potential catalysts for government action.
- 13 June – German inter-party discussions. In order to ratify the fiscal compact, a super-majority is needed in the Bundestag. The opposition Social Democrats (SPD) is insisting on a parallel set of growth-oriented measures in order to provide their necessary support. These measures will take the form of the much discussed financing of infrastructure projects, as well as the standard prescriptions of structural reform. The details are to be fleshed out at a meeting between the SPD and the government parties on 13 June. This occasion will also offer an opportunity for discussion of broader mechanisms to address the Euro crisis, notably the German Council of Economics Advisers’ proposal for a debt redemption fund. This proposal has been embraced by the SPD in the past – even while Ms. Merkel expressed some scepticism. (For our take, see this note by Francesco Garzarelli and Sylvia Ardagna). Were we to see wider enthusiasm for such an approach from across the German political spectrum, this would be a significant move in the direction of explicit German recognition of some willingness to share the burden of the Euro area’s significant debt overhang, thereby making its ongoing financing less costly and problematic as liquidity and rollover risk are reduced.
- 17 June – Greek and French elections. With the 6 May elections having failed to produce a government, Greeks will go to the polls again on 17 June. As we have argued elsewhere (see Greek eclection scenarios here [13]), it is likely that the new elections will also fail to produce a definitive result. We expect a further period of political uncertainty, as no party is likely to achieve a working parliamentary majority. Something more concrete may emerge from the French National Assembly elections that are held on the same day. The two-round electoral system creates uncertainty about the final result. It appears likely that the left will win an overall majority in the Assembly, but this may depend on a coalition potentially including the harder-left. In such circumstances, President Hollande may be under pressure to deliver on some of his more radical proposals that surfaced in the election. Were the Socialist Party to score well enough to reduce or eliminate such dependence on the harder-left, then he would be better placed to outline his own programme for addressing the Euro crisis, noting that the ongoing politicking ahead of the Assembly elections may have constrained his scope to show greater pragmatism thus far.
- June 28-29 – EU summit in Brussels. Notwithstanding the dates mentioned above, we can expect attention to focus on the next EU summit, due to be held in Brussels at the end of the month. The main item of business is the announcement of the proposals for a growth compact: we can expect a restatement of the structural reform agenda and concrete proposals for infrastructure projects and their financing. But with the markets in their current state, expectations are likely to be raised for more dramatic action. The ECB, Commission and many governments are pushing for a ‘banking union’, embodying recapitalisations financed directly by the EFSF and the creation of a pan-Euro area bank deposit guarantee. Greater fiscal integration and Eurobonds may also be discussed, even if less extensive forms of debt mutualisation (such as the redemption fund mentioned above) are likely to be in greater focus. But we doubt that the summit can deliver concretely on such proposals: the current Treaty framework is not flexible enough to permit such significant innovations to be introduced in a legally and institutional sound way at such short notice. We can hope for a clearer statement of where the Europe is headed, laying out the 10-year vision for the Euro area’s future that ECB President Draghi has demanded. But articulation of this vision is unlikely to satisfy market pressures in the short term. One can envisage a repeat of the experience throughout last year: a summit promises to deliver a new and credible set of measures and markets rally in anticipation, only to be disappointed after the fact.
Reasons for scepticism. A bold step forward to fiscal and financial integration is needed to contain the Euro crisis. But taking such bold steps is difficult. Aside from the practical difficulties of effecting change within the current Treaty framework, the underlying problem rests with the different perspectives of the key national governments.
Italy and Spain are facing mounting macroeconomic challenges and require help from the rest of the Euro area. Recapitalising the Spanish banking sector is the most immediate need. The resources to offer this support exist. But Germany – the ultimate paymaster – is unwilling to underwrite this support without obtaining some credible guarantee of future discipline and probity from the governments in trouble. And, even if Italy and Spain are now willing to offer such guarantees in the fiscal and banking domains (as, for example, the Spanish willingness to move in the direction of banking union implies), in the multilateral context of the Euro area, Germany would be ill-advised to agree to expand conditional support without obtaining equivalent guarantees from their biggest partner, France. Thus far, notwithstanding signing the fiscal compact, French political willingness to accept the loss of fiscal and political sovereignty associated with ensuring fiscal and financial discipline on the German model has been largely absent.
Suspended animation. Short of Germany simply caving in to pressure to provide unconditional financing for the Euro area periphery and/or France accepting the loss of sovereignty to German-inspired European fiscal institutions – neither likely scenarios in our view – we will have to await market pressure to force a new German-French agreement to underpin the Euro area. And while the French sovereign market is buoyed by liquidity injected via the ECB’s 3-year LTRO operations earlier in the year, such market pressure is contained (as recent developments in OAT yields demonstrate).
Therefore, we may have to wait some time for resolution of the Euro crisis. Meanwhile, Spain and Italy could enter a state of ‘suspended animation’, as they become increasingly reliant to direct and indirect official support. Spain is already embarking along this route. The ECB will again be drawn in to offer support. Such an outcome is not a solution for the periphery. On the contrary, it hinders the necessary strengthening of bank and sovereign balance sheets that is a precondition for recovery. And growth and employment will continue to suffer.


