Decision Time For Europe: The Definitive Presentation On The Future (Or Lack Thereof) Of The Eurozone

When dealing with the daily barrage of headlines from Europe, it is easy to get lost in the trees and forget what the forest looks like. That's perfectly understandable - after all, it is precisely the intention of the Eurocrats to confound everyone with noise, so any track of the fact that the big picture is unfixable is if not lost then promptly forgotten, with reactionary newsflow dominating the flawed decision-making process. Luckily, the fact remains that no matter what, no matter the scale of lies out of Europe, the problem still remains: the math just does not make any sense. Conveniently reminding us precisely of this, we present to our readers the must read presentation by Swiss private bank Pictet titled "Decision time for monetary union" which puts the forest right back into focus, and explains why all attempts to kick the can down the street will be met with a prompt and furious response by the bond vigilante crowd, which has now officially been thawed out of cryogenic stasis. Because, all noise aside, the Eurozone has two options - continue the current course which is catastrophic: "Current response to the crisis has created conditions leading the euro area towards depression" or accept the reality and do something about it, yet "things are going to get worse before European authorities decide to wheel out their heavy artillery." Said otherwise: lose-lose. So without further ado, let's dig in...

1.Italy has put its head above the emergency parapet

2. The good news: Italian public accounts well on track

  • Italy and Germany are the rare countries likely to record primary surpluses in 2011

3. The bad news: Italian public debt: a weighty millstone


4. All benefits from the creation of the euro have been erased: Spreads above levels prevailing before the euro's birth

5. The light at the end of the tunnel is a trillion and a half euro oncoming train: €1,500bn to be financed in peripheral euro area states between now and 2014

6. From Arab Srping to European Winter: Winter and springtime will be busy seasons for refinancing

7. Surveys now clearly in recession territory

  • Only the post-Lehman deterioration was as rapid as the current downswing

8. Orders/inventory ratio has continued to deteriorate

  • As a result, production has to be scaled back further

9. The bad news: Recession looming

  • Q3 should turn out better than heralded by surveys, but full-blown recession is likely to hit this winter

10. The worse news: Threat of a credit crunch looming

  • Bank deleveraging will translate into shrinking credit

11. The worst news: Current response to the crisis has created conditions leading the euro area towards depression

  • Germany's refusal to back other member states' debt has brought about a savage repricing of the risk. Highly indebted countries have become insolvent owing to the steep increase in their debt-servicing bills.
  • The German recipe for solving the crisis is geared towards deleveraging all economic agents simultaneously. This is
    utopian. This policy will brutally
    • depress aggregated demand – most European economies are likely to sink into recession this coming winter
    • limit the availability of credit
  • This is the route that led towards the Depression of the 1930s.


12. What can be done -  a blend of measures:

  • German recipe combined with a lack of means will not stop the crisis spreading
  • Response should be two-fold

1 . Urgent measures: stop the haemorrhage

  • ECB interventions to be increased (SMP: 180bn)
  • EFSF guarantees (<300bn leveraged to 1,000bn)
  • IMF precautionary line of credit ($300bn currently available)
  • ECB large-scale guarantees (theoretically unlimited)

2. Long-term solutions: save the euro

  • German recipe
  • pro-growth policy on the periphery (EU structural funds, EIB investment projects)
  • stimuli in creditor countries in order to foster domestic demand
  • increase transfers (fiscal union, euro-bond, etc.)
  • public debt restructuring
  • members exiting

13. ECB has bought €110bn since resuming sovereign bond purchasing programme

14. Even after full monetisation, the ECB's expansion will remain below the Fed’s

  • If the ECB finances the entirety of peripheral countries' financial needs up to 2014 (€1,500bn), its balance sheet will expand by 2.6X compared to its pre-crisis level

15. Euro break-up would represent massive loss of competitiveness for Germany

  • Expected devaluation on the periphery (in the range of 30%-40%) would hit German exports hard

16. The opportunity cost: Germany's huge external assets would suffer from a euro break-up

17. The cost of a euro break-up: Germany particularly exposed to a euro break-up

  • Without wholesale 'socialisation' of euro area members' debt (through a form of fiscal union, ECB guarantees), the current situation is likely to move towards a break-up of the euro.
  • A euro break-up would have dire consequences for all euro area countries
    • banking systems severely shaken
    • loss of competitiveness for core countries
    • massive asset haircuts due to defaults on the periphery
  • The overall cost of a euro break-up is likely to exceed the bill for the bail-out by a significant amount.
  • Creditor countries' reluctance to bail out is not motivated by a lack of means, but by their determination to avoid moral hazard
  • When sufficient evidence has been accumulated for Germany to guarantee future adherence to fiscal discipline in peripheral countries, the German authorities could opt for further fiscal integration

18. All sovereignty abandon ye who enter: Sovereignty progressively transferred from the periphery to the EU

  • The European Commission (EC) has established a monitoring capacity on the grounds of ensuring compliance with the Greek adjustment programme.
  • Surveillance of member states' budgets under the so-called 'European Semester' by the EC and the EU Council through
    peer pressure
  • EC and the EU Council will be allowed to examine draft national budgets and pass judgement on them before they
    are adopted by the relevant national parliaments
  • Members' ability to challenge EC decisions to launch disciplinary proceedings against profligate governments would be curtailed

19. Scenario: Things are likely to get worse before authorities adopt definitive measures, as confirmed by today's interview between the FT and Jens Weidmann

  • Changes in government on the periphery (Greece, Italy, Spain) could offer some temporary relief as adjustment programmes will be easier to implement.
  • But the benefits of adjustment programmes are likely to disappoint again as recession will probably hit home next winter.
  • So, the crisis of confidence related to imbalances between the huge financial needs and the responses in terms of aid packages will continue to loom large.
  • At this point, pressure will mount on the ECB to step up its intervention significantly. This action will offer the relief needed to give authorities the time to mould the new shape of monetary union
    • institutionalise a form of fiscal transfers
      • European Monetary Funds, fiscal union or euro-bonds…
      • new Treaty
  • The euro should survive, but things are going to get worse before European authorities decide to wheel out their heavy artillery

20. Greece: only €120bn out of €280bn debt held in private hands

  • Reducing public debt to sustainable levels without affecting official holders implies haircuts harsher than 50% for the private sector

21. Periphery bidding for the bulk of the ECB’s liquidity

  • Periphery (34% of GDP) bid for 67% of the ECB’s liquidity