Europe faces three systemic risks: Sovereign (GRExit vs. GERxit), Liquidity (unsustainable refinance rates and foreign capital outflows), and Banking (insolvency and under-capitalization). All of these can fundamentally be traced back to an era of excessive over-indebtedness, which as Pictet notes, leads to required deflationary policy responses that are incompatible with developed market government targets (of re-election, Keynesian pro-growth fiscal policy, and satisfying financial market's expectations). While LTRO did indeed address liquidity risk in the very short-term, it is now painfully clear (just look at European bank stock prices) that financials are driven by sovereign risk (not so much liquidity risk) at the margin. The following three charts provide a roadmap to Nirvana or Samsara (hell). With the Summit underway, Pictet's path to catastrophe roadmap (tactical and strategic) is critical to comprehend.
It's not a liquidity problem, it's an insolvency problem...
In an over-indebtedness regime, Developed Market governments have three incompatible targets:
But decisions and policy actions are limited in capability as the Euro-Area roadmap to catastrophe remains clear (monetization, permanent transfers, or default/restructuring versus Greek insolvency, exit, and contagion)...
and the tactical and strategic scenarios and probabilities remain as binary as ever:
At this juncture, the EU authorities will have to decide whether to continue supporting Greece with more lending and postpone targets or whether to let Greece fall apart.
In order to keep Greece inside the euro area and prevent contagion from spreading, the EU will have to adopt some bold measures:
- Increase transfers: ESM, eurobonds, EIB, Federal deposits guarantee, fiscal union, etc.
- Debt monetisation: ECB’s own QE
- Debt restructuring for overindebted countries
- or a mix of the three options.
Unless it is addressing the backdrop issues (Great Divergence, lack of competitiveness), the euro area will not be able to survive in it current form over the longer term. The euro federalism, the only possible structural solution, will require an additional political commitment from all European countries. Even at this stage of the crisis, we do not perceive any early signs of such premises.