Conference Call

Eurozone Policy Options and Likely Outcomes

Meeting date: May 16th, 2012
Start time: 09:00 AM EDT
Duration: 1 Hour
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RGE Chairman Nouriel Roubini and the Western Europe Team discuss the recent developments in key eurozone countries, covering the following topics:
  • How has austerity affected politics in the periphery?
  • How has the EZ's power base shifted with Hollande's election?
  • What options does the EZ have for developing and implementing a growth compact?
  • What policy bullets does the ECB have left?

To listen to a recording of the call, click Download MP3 above.

Call Transcript

A couple of weeks ago, before the latest batch of eurozone (EZ) data, we wrote a piece entitled “What’s on Nouriel’s Mind: 12 Drivers of the Eurozone’s Slow-Motion Train Wreck.” Today, two weeks later, with a bunch of elections behind us and more of them ahead of us, there is still a train wreck in the EZ; and, instead of being slow motion, the pace of that train wreck is accelerating. So, we’ll try to give you our best assessment of what’s going to be happening.

Deepening EZ Recession

The first observation that I’m going to make is the following: It’s clear that there is a severe recession in the periphery of the EZ and there is also a significant downturn in the rest of the EZ. The exception is Germany, which is still showing a significant amount of economic resilience. But certainly, most of the periphery is in a deep recession and even the core, like France, essentially has flat economic activity. In our view, in the next few quarters, this EZ recession in the periphery is going to get worse, for several reasons:

  • First, fiscal austerity might be necessary but, in the short run, raising taxes, cutting transfer payments, cutting government spending, makes the recession worse (as any economic study suggests, including those of the IMF). This is because you are reducing aggregate demand and disposable income;
  • Second, with the euro below 1.30, but still well above parity, Germany is uber-competitive. But the periphery of the EZ, where unit labor costs have risen 30-40%, would require a euro closer to parity with the U.S. dollar to restore its competitiveness;
  • Third, there is a severe credit crunch in the periphery of the EZ. The banks in the periphery have dealt with their liquidity problems, partially with the long-term refinancing operations (LTROs), but they have severe problems in terms of achieving their 9% capital targets. The way they’re going to do it is by selling assets and further contracting credit;
  • Fourth, rising oil prices, since the EZ depends almost completely on imports for its own consumption of oil;
  • Fifth, and more importantly, there is a significant and increasing amount of political and policy uncertainty that has been exacerbated by the recent elections. The way we characterize the situation in the EZ is that you have, on one side, “austerity fatigue” in the periphery of the EZ (in Greece, and increasingly even in Italy and Spain and other parts of the periphery, where people are saying: “We’re tightening our belts, but the recession is becoming worse,” and now, in elections, radical opposition parties are gaining in strength—parties that I would call “anti-austerity”), and on the other side you have “bailout fatigue” in the core of the EZ. But the austerity fatigue is no longer just in the periphery; even in the core of the EZ right now, there is the beginning of some austerity fatigue. You saw it with the elections in France, with the fact that the Dutch government collapsed on fiscal austerity, with the fact that even Chancellor Angela Merkel’s coalition is losing votes in German regional elections. There may be local factors involved, but certainly oppositions are winning support by demanding less austerity and more growth.

So, there is austerity fatigue on one side, but on the other side there is also significant bailout fatigue. When travelling through the EZ core, whether to Austria or Germany or other parts of the EZ, people are getting nervous about the amount of resources that are being provided to the periphery and the credit risk that the core is now facing. To put it bluntly, some Germans, say that “the Greeks had a ‘big fat Greek wedding’ not for a weekend but for the past 20 years. We gave them a first bailout, we gave them a second bailout, we gave them a 75% reduction in their foreign debts and they are still not doing austerity or adjustment reform. Enough is enough. Let’s pull the plug on them.”

So, our worry is that increasingly from a political point of view this austerity fatigue is going to clash with the bailout fatigue in the core and it’s going to create more policy uncertainty, and of course it is very negative for the markets. And European markets are already down more that 10% at this point from their peaks in the middle of March.

The Stance of German Policy Makers

Now let’s think of some of the specifics about Germany, Greece and the rest of the EZ. We had the chance to speak recently with very senior policy makers in Germany, and I would make the following points that are important for explaining what the policy reaction of Germany and the troika is going to be to developments in Greece, or in France and the rest of the EZ:

  • First, the German government today is divided because there is a strong faction led by Finance Minister Wolfgang Schaeuble that essentially says that, at this point, we have to give up on Greece, we have to let them exit and make contingency plans to deal with the collateral damage. Merkel is not yet of that view: She believes that something can still be patched up in the case of Greece; and certainly she signaled yesterday in her first meeting with new French President Francois Hollande that they want to help Greece, to try to help them stay in the EZ. And even the Eurogroup has made similar signals. But the point is that, right now, members of the German government (not just a bunch of radical people in Germany or Austria or Finland) have started to seriously consider that, if the new government in Greece after the elections is going to try to really radically renegotiate the memorandum, then they should plan for pulling the plug on Greece; and then deal with the collateral damage in ways we’re going to discuss. That’s a meaningful change in the German position.
  • Second, Germany has to vote in its own parliament on the fiscal compact and the European Stability Mechanism (ESM). That vote is likely to be postponed, for a number of reasons. First of all, there is a fight on the financial transaction tax: The CDU is in favor of it; the opposition puts it as a condition for voting for the ESM and the fiscal compact; but within the coalition, the Free Democrats are resisting it, so this thing is going to drag. Secondly, the opposition has been strengthening in the election, and is now saying that: “Unless there is something of a growth compact, we don’t know if we’re going to vote for the fiscal compact.” And then the government needs two-thirds of the parliamentary vote to pass it. So, even the passage within Germany’s own parliament is now somehow at risk.
  • Third, yesterday, Merkel and Hollande played nice with each other, but that cannot hide that there is a substantial difference in their views. Angela Merkel does not really believe in a growth compact. She believes strongly that you need serious fiscal consolidation, even in France; and serious structural reforms, even in France and the periphery of the EZ. She’s not going to be playing tough in public, but she’s willing to let market structures impose discipline on the periphery, and of course discipline even on France. She thinks that, if she can play for time, spreads in France are going to rise and then Hollande is going to be forced to move to the center. The German view has been all along that the hedge funds are not actually vultures; rather they are very useful because, whenever spreads go higher, that forces Spain, Italy, Greece, France to do more fiscal reforms and more austerity. So, they’re going to play tough on this thing; they’re not going to really compromise.
  • Fourth, the Germans are willing to accept slightly more symmetric adjustment in the form of private wages growing slightly faster in Germany, above productivity growth as a way of increasing consumption. And, if that leads to a slight increase in inflation (slight, maybe from 2% to 3%), in Germany, they can live with it. But that’s the most they are willing to do.

Greek Political Scenarios

Now, let’s move to Greece and the Greek election. Greece is going to new elections and the recession is becoming a depression; so, what’s going to happen to the country? There is a small chance that the Greek voters were venting: They voted for all these opposition parties, but once new elections occur they’re going to go back to vote for, mostly, New Democracy and PASOK. In which case, after the election, you’ll have a New Democracy and PASOK (plus a few other parties) coalition government. They’re going to negotiate some obvious change in the memorandum and there’ll be an agreement, at least for resuming the program, rather than everything collapsing.

However, there is another view that there is a bigger chance that the winner of the election is going to be the opposition party Syriza. If they win they get the 50 bonus seats in parliament awarded to the biggest party in accordance with the Greek constitution and  and could form a coalition to run the country. Once there is that coalition there to negotiate the agreement with the IMF and the troika, there is a chance that they will blink; that, realizing that the troika is not willing to accept significant changes to the memorandum, the best thing to do is compromise and accept more or less a variant of the current memorandum, with just small changes in the form of less front-loaded fiscal austerity and a postponing of the structural report. Of course, there is also a chance that they do not compromise and the set of policies that are acceptable to a Syriza-led government and that are acceptable also to the troika, the set of policies is a null set, an empty set, in which case, a debt-collision course could lead effectively to a Greek default and eventual exit (sometime this year even).

Now, even if the Greeks form a government and even if they reach an agreement with the troika, clearly they are still on a path where recession is becoming depression, and there is even the beginning of a bank run on retail deposits. Given the political uncertainty, economic activity is going to contract even faster; so, in our view, the issue is not whether Greece is going to exit, but rather is it going to exit this year, or is it going to exit next year?

The second issue with Greece is: Would the troika be willing to finance the exit of Greece to make it more orderly for Greece and to limit the collateral damage to the rest of the EZ? Many are arguing that we’ll have to pay the Greeks to make it orderly, because otherwise the collateral damage to the rest of the EZ will be severe; that’s one view. But there are some hawks, even within Germany, who say: “If Greece exits, let’s punish them. Let’s make them an example and that’s going to teach a lesson to everybody else in the rest of the periphery of the EZ that they should accelerate fiscal austerity and reform, so we should not help Greece. Let’s maybe backstop the rest, but let’s not make the pain for Greece minimal, because otherwise that’s going to have more adverse implications.”

So, the point on Greece is that we see an exit as being likely (even if that exit might be postponed until next year), and the collateral damage of a disorderly exit of Greece is going to be significant.

The Growth Versus Austerity Debate

What about this debate on growth versus austerity? There is a clear push for policies to try to restore growth. What may be included in this growth compact is going to be very little. There is not going to be any significant change in the fiscal compact. They might agree maybe on making some of the austerity slightly more back-loaded, but not the basic rules that they’ve now approved. They may apply a bit more capital to the European Investment Bank, they are talking about these “project bonds” (that’s going to be relatively small, and spare change), there may be some talk about better use of structural reform funds and so on, but all these things are not very significant. It’s clear that the Germans are not going to accept the following things in the growth compact: They are not going to accept E-bonds or debt mutualization; they are not going to accept a dual mandate for the ECB; they are not going to accept any fiscal stimulus that may be increase fiscal deficits in the core or the periphery; they are not going to accept a watered-down fiscal compact with changes to the agreed fiscal route and so on. So, that’s what’s going to happen in terms of the growth compact.

France and Hollande

Let’s briefly speak about France and Hollande. The main thing he cares about is to win his own parliamentary elections in June, and therefore, for now, he cannot back down from trying to push the Germans to accept a growth compact and he cannot back down from his own promises (like reducing the pension age, increasing the tax on the rich to 75% and the kinds of things that were on his program). He’s going to try to negotiate with Merkel, but Merkel is very clear about the fact that, while she can talk in public about “yes we need a growth compact,” what she’s going to be willing to put in that growth compact is very much at odds with what the French want. And by the way, the Germans also argue that, while Spain, Italy and Portugal are also talking about growth rather than austerity, they are so terrified of the bond vigilantes pushing their spreads through the roof that actually even the Spanish government says: “We don’t want to have any more back-loaded austerity, we have to stick to our program”. So, while the periphery might be speaking about growth, in practice, Spain, Italy and Portugal are wary of pushing that line too much. So, Hollande might end up being isolated on that issue.

There is also a risk that France may not achieve its 3% deficit target next year and therefore might have to front-load additional fiscal policies and spending cuts as a way of achieving that target. Therefore, Hollande is running a very fine line: If he pushes too much for his own agenda, the risk is that spreads in France widen very sharply and then France ends up looking like the periphery. Merkel is waiting for that to happen, to push Hollande to the center. And Hollande will eventually have to move to the center because otherwise the consequences for France could be severe.

The ECB’s Options

What about the ECB, what are its options?

  • It’s highly likely that it’s going to cut the policy rate at the June meeting by 25 bps. Later this year, it could do more (between 1% and 0%), so there is still some way to go.
  • If the spreads on Spain and Italy become wider (and today, for a brief moment, 10-year Spanish bonds were trading at a yield above 6.5%), when they get above 6.5% toward 7% the ECB usually intervenes, using its Securities Markets Program (SMP) program; that will be the first line of defense.
  • Some people have suggested that, eventually, the new ESM (coming in July) would be given a bank license as way of leveraging. The ECB is, thus far, against it. Another option is the ESM could go directly to the market, issuing its own deals and then repoing it with the ECB or other banks. That may happen, but has not happened so far.
  • Outright quantitative easing by the ECB is not likely since headline inflation is still at 2.6% (even if core inflation in the EZ is at 1.6%).
  • Could the ECB do more LTROs as a backdoor way of backstopping the sovereign? It’s a possibility, but there are constraints: First, the two three-year LTROs reduced spreads only for a while, and now we’re back to nearly what spreads were back in November. Second, the collateral that is deemed acceptable by the ECB for LTROs is shrinking: There is a serious problem of whether the Spanish or Italian banks have enough collateral that is acceptable to the ECB today. The ECB could again change its collateral rules (unlikely), and could also impose smaller haircuts (also unlikely). And probably, for an LTRO to happen, interbank spreads, which right now are low (around 30 bps), will have to spike again.
  • Certainly, if inflation were to be reduced further in the EZ as the recession becomes worse, the ECB has more room to do more, but they are going to move cautiously. Would they accept a higher inflation rate? Not really. Yes, the Bundesbank gets signals that maybe German inflation could be slightly higher than 2%, but that doesn’t mean a change in the inflation target, it doesn’t mean a dual mandate. 3% inflation may be acceptable to Germany and to the Bundesbank, but that’s it in Germany. Not much more than that.
  • Of course, if things become disorderly, and you have a Greek exit and massive contagion, the ECB’s going to do more. It’s going to do a blanket provision of liquidity to the banks; there is even talk of creating a European-wide deposit insurance for the rest of the EZ; emergency actions are going to be taken to try to backstop and ringfence Italy and Spain, including using the ESM, IMF and troika money to provide full bailout money to Spain, which is among the most stressed. But that would only happen if we end up in a situation of a disorderly Greek exit.

Spain: Spreads Creeping Higher

What can we say about Spain, on which we have been writing a lot recently? The spreads are creeping higher and higher, the process of bank recapitalization is still too slow, Spain is behind the curve and is not taking the IMF advice of direct European Financial Stability Facility (EFSF) injections into the banking system; instead, it is borrowing more and increasing its public debt, which might eventually lead to sovereign risk. The recession is becoming more severe and, paradoxically, while the new commission is telling them we might go a little bit slower with you on what we require in terms of fiscal adjustment, the Spanish government is actually pushing for as much fiscal austerity as they have agreed, because they worry about the market consequences of loosening up the path over which they are going to achieve those fiscal targets. The trouble is the debt control fiscal austerity 3.5% primary adjustment this year alone is making the recession worse.

We’re not yet at the point where Spain has lost market access and requires the full troika bailout program (SMP is going to be used before that happens, and there may even be more LTROs), but there is a risk that, by year-end, the situation in Spain becomes strained enough that the full IMF bailout program is going to become necessary. And once that happens by the way, the risk that Spain does not recover market access becomes higher because, once you have a troika bailout, private claims become subordinated de jure or de-facto to the official claims. And therefore, spreads, rather than narrowing, would widen again.


So, in conclusion, it’s a slow-motion train wreck: The train wreck is accelerating, it’s becoming more severe and there are many significant tail risks; but, of course, when things become worse, EZ policy makers find new rabbits to take out of their hats (and they still have a wide range of policy options). The risk is they always take them too little, too late, when they are against the wall, and therefore the policy reaction is perceived as a sign of weakness, as opposed to a sign of having a clear plan of how to get out of these severe economic, fiscal and financial strains.