The insolvent household called Europe

23 November 2011

We must rethink Europe's economy now, or else it faces oblivion.

Not a week goes by without European leaders unveiling new, by-now ritualistic, plans to deal with the crisis that has engulfed the entire eurozone, issuing endless and largely meaningless statements of the obvious and holding vacuous summits. After a year and a half of wildfires in the form of market downgrades the scorched financial landscape of the common currency remains under theat.

In the meantime, the list of banned financial practices continues to grow and the litany of proposals to restrict information and transactions flows continues to expand. Having first destroyed economies of the ‘periphery’, the crisis is now demolishing fragile economic recovery even in the core economies of the eurozone. Political processes accompanying this devastation have been more ominous than anything seen since the end of the World War II — at least two countries have seen democratically-elected governments displaced in technocratic coups sponsored directly by the EU. Another core EU member state — the UK — is being repeatedly told to ‘shut up’, that its views are not wanted, by the Paris-Berlin duet of incompetence, venality and nationalistic surrealpolitik.

Europe here and now

This is the State of the Union in Europe today: a sordid fiasco that has exposed not just the irreparable technical faults of the single currency, but the deeply-rooted faults of the entire European Project. Conceived as a technocratic, but benign, tool for promotion of free trade, free mobility of labour and capital, the Union has morphed into a Brezhnevite bureaucracy that is now completely detached from its subjects and its core objectives, incapable of leadership and lacking both the expertise to deal with the crises and the willingness to listen.

The plight of the euro area sovereign bonds markets might be the stuff of the front pages of the traditional newspapers, commonly focused on ‘big headlines’, but the real dimensions of the European crisis reach much deeper than the sovereign debt implosion we are witnessing. The real car crash is happening elsewhere — at the levels of European economies and financial systems.

European economies are cancer-ridden with debt. Not just the sovereign debt, but what can be termed the real economy debt – a combination of sovereign, private non-financial corporate and household debts. The table below shows the extent of the real economic debt overhang in the advanced economies, as the end of 2010. The striking nature of many Euro area countries’ insolvencies is reinforced by the fact of their combined real economic debt overhangs. These have reached levels in excess of 250-255 percent of GDP and will yield permanent reductions in potential rates of economic growth, as shown by recent research from the Bank for International Settlements. (See: “The real effects of debt” by Stephen G. Cecchetti, M.S. Mohanty and Fabrizio Zampolli, 5 August 2011).

No growth zone

Much of this debt will have to be restructured. Eurozone economic growth, according to the latest IMF projections, is likely to average just 1.4 percent in constant prices terms in 2011-2013, against 3.7 percent for other advanced economies — and 4.1 percent for the world at large. The eurozone's output gap is projected to average -1.6 percent over the same period of time, meaning that, even under the most benign assumptions of full employment, the euro area is unlikely to achieve any substantial growth. The eurozone is rapidly decoupling from the rest of the world — between 2000 and 2015, the common currency area’s share of world GDP, adjusted for purchasing power of its currency, will decline from 18.34 percent to 12.72 percent despite the fact that the block membership has grown since the beginning of the century.

The fiscal squeeze awaiting the eurozone is massive. In 2011, general government net borrowing by eurozone states will be around 4.15 percent of GDP. By 2015, the plans are to draw this down to -1.58 percent. Over the same period, non-euro area and ex-G7 advanced economies are expected to move from a benign deficit of -0.16 percent in 2011 to a surplus of 1.53 percent. And even with these ambitious austerity plans, the euro area’s government debt to GDP ratio will remain at 88 percent in 2015, against a non-euro area ratio of 34.3 percent.

Courtesy of the debt overhang, the eurozone is likely to remain investment-starved compared to the rest of the world. The latest projections show that between 2000 and 2015, investment as proportion of GDP will decline from 22.1 percent to 20.5 percent while worldwide investment is likely to rise from 22.5 percent to 26.2 percent over the same period of time.

The above projections are not taking into account the expected tsunami of banking asset de-leveraging across the common currency area. Using the European Banking Authority's stress testing model, imposing sovereign debt haircuts on PIIGS countries sufficient to bring their public debts to within the long term sustainability thresholds identified by research from the Bank for International Settlements, while raising banks core tier one capital ratios to the current US banking sector averages, will require €680-703 billion in fresh capital. Much of this will have to be raised over years to come and major part of these funds will have to come from assets disposal.

By my estimates, some €230-305 billion in asset sales will be required to achieve stabilization of the European banking sector over 2012-2015 — a figure so staggeringly high that it will result in a perfect financial markets storm, combining:

• Massive asset values collapse across Europe and deep asset values declines in the US and the UK, where major European banks hold large volumes of corporate and financial loans

• An explosion on the ECB, Bank of England and Fed balance sheets as sales lags can require significant warehousing of assets and liquidity continues to dry up in the environment of general system-wide de-leveraging

• Severe and prolonged credit crunch for European corporates as they compete for capex funding with markets saturated by banks' assets

• Medium-term continued inability of the sovereigns to raise funding.

All of the above factors are likely to compound the growth-retarding nature of European Union investment and development policies that, since time immemorial, relies on a centralised system of subsidies and public investment schemes.

In short, Europe’s real crisis is not that of sovereign financing and banking insolvencies — it is a much more structural economic insolvency of the continent incapable of supporting real economic growth, yet saddled with political and consumer preferences for high and growing expenditure. The insolvent household called Europe can’t be rescued by getting another credit or by centralising all its finances in the hands of the stern grandfather that is Germany. Europe requires a radical rethink of the way we approach economic growth, a model for social development and a political system with democratic accountability. Barring that, it’s the proverbial dustbin of history for the Grand Project.

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