Second Verse Same as the First: European Debt Crisis Continues

There is one major force at work in the global capital markets and it remains the European debt crisis. The basic concern is that the debt dynamics present not simply a liquidity crisis but a solvency issue. The latter point is underscored by the poor growth prospects in the periphery of Europe, which in turn also reflects underlying competitive issues. Of course, European officials are correct: Greece is unique. Spain and Portugal are different. But the market is right too that the similarities are striking.

Greece stands out as an extreme case, for sure, but others have been hobbled by the same problem, even if each national iteration is somewhat different. For example, public sector indebtedness in Spain and Portugal is not as large as Greece, the private sector debt burden is substantial and rigidities in the labor market, contracting economies and weak competitiveness are generally similar.

As is often the case, the challenges are formidable themselves, but what appears to have made the crisis acute is the policy response. Yogi Berra, the colorfully quotable American baseball player, reportedly once quipped that when you reach a fork in the road, take it. And through the crisis, European officials have consistently taken the wrong fork.

German Chancellor Merkel has her own political pressures, ahead of the May 9th election in the largest state, which if her coalition losses, as polls suggest is likely, she will lose her majority in the upper house of parliament. However, her insistence that Greek assistance can only be a “last resort” simply required the crisis to become acute before Germany would move. And in the context of decision-making requiring unanimity, this meant that the Greece had to be brought to the edge of the proverbial abyss before Europe would respond. This locked Europe into a reactive posture at precisely the moment when strong preemptive action was needed.

The ECB’s Trichet is well admired by many, even after the July 08 rate hike, but he has been forced to backtrack three times in recent weeks and this also has not been helpful in the context of bolstering confidence and credibility. Trichet took a strong stance opposed to the IMF involvement in any kind of material assistance to Greece. He backed down within days. Trichet claimed the ECB would not change its collateral rules for any one country. He backed down by extending the lack collateral rules. And finally, he has agreed to accept Greek bonds indefinitely as collateral regardless of their credit quality. This last retreat has gone over like a lead balloon, especially in Germany. Together they point to the politicization of the ECB and given rise to much speculation that the ECB could be forced to buy sovereign bonds. There is other talk of possible intervention in the foreign exchange market to support the euro.

It is not, however, simply Europeans’ failure that is weighing on the euro. If the EU/IMF facility was not needed or even if it was more credibly accept by the market, it would still not have prevented a euro decline (for very long). The fiscal austerity being implemented in southern Europe, and in other parts of the euro zone as well, will undermine domestic aggregate demand. In order to blunt the impact of this, increased foreign demand is needed. European companies, for the most part, are more reliant on exports to service foreign demand than the US or Japan. US and Japanese companies service foreign demand primarily by building locally and selling locally. Europe’s export-oriented approach may require a weaker currency. Although the euro has fallen nearly 15% since late Nov 09, it is still above move measures of value (OECD’s PPP or a various FEER and REER models).

Europe continues to report favorable survey data. The increase in the manufacturing PMI earlier this week has been matched by a rise in the service PMI (55.6 in April from 54.1 in March and a 55.5 flash reading). The UK’s construction PMI posted a strong gain to 58.2 from 53.1 in March, which is the best reading since Sept 07. This has been largely overshadowed by the debt crisis and tomorrow’s UK election. At the same time, the US has reported a relatively robust string of data. Of note, within the stronger than expected factory orders report yesterday contained an item showing that inventory to shipments fell to a new low (1.27 months from 1.29 month) and this bodes well for continued output gains and additional inventory building in the coming months.