Update on the Euro Crisis

Posted · Add Comment

Summary

In this note we recap the background to this crisis. We go on to make the point that the European Central Bank (ECB) can solve the problem and we believe will do so. The ECB however needs to keep the sense of crisis to motivate the politicians to make well needed reforms and adjustments. We expect increase ECB intervention in the short term and consequently improved market conditions.

As the crisis developed

The Euro crisis only really became a world crisis once it evolved to include the socalled periphery countries of Ireland, Portugal and Spain. These countries are unlike Greece in that they are mostly well managed economies hit with a short term set back.

From 1998 to 2008 Ireland ran a budget surplus every year. It was only when the Irish government was unwise enough to underwrite the debt of their oversized banking system that they got into real trouble. The Irish debt is owed largely to German and French banks.

The Spanish too have also run conservative government accounts, getting to very respectable surpluses in the three years before the crisis. The economy was however dependent on Spain’s role as a holiday and retirement destination for the rest of the EU. This was a function very similar to Florida in the USA and was always going to be hit hard by a recession.

ireland government budget

The Spanish too have also run conservative government accounts, getting to very respectable surpluses in the three years before the crisis. The economy was however dependent on Spain’s role as a holiday and retirement destination for the rest of the EU. This was a function very similar to Florida in the USA and was always going to be hit hard by a recession.

spain government budget

Portugal did not get to a budget surplus but was certainly no Greece.

Core to any understanding of the crisis is the fact that these countries are essentially well run solvent economies facing a temporary setback. They all however need some structural adjustments and need to reduce their deficits and adjust structural issues such as overly demanding public sector unions.

As the crisis evolved these countries became referred to as the periphery, which is Politic-speak for someone else’s problem.

When the crisis spread to Italy it suddenly became a core problem. Simply put, if Italy were to default this would implode France and, despite German belief to the contrary, it would do the same to them. The Italian economy has been reasonably well run over the past 10 years but has a large legacy debt position that requires refinancing.

As with Portugal, Ireland and Spain, the heart of the Italian problem is one of liquidity not solvency. However should they be forced to fund their debt at current levels they will face insolvency issues.

italy government bond 10y

Enter the ECB. They initially made an impact in August in getting Italian yields down from 6% to 5% but their lack of commitment has made it a futile effort. The ECB has the firepower to stop the crisis in its tracks in that they have unlimited Euros since they can print them. What has been lacking is the desire to do so.

The first source of this lack of desire is the Germans, but as we have written in the past the Germans have but one vote in the ECB structures and can do little should the majority decide to do QE and print money. We have been expecting this override to happen soon as the rest of Europe is not going to stand by and watch the whole of Europe go into depression to keep their Teutonic neighbours happy.

However A NEW FORCE HAS COME INTO PLAY.

EVERY CENTRAL BANKERS FANTASY

Does every central banker not fantasize of a world where he can call in the politicians like naughty school boys, give them some difficult homework and demand that it is on his desk first thing Monday morning? The central bankers running the ECB have realized that if they keep the fire under the politicians hot enough they can force through reforms and concessions that they in the past could have only dreamed about.

There are risks to this game, in that the fire could get out of control as the crisis escalates. One measure of this temperature is to look at French Government bonds. Simply put, if Italy goes France is next. As of yet the French yields are not saying that the crisis is going to blow up. We have however seen some increase in the past couple of weeks and would expect that the ECB will start to put some serious water on the fire pretty soon.

france goverment bond 10y