02 December 2011
The crisis in Europe is entering a delicate phase: Markets are nervous, politicians are trying to solve complex problems in a short span, funds are departing, banks are tightening and the clock is ticking. In a nutshell, the game is so tight that a simple trigger, such as a bank run or trouble in the non-banking sector, a downgrade in rating, troubles in Eastern Europe, a country calling it quits and leaving the Euro, a political stalemate could just throw the spark into the tinder box. Out-of-the-box events and miscalculations could horribly conjure a column of falling dominoes, creating a momentum out of reach of the general will to stop it. Despite the recent call of duty from a string of central banks, we are now at the stage of contingency planning and the need to closely watch a possible eruption. A break-up of the Euro would create huge vibrations in interest rates, exchange rates and quite a legal tangle. We know the argument that the stakes are too high for a fumble, but then plenty of advocates have never lived through a real crisis before. Big events can go wrong.
How in the hell has the European Union got into this predicament? For two reasons: Ballooning debt and falling economic growth.
In a matter of about a decade, the balance between acceptable sovereign debt and potential economic growth has moved from good to bad. From a comfort zone tolerated by economists and financial markets to a situation where the future of the Euro zone is under a big question mark. The speed of this inflexion point has taken decision makers by surprise. On the one hand, debt, public and private, built up during the so-called golden age of private equity (2000-2007), or the golden age of leveraging when debt was a cheap currency. Extreme liquidity, speculation, corruption and bad debt have mixed again in the history of finance to inflate and deflate another financial bubble. Then the financial crisis of 2008-2010 called for additional debt, on top of budget deficits, to bail out and pad the banking systems. Several countries suddenly hit debt ratios in the range of 80 —100% of GDP, setting warning lights. All this would under normal circumstances remain within the manageable realm: A mix of austerity programs, weakened currency, export growth, recapitalisation of affected banks would have done the trick much like in the past. But another force has been at play in the last decade.
Real prospects for economic growth have simply eroded with time. A sub-standard level of productivity, an aging population, a lagging performance in technology and R&D, the shocks of low costs from Eastern Europe and subsequently from China and an economy drugged with consumption have combined to form a landscape of mixed competitiveness within the European Union. The rise of China has been exponential and probably too fast for the comfort of the planning horizon of policy makers. This drop in economic growth and competitiveness is creating two problems: the current social democrat system is becoming too expensive and keeps generating deficits, all in the face of a pile of accumulated debt that is reaching saturation. ‘There is not just enough growth to pay for all this’ is what financial markets are now saying. Investments and their growth options have moved to Asia and other BRIC nations, with expanding populations and middle classes. In Europe, we are now dealing with middle income countries stung with liquidity issues (Spain, Ireland, Portugal), solvency issues (Greece) and near solvency issues (Italy).
As much as Asia is on an upswing reinforcement cycle fuelling economic growth, as much as Europe is on the edge of a dragging down cycle: austerity, mild recession, tighter credit, growing debt, rising bond yields, creeping unemployment, weakened demand, social tension, falling confidence index, and more austerity. Stabilizing the sovereign debt problem and the Euro is the urgent priority. It will most likely require external help, from the IMF and other central banks. Yet some thorny issues will remain outstanding for a while: under what shape can a fiscal union take place, how to restructure debt without crippling banks, etc. The lack of progress on the finance side is exposing the second weakness: Where will the new growth come from? Investments, exports, productivity, innovation, lower wages, protectionism? Politicians and policy makers are not used to producing smart economic growth strategies. Most have honed their craft under the affluent society of the past century, before the rise of China came to challenge the world order in trade and investments. Beyond the infrastructure stimuli, most options for growth will require toil and sweat. Inevitably austerity will bite the middle classes. With unemployment sticking up and bleak economic prospects ahead, no wonder those middle classes are throwing out politicians and parties that reigned under that damaging decade. The next couple of weeks will be crucial in Europe, as France and Germany will tango in their efforts to finally establish that firewall around the Euro.
At the end, structural reforms will make a difference, like what Australia did in the last decade: Along with the Asian boom, they restructured their economy to make it more competitive. They are happy about it today. Other countries endowed with natural resources will find some breathing space, just for a while. But the same fragile balance between debt & growth is present in a number of American states and Canadian provinces. They are fortunate to be under the cover of full federal systems, unlike Europe. But inevitably, deleveraging will take its toll for the rest of the decade. And perhaps beyond. Astonishingly, consumption as % of GDP is still at 71% in the USA, and 36% in China. The most fundamental structural imbalance in the world has not moved an iota in the last three years! The big powers are not moving from their model.
This is really the crisis of the industrialized nations: Debt and growth. In the coming years we are going to witness an experiment amongst western nations about how best to solve the three following questions, which will craft their outlook for a generation:
1. How best to conduct austerity?
2. What structural reforms will have the best pay-off?
3. What set of economic policies will work best?
In the meantime, in Europe, lurks one spark, that could burn the recovery to ashes and make this decade really miserable. Again CFOs will spend some nervous vacation time at year end. Good luck.
Andre Du Sault
MBA (LBS), MPA (Harvard)
I cannot tell a lie, that relaly helped.
European countries have been linivg on a socialistic world for a very long time,they enjoy less working hours,more holidays,great unemployment allowance and now they cant do that anymore.Thats why Paiya is asking Vinavu to not discuss European issues