A little light in the old world Europe

The most recent data out of Europe has been getting noticeably better over the past few months. However, without electoral mandate, it is doubtful that any politician can even think about any meaningful reform even if they were interested. The economies of Europe have made a little progress, but it may remain just that-a little

After the long harsh winter of recession, the Eurozone is finally beginning to see signs of spring. The most recent gross domestic product (GDP) numbers for the European Union (EU) countries was published last Wednesday and it certainly looks like the worst is over.


Germany and France, the largest economies in Europe, did quite well. Germany has recovered from no growth in the last quarter to a respectable 0.7% or 2.8% annualized rate. France did especially well. Last quarter it was still contracting. This quarter it was expected to resume a 0.2% rate of growth. It beat market expectations and grew at 0.5%, a 2% annualized rate. Spain and Italy are still contracting but at a slower rate.


The real surprise was Portugal, which just began its recovery with a surprising 1.1% rate of growth for the quarter, beating its European partners. The combined growth for the Eurozone was 0.3% ending 18 months of recession about on a par with the US at 0.4%. So everything is fine right? Maybe. Maybe not.


Europe has one major problem. It has not solved its problems. The potential collapse of the Eurozone last summer seems to be in the far distant past, but the reforms that were promised at the time to steady the market are as far in the future as ever.


Central among the issues facing Europe are its banks. Many still have weak balance sheets. In order to comply with the new regulations under Basel III, Europe’s largest banks alone will have to cut €661 billion in assets and generate €47 billion in fresh capital over the next five years. Together the Eurozone’s banks will have to shed €3.2 trillion assets to comply. This burden falls heaviest on the Eurozone’s smallest banks. They will have to lose €2.6 trillion in assets.


In short, Europe still has too much debt. Before the recession, the private sector debt levels in Europe and the US were similar. The difference has been that the US is better at liquidating the debt often through foreclosures or bankruptcies. These processes are often avoided in Europe, so many of the bad debts remain on bank balance sheets especially in peripheral countries like Spain and Italy.


The easy money policies of the European Central Bank (ECB) avoided disaster, but did not solve the problem. They just made it easier for insolvent companies and households to roll over or extend their debts without the slightest possibility of ever paying them off. With the banks shedding assets, new loans are out of the question especially to the medium and small businesses.


Banks, especially smaller banks, might have better access to capital markets and make more loans if the reforms promised last summer had come into effect. The major reform would have been a region wide banking regulator and deposit insurance system. This would have meant that the stronger financial systems would have helped support the weaker ones. The risk would have been spread across the entire region.


While much discussed, it never occurred mostly because of the objections by the people who might have to foot the bill, Germany. German taxpayers are certainly not interested in guaranteeing other countries’ savings and they are likely to express their strong preferences at the polls at the end of September.


The unbalanced nature of debt exacerbates another problem. The debts are heavier in peripheral countries and in smaller banks. Loans in Southern Europe are harder to come by and more expensive than in Germany. This exacerbates the second drag on growth, unemployment. Unemployment across Europe remains at a record high of 12%. In countries like Greece and Spain it is twice that.


Europe’s entrenched interest favours older, more entrenched often government workers at the expense of the young. There have been a few reforms, but there is not a sufficient level of crises in Italy or France to dismantle the sclerotic labour regulations, which perpetuates the inequality. The growth that has been achieved is not sufficient to allow entry of younger workers into the labour market nor awful enough to stimulate reform.


The welcome growth causes a third problem: government deficits. The austerity programs have been successful in reducing deficits in Spain and Belgium, but not in the Netherlands. In Italy it has increased. Economic growth could exacerbate the problem. Greece’s level of debt decreased to 160% of GDP, but is likely to shoot up again to 180% this year. Italy, Portugal and Ireland deficits will all remain above 120% of GDP, which is considered unsustainable.


The basis of Europe’s economic growth is also cause for concern. Europe is highly dependent on exports for growth. The European Union is the world’s largest exporter. The US economy relies on exports for only 12% of its GDP. The German economy exports 47% of its GDP outdoing even the workshop of the world, China, whose exports amount to 30% of its economy.


It is not only the reliance of the European economy on exports, but also who they are exporting to. Their largest trading partner is the US, but the top ten includes the BRICs. As growth slows in the emerging markets, so will European exports.


The final threat to the European recovery is probably the most dangerous of all, the Federal Reserve. Last week economists working for the San Francisco branch of the Federal Reserve published a paper pointing out that the policy of quantitative easing or QE had only a mild effect on the economy, not the cure promised by Ben Bernanke. Worse, the Fed has belatedly realized that the program does have unintended consequences which are distorting the market.


Just the rumour, that the program would be cutback, has had a dramatic impact on US interest rates. They have almost doubled since May. This rise has been reflected at least in Germany where the rates for the German Bund are up 63%. Thankfully, it has not been devastating for large peripheral countries like Spain and Italy. So far, they are still sheltered by the European Central Bank’s president Mario Draghi’s promise to “do whatever it takes”. But if the trend continues they may be in deeper trouble. At the very least, the higher rates will have an impact on growth and hit hardest where the economies are weakest.


The most recent data out of Europe is certainly a welcome change. It has been getting noticeably better over the past few months. Still the time dearly bought by the external commercial borrowing (ECB) has been wasted by the politicians. Perhaps only Chancellor Merkel of Germany is sure of an electoral victory. Most European leaders and parties are heartily disliked and probably could not be re-elected. Italy barely has a functioning government. Without electoral mandate, it is doubtful that any politician can even think about any meaningful reform even if they were interested. The economies of Europe have made a little progress, but it may remain just that, a little.


(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)

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