As I’ve been promising, this post will be an economy update for Europe in much the same as yesterday’s was about the US.
Even as the American economy seems to be stuck just on the verge of true recovery performance, Europe’s is without a doubt in crisis territory. If you follow my thread back a few months, you will find an attentive study of the European crisis as the probability of a Greek default and exit from the Eurozone has grown continuously despite the “best” efforts of Merkel and Sarkozy. The world has watched with more than a little trepidation as the the July 21 and the more recent October Euro summit agreements failed to calm the bond markets. Yields not only remain high in Greece, but the long-feared contagion (the spread of elevated bond yields to into the other peripheral Euro-area sovereign debt markets) has hit both the Spanish and Italian markets. This was the situation up until the week.
Unfortunately, the bad news continues to pour out from the European headlines. Italian bond yields have continued to soar over the last week. As I mentioned yesterday, Italian 10 year yields have remained elevated above the 7% mark that broke both Ireland and Portugal over the summer. Now, even the six-month notes are above the 6% mark. Luckily Spanish debt hasn’t crossed the 7% level just yet, but I certainly wouldn’t count it out. I think, however; that things are coming to a head in Europe and that we will see some sort of climax by the Christmas holiday or around New Year’s. If the experiences of Ireland and Portugal are in fact indicative of how far the bond market can push a sovereign before it fails, we will not have to wait long for before Italy either defaults or is provided stronger assistance (stronger than currently, at least) from the ECB. Hopefully, the new technocrats in power in Italy will be able to put together a strong enough set of structural reforms that bond yields will begin to calm down.
What worries me about this whole situation, though, is that we are not looking at an isolated debt event like Argentina in 2001 or Mexico before her. What we are witnessing is the result of having multiple sovereign debt markets with a single currency. Investors would prefer to assess these countries on a more or less individual basis, but the existence of the euro makes it impossible for these countries to simply default and devalue. The threat to the continued existence of the currency forces the stronger members (Germany and France) to take steps to preserve their exchange rate. The resulting uncertainty of fiscal policy combined with a single (German-dominated) monetary policy creates a situation ripe for contagion. And this is exactly what we can expect.
Most recently, we’ve seen increasingly large spreads between French and Belgian bond yields over their German counterparts. Murphy’s law apparently still holds as apparently on Friday, as us Americans were still working through our Thanksgiving leftovers, the Belgians were less than thankful for the downgrade given to them by S&P. The Belgian government is now rated at AA and finds its bond yields increased by an entire percentage point up to 5.8%. The spread of Belgian bonds over the 10 year German bund now stands at 3.6%. This number was only 1.89% on September 1. Amazing how quickly things change in the sovereign bond markets these days.
The final threat to the euro ,which to me signals an almost certain collapse or a much stronger union of fiscal policy, is the danger of recession in the eurozone. In this situation we’d love to see very fast Italian and Greek growth so that the growth in income might outpace growth in debt leading to market confidence in the country’s ability to pay. Here in the United States we worry about our quarterly growth being revised down 0.5% from 2.5%. Unfortunately for Italy, the eurozone’s third largest economy has not managed a quarterly growth rate above 0.6% since the recession ended and has not posted growth above 0.3% since the beginning of 2011. Germany, seen as the powerhouse of Europe these days, only managed quarterly growth of 0.5% in the third quarter. Greece is already in a recession, a pretty deep one in fact. If this isn’t enough to convince you that the eurozone is in serious danger of a renewed recession, the overall growth rate for the eurozone was only 0.2% for both the second and third quarters.
This is quite the confluence of factors. Whether or not Europe can navigate all of these problems at once I think is not really the question here. Unless Europe gets very lucky, we should be seeing a continued escalation of the crisis until it peaks around the holiday season. After the peak we are either going to see a much stronger union or a much smaller one. I think it is too soon to tell which we will see in 2012.