The Euro Mess

The people want prosperity, not austerity. That seems to be the message sent by voters in the first round of the French presidential election a week ago. This coming weekend, they’ll get to vote again in the second and final round that will pit Socialist candidate Françoise Hollande against President Nicolas Sarkozy. Sarkozy signed on in December to an EU “fiscal pact” to keep annual budget deficits within EU targets or face sanction. Hollande wants to renegotiate the agreement, or at least offset it with a “growth pact.”

In France, the parties on both the left and on the right seem to be opposed to austerity measures. Maybe they should get together and form the “Party Party” to bring back the fun of the good old days. They could work together on fashioning and implementing pro-growth policies. I’m all for pro-growth policies. However, there are three radically different versions of them.

The Party Party seems to favor a continuation of the deficit-financed social welfare spending that led to the Euro Mess. The problem with trying to revive this first approach is that the Bond Vigilantes are no longer willing to finance the deficits of the European social welfare states. The second approach requires that the ECB enables the fiscal excesses by purchasing the sovereign debt of debt-challenged European governments. Hollande champions this approach. The third alternative is Reagan-Thatcher supply-side policies emphasizing lower income tax rates and enforcing greater tax compliance, as I discussed last week. Sadly, no one seems to be promoting this one and only approach that could actually revive growth in Europe.

Prime Minister Margaret Thatcher, in an interview for Thames TV This Week on February 5, 1976 said, “...and Socialist governments traditionally do make a financial mess. They always run out of other people's money. It's quite a characteristic of them.” She probably never anticipated that central banks would so readily volunteer to finance the fiscal recklessness of their governments as they have over the past few years.

This certainly explains why European stocks rallied on Friday despite the downgrade of Spanish government debt by S&P on Thursday after the close of US markets and news that Spain’s unemployment rate rose during the first quarter to 24.4%, the highest in 18 years. Yet this morning, the Spanish 10-year yield remains under 6% at 5.73%. Stock and bond investors must be expecting that the ECB will be forced to implement LTRO-3. I think that is much more likely than another round of QE from the Fed.

That would be quite a Ponzi scheme since the Spanish and Italian banks would most likely use the government bonds they just bought with LTRO-2 cash as collateral to receive the next round of cash from the ECB to buy more government bonds. The ECB has had to resort to this stealth version of the Fed’s QE because it is prohibited from buying bonds in government auctions, and the Germans have opposed its buying in the secondary bond markets. Let’s review the latest facts and figures on the Euro Mess:

(1) A billion here, a billion there. From December through February, Spanish credit institutions increased their holdings of Spanish government debt by €52.9 billion. Loans extended by the ECB to Spanish banks soared from €106.3 billion during November of last year to €316.3 billion during March. European banks had a net exposure of $443 billion to Spain and $644.5 billion to Italy during Q4-2011, according to recently released BIS data.

(2) Merkel says “read my lips.” German Chancellor Angela Merkel said in an interview published in the Saturday edition of the Leipziger Volkszeitung, "There will be no new negotiations on the budget pact. Twenty-five heads of government have signed it… It has already been ratified by Portugal and Greece and Ireland will put it to a referendum in May." If elected, Hollande said he would tell Merkel "that the French people have made a decision that presents a renegotiation of the [fiscal pact] deal." Sarkozy last week said that if the pact doesn’t pass the Senate, then he would organize a “referendum to ask the French people what they think.”

(3) Merkel faces opposition in Germany too. Before Germany can ratify the fiscal pact in May, Merkel must first negotiate with opposition parties to obtain a two-thirds majority in parliament. The opposition demands measures such as the taxation of financial market transactions and a program to stimulate growth in weaker European economies. Merkel's coalition could lose power to the resurgent center left in state elections on May 6 in Schleswig-Holstein and on May 13 in North Rhine-Westphalia, the country's most populous state.

(4) The people on the street are sick and tired of austerity. In Ireland, polls show that support for the coalition government's policies is collapsing, while Sinn Féin has become the second most popular party mostly because it is calling for a "no" vote in next month's referendum on the EU fiscal compact. The Dutch coalition government fell a week ago because one of the parties refused to sign off on the EU’s austerity measures. Ironically, it had been one of the most aggressive in favoring the imposition of tough fiscal discipline on Greece and Portugal. Now, opinion polls in the Netherlands show that if elections, which are set for September, took place today, parties both on the left and the right that oppose the austerity regime might win up to a third of the seats in parliament.

(5) The Greeks invented the Trojan Horse. On May 6, they might deliver it to the euro zone by voting against the two political parties that have supported the tough measures imposed on the country by the EU/ECB/IMF in return for bailout funds. The elderly who account for about 30% of the vote are likely to defect in mass. Legions of young voters are also turning their back on the two parties because the unemployment rate for Greeks under the age of 25 tops 50%. Opinion polls show gains for small parties that oppose the steep wage and pension cuts imposed on Greeks.

Today’s Morning Briefing: What Is the US Economy Doing? (1) Slowly, but surely. (2) From green shoots to weeds, double dips, and stall speed. (3) Boom-to-bust sectors still busted. (4) Regional business surveys are down on orders, but up on employment. (5) Consumers are consuming. (6) Fewer panic attacks. (7) May is just another month like all the rest. (8) Republican Trifecta or Fiscal Cliff? (9) The pattern in earnings estimates. (10) China's PMI puzzle. (11) Market weighting Consumer Staples. (More for subscribers.)