Monday, June 4, 2012


Let’s consider the breakup of the euro zone. Is it inevitable? I believe that the founders of the EMU must have known that a monetary union without fiscal unification would eventually experience a major crisis. My hunch is that they assumed that it would force the Europeans to implement a fiscal union. That assumption is getting stress-tested right now. In my opinion, there is a plausible scenario in which the euro zone comes together rather than splits apart. Indeed, European leaders are starting to talk the talk. The question is whether they will walk the walk.

On Thursday, Mario Draghi, the ECB chief, said that the euro zone needed "further centralization of banking supervision." He appeared to give a general endorsement of the proposal outlined on Wednesday by the European Commission to create a "banking union" that would be based on a centralized regulator and bailout fund as well as an EU-wide deposit insurance backstop.

Yesterday, Reuters reported: “German Chancellor Angela Merkel is pressing for much more ambitious measures, including a central authority to manage euro area finances, and major new powers for the European Commission, European Parliament and European Court of Justice. She is also seeking a coordinated European approach to reforming labor markets, social security systems and tax policies, German officials say. Until states agree to these steps and the unprecedented loss of sovereignty they involve, the officials say Berlin will refuse to consider other initiatives like joint euro zone bonds or a ‘banking union’ with cross-border deposit guarantees--steps Berlin says could only come in a second wave.”

Spanish Prime Minister Mariano Rajoy proposed on Saturday that the 17 countries in the euro zone create a common fiscal authority, with each surrendering a significant amount of its national sovereignty to send a signal to financial markets about the certainty of their single-currency experiment. The sudden willingness to talk the talk on moving forward with “more Europe” is driven by the bank run unfolding in the region. Let’s review the latest unsettling banking data and other developments that will influence the outcome of this crisis:

(1) Bank run in Spain. According to data compiled by Spain’s central bank, foreigners reduced their deposits at Spanish credit institutions by 102.3 billion euros from a record high of 547.1 billion euros during June 2011 to 444.7 billion euros during March. In March alone, the outflow was 30.9 billion euros, and it probably accelerated during April and May.

(2) ELA propping up banks in Greece. The latest ECB balance sheet for May 25 shows a rise of 34.1 billion euros to 246.6 billion euros in “other claims on euro-area credit institutions denominated in euro.” This item includes the Emergency Loan Assistance (ELA) facility. Under ELA, the 17 national central banks in the euro area provide emergency liquidity to banks that can’t put up collateral acceptable to the ECB for refinancing operations. The risk of the lending is carried by the central bank in question, ensuring any losses stay within the country concerned and aren’t shared across all euro members. On May 17, the ECB confirmed it had moved some Greek banks onto the ELA program of Greece’s central bank until they are recapitalized.

(3) TARGET2 imbalances widening rapidly. TARGET2 is the euro’s cross-border payments system coordinated by the ECB with the participation of the national central banks. Floyd Norris did a good job of explaining how it works in his 5/31 NYT column. Prior to January 2009, the payments system was relatively balanced  However since then, the Bundesbank’s balance has soared from 133.7 billion euros to 644.2 billion euros as of April. That’s because deposits funds have poured into Germany (as well as Finland, Luxembourg, and the Netherlands) and out of the PIIGS, which had a record negative balance of 851.2 billion euros in TARGET2 in April.

(4) Money supply growth is slow and uneven. The TARGET2 balances are more or less consistent with the trends in M2 money supply measures over the past year showing that they are falling in Spain and Greece while rising in Germany. On balance, M2 in the euro zone was up 2.8% y/y during April. This suggests that while the area's depositors are moving their funds from the periphery to the core countries, they aren’t fleeing the euro. However, the recent plunge in the euro suggests that they may be starting to shift funds into the US dollar. Of course, the positive spin on a weak euro is that it should provide some lift to euro area exports. That might help to moderate Europe’s recession, which deepened during May according to the latest manufacturing PMIs.

(5) Important elections are ahead in France and Greece. Previously, I’ve observed that at the heart of the European crisis is a crisis of leadership. There are elections coming up that will determine whether the French government will be gridlocked and whether the Greeks can even form a government.

My friend Robert Hardy observes in his excellent The Geostrat: “France will hold elections on June 10th and 17th for the 14th National Assembly. The election will see 577 constituencies contested. The Conservative UMP party of former President Sarkozy now holds 314 seats to Hollande's Socialists' 204. It will be important to watch the outcome to judge the depth of Hollande's victory, and whether it was a personal repudiation of Sarkozy and his policies, or a real change of course. If the Socialists have a good showing it will increase France's power in the Eurozone.”

My hunch is that the UMP will succeed in denying the Socialists a victory. If so, then a period of "cohabitation" will follow. In this case, French President François Hollande won’t be able to deliver on many of his extremist proposals, and might be less of a pain in the derriere to German Chancellor Angela Merkel.

Recent polls suggest that the Greek national elections on June 17 will lead to a governing coalition led by New Democracy and Pasok. I don’t know whether we should be rooting for this outcome or not.

Today's Morning Briefing: Lake Winnipesaukee's Eight. (1) Almost as much fun as Ocean’s Eleven. (2) No retreat for the perma-bears. (3) From “Grexit” to “Spanic.” (4) The US economy is questionable again. (5) Fiscal union will make or break monetary union. (6) Europe’s ELA and TARGET2 showing bank runs. (7) Gridlock in France? (8) Shaving GDP in US. (9) Here come the Fed, ECB, PBOC, and BOE, again. (10) Time to buy? (More for subscribers.)

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