Summit's achievements fall well short of the mark

SERIOUS MONEY: THE SEEMINGLY endless turmoil in the euro zone virtually ensured that 2011 would prove to be a difficult 12 months for investors in risk assets.

Indeed, the increased stress evident in the region’s sovereign debt and bank refunding markets in recent months – alongside growing concern that the single currency might unravel – is the primary reason that the developed world’s major stock market indices failed to stage a meaningful recovery off the cyclical bear lows registered in the autumn.

Stock markets climbed higher during the spring and managed to retain their positive momentum in the face of higher oil prices – precipitated by political unrest in the Middle East and North Africa. However, the rising appetite for risk struck a speed-bump towards the end of April as a long string of negative economic surprises in the US – just as the Federal Reserve’s second round of quantitative easing neared an end – caused fears of a double-dip recession to resurface.

Stock prices in the developed world and elsewhere duly registered a bear market decline of more than 20 per cent but, just as investors’ recession fears subsided and the world’s major bourses began to stabilise, attention shifted across the Atlantic to the deteriorating and seemingly hopeless position facing the Greek government. This had seen its economy plunge into a severe downturn on the back of the harsh austerity programme prescribed by the so-called troika.

Europe’s leadership announced to the world in September that they had just “six weeks to save the euro”. The disturbing rhetoric was duly followed by the 14th summit in less than two years and the third comprehensive attempt this year alone to quell the crisis that continues to question the viability of the region’s monetary union.

The proposals agreed to at what was dubbed the “summit to end all summits” were received enthusiastically by investors but, upon further reflection, the measures were deemed to fall well short of what was required. A wave of selling followed and the stress once confined to the sovereign debt markets of the miscreants in the monetary union’s periphery steadily moved inward to infect the core, including Germany.

The growing sense of panic among the international community has been palpable as the realisation that a disorderly break-up of the single currency is no longer a trivial probability dawned on observers. All eyes were focused on the gathering of the EU’s political elite in Brussels last week.

The summit to save the euro did not disappoint and delivered as expected – with much of the detail well-flagged days in advance – and the response in currency and credit markets was relatively mute. More importantly, the measures agreed reveal the EU’s political leaders remain in denial or are blind to the true nature of the crisis.

The EU’s leadership continues to believe that profligate government spending in the euro zone’s periphery is the central problem. It insists that fiscal austerity is the only path to future stability. With this in mind, the summit proposed that euro zone members adopt constitutionally binding debt brakes requiring states to maintain balanced budgets, defined as structural deficits of no more than half a percentage point of gross domestic product.

The idea that the euro zone’s woes simply reflect fiscal mismanagement is not borne out by the facts. Before the crisis, only Greece and Italy showed government debt ratios well above the Maastricht limit of 60 per cent.

The euro zone’s periphery came unstuck because large private sector deficits led to unsustainable external imbalances that had to be financed in a foreign currency – the euro – since member states had given up their currency sovereignty upon admission. This meant euro zone countries with large current account deficits and the accompanying foreign debt were vulnerable to a sudden reversal in capital flows.

This fact seems to have gone unnoticed by Europe’s leadership, which continues to pursue the fiscal austerity route. Those of a bullish persuasion will argue that the constitutionally binding debt brakes are a welcome step. However, the measure enshrines pro-cyclical fiscal adjustments in the union’s struggling member states, without countervailing transfers from a central fiscal mechanism. The downward pressure exerted on the economy under such an approach can only be overcome by higher domestic consumption and investment or a trade surplus. The former is unlikely since the private sector is already heavily indebted across the periphery, while the latter was not adequately addressed at the summit. The chronic current account deficits in the periphery are the mirror image of the surpluses in the core and, these imbalances must be considered to find a resolution.

The current approach is designed to make matters worse, given member states issue debt in a foreign currency and have no credible central bank backstop. The financial market stress is virtually certain to continue.

As Otmar Issing, the prominent German economist, once noted: “There is no example in history of a lasting monetary union that was not linked to one state.” Investors take note.

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