by Lance Roberts
I have written in the past that all is not solved in the Euro-zone. In fact, despite the ongoing jawboning from the ECB that they stand ready to "do anything," in reality they have done little to this point other than just talk. While that has worked to a large degree to suppress rising interest rates on debt burdened Euro-zone countries there has been no progress on the "unification" of the Euro-zone or a resolution to its burgeoning debt problems. At the end of February I wrote "Get Ready For A Run To All-Time Highs" wherein I stated:
"My best guess, as I have been discussing for the past four months, is that by the end of the summer the Euro-crisis will be back. The recent elections in Italy, and the subsequent curtailment of austerity, clashes with the goals and plans set forth by the ECB last year. Furthermore, the German elections may also prove disastrous to the ECB plan if Angela Merkel is unseated.
German Finance Minister, Wofgang Schaeuble, just recently stated that:
'Now it is up to those who were elected in Italy on Sunday to form a stable government. The faster they do this, the quicker the uncertainty will be overcome, and by the way, I never said the euro crisis was over. I only said that we have made significant progress. We need to continue on this path, but we will have setbacks.'
His statement was also confirmed previously by Angela Merkel's economic advisor who stated in an interview that:
'The sustainability of Italian public finances is in jeopardy. The euro crisis will therefore return shortly with a vengeance.' Apparently, the Italians were not ready to move on the path of reform that has been taken by Mr. Mario Monti, Field said. 'You cannot expect that Italy's European partners or the ECB will stabilize the Italian economy, when its people are not ready for reform.'"
If we flash back to just one year ago we find the ECB faced with an imminent collapse of the Euro-zone. Borrowing costs are surging, central banks of Greece and Spain are on the verge of default, and economic deterioration is rampant. As stated above, Mario Draghi floated his now famous and historic speech upon the financial markets quelling fears of central bank default through the promise of unlimited outright market transactions (OMT). It was literally the nuclear bomb of monetary interventions. The problem is that the funding from the OMT's was to come from two existing funding programs - the European Financial Stability Fund (EFSF) and the European Stability Mechanism (ESM). The EFSF was almost entirely depleted at the time of Draghi's speech which left the bulk of the OMT program based solely on the ESM which has, up until this point, remain not ratified or funded.
This week, however, the German Constitutional Court will conduct a public hearing on the various challenges to the ESM and OMT. It is likely that the ECB will have no choice but to disclose more details about the real terms of the OMT to assure smooth passage and keep from sending the borrowing rates spiking higher on the viability, or lack thereof, of the ESM as the funding source for the ECB to meet its promises of buying debt, as necessary, from struggling Euro-zone countries. The problem, of course, is that Germany is the lynch-pin between the ECB and the Euro-zone as they are the supplier of the money used for the ESM. Unfortunately, Germany is rapidly tiring of bailing out countries that are doing nothing in the way of reforming themselves.
One year later the Euro-zone is still mired in a deep recession, see chart below, and there is no better example showing the lack of progress on governmental reforms than Greece. At the end of 2012 the EU and IMF agreed on Greek Debt/GDP targets and pronounced the nation "fixed." Expectations were that the Greek economy was set to rise sharply from its depression level state and that such an economic surge would set the country back on the path to self-sustainability. Unfortunately, as have so many time in the past, such expectations failed to become reality and now, as Der Spiegel recently reported, the IMF is refusing to participate in further rescue programs for Greece unless financing for the nation is secured for the next 12 months. This explains why interest rates on Greek debt is now surging and it is likely that holders of Greek debt will experience another haircut to cover the €4.6 billion funding shortfall.
Here is the real issue that is most overlooked by market participants currently. As stated above, Angela Merkel is now just a few short months away from the general election with the opposition party gaining some traction given the German populations dissatisfaction with the continued bailouts of the Euro-zone countries. With Germany slipping ever closer to recession and employment showing signs of strain this will not bode well for Merkel at the ballot box. Furthermore, with Germany owed €15 billion in KfW loans and a further €35 billion in contributions to ESM/EFSF mechanisms any agreement on her part would solidify opposition parties' proof that taxpayer money was lost.
Not So Unlimited After All
As with the Federal Reserve's current unlimited Quantitative Easing program which is now seeing talk of ending; the ECB's unlimited OMT program likewise may not be so unlimited after all. As reported by ZeroHedge:
"The first such notable detail comes courtesy of the FAZ this morning, which reports that 'in fear of the judgment of the Federal Constitutional Court, the European Central Bank (ECB) has revealed for the first time the boundaries of their controversial bond buying program... ECB President Mario Draghi announced last year, if necessary, that unlimited government bonds of distressed euro countries would be monetized to save the euro. Meanwhile, however, the central bank has limited this program to a maximum volume of €524 billion and also communicated this to the court.' This is the maximum allowable purchases of Spanish, Italian, Irish and Portuguese bonds.
Why is the ECB revealing that the open-ended program in fact has a very set end now? 'Apparently, to make the program legally less vulnerable the ECB has now said that it has commissioned legal opinions boundaries. Central bankers described the process as "containment.'"
As the chart shows below there is a huge problem for the Euro-zone coming.
While the ECB can only buy bonds with a maturity between 1 and 3 years it is not likely to sufficient in either size, or scope, to bring down the longer end of the interest rate curve which is where the funding problems will occur for the smaller Euro-zone countries. While the ECB continues to talk rates down currently, and may be effective in that regard for a while longer, it will only take a small disruption in the economic system that the ECB can't offset that will unleash the next surge in the financial crisis.
The chart below shows the economic contraction currently underway in the Eurozone. I have overlaid US GDP growth as well for comparison.
With youth unemployment spiraling higher, economic stress rising and government revenue shrinking it is only a function of time until something goes horribly wrong. The timing of such and event, however, is the key. It is also questionable just how long Federal Reserve interventions can continue to keep the divergence between the Euro-zone, which is a major export partner and a big chunk of corporate profitability, and the U.S. from reverting.
Three Problems That Still Exist
There are still three major problems with the Euro-zone that, without fixing, will lead to the next chapter in the ongoing Euro-zone saga.
1) Lack of a constitutional and monetary union.
2) Lack of centralized fiscal and monetary policy controls.
3) Lack of centralized leadership.
The lack of a centralized constitutional and monetary union has led to several years of inaction in the process of unification of the Euro-zone. While it was a "grand experiement" to run the Euro-zone under a single currency the underlying structure to make it effective long term was never achieved. The U.S. is a monetary union under which all state governments act under the central authority of the government and the central bank. The problem for the Euro-zone is that their are 27 leaders and no followers. This is why fiscal reforms remain elusive and each and every promise made by the individual governments to the ECB and IMF for assistance eventually fail.
The problem for the Euro-zone is that without a centralized leadership with the ability to issue its own debt, strong fiscal/monetary policy tools and a central bank with a "printing press" to support it, the survivability of the Euro-zone in the long term is likely doomed. Eventually, smaller countries will want to withdraw from the Euro due to the pressures of austerity requirements or Germany will decide to quit bailing out bad behavior at the own country's expense. The problem then becomes who is going to make good on all the debt held, and guaranteed by, the ECB?
There are currently many promises that have been made to the financial system by the ECB. The question is whether or not they can ultimately "cash the check." While I do not have certain answers as to the where, the who or the when - I am fairly confident that it will be sooner than we currently imagine. I do believe that the ECB will be able to skirt by the ratification of the ESM this coming week and get some limited funding into place, however, I still believe the bigger problem comes at the end of summer when the German voters begin to voice their concerns - after all it is their money that is being wasted.
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