- France: Bet on a bankruptcy of the French government
- Italy: Will not be able to fund its debt obligations without external help
- Spain: The best outcome at this point is years of grinding financial repression
- UK: At growing risk of a big upward spike in price inflation, leading to a currency crisis
Perhaps the cameo event that best describes French attitudes was the recent correspondence between Maurice Taylor Jnr, head of Titan International, the tire manufacturer, and Arnaud Montebourg, France’s Minister for Industrial Renewal. While it was good theatre, the serious points were that on average a French worker at an industrial plant works for three hours a day, and that the Minister resorted to threats that any Titan products imported into France would be “inspected by the relevant authorities with extra zeal.” That is the way things are done in France: Upset the Minister or a government functionary and none of your product gets to market, as Mr Taylor will shortly find out.
France has an official unemployment rate of about 10.5%, which would be somewhat higher if it were not for three-hour days in many of the factories. Taxes on employers are among the highest in Europe, and employment legislation is so onerous that employing an extra hand is the last option for all private sector employers.
Large companies, such as Peugeot-Citroen, generally tolerate poor labour productivity and sub-standard quality products – partly because the unions are strong, and partly because senior managers look to government to “help” by providing subsidies and by other means. Consequently, private-sector manufacturing is not competitive, and sales in the troubled Eurozone are collapsing. Peugeot’s share price says it all.
Decades of government protection have left France’s industrial sector in the weakest position of the larger Eurozone economies. Smaller businesses, outside the major cities, are heavily reliant on agricultural produce and hospitality, much of which is undeclared, untaxed, and untaxable. Furthermore, France’s farmers have long been beneficiaries of the EU’s agricultural subsidies, and have never had to be efficient.
This is the tax base that the French government is relying on to contain its deficit. If you add into the mix the growing pension problem, it becomes clear that there is only one likely outcome for France even without a banking crisis: the bankruptcy of its government.
It is a trend that has been in place for a long time: For those that think in cycles, it’s a big one, a super-cycle perhaps. The timing of the market’s realisation of this increasingly certain event has become the important question, and that will be realised by a spike in government bond yields, taking them up to levels you wouldn’t want to buy them at anyway. The control the Bank of France and the ECB exercises intervening in financial markets has so far been sufficient to keep ten-year bond yields at a derisory 2-2¼%. As markets tend to be driven by optimists, they normally lend more credence to the central banks than to fundamentals, so for bond yields to rise sharply might need an exogenous shock, perhaps from the banking system, or even a sterling crisis with its unpredictable consequences for Anglo-French trade and finance (more on sterling follows).
The Italian general election turned out to be a stalemate with no overall winner. The centre-left parties under Bersani obtained control of the Lower House, while the centre-right under Berlusconi obtained the largest number of seats in the Senate, but failed to achieve an outright majority. Any legislation that is passed will therefore depend on cross-party agreements. Achieving these agreements requires two hurdles to be negotiated: Firstly, the ex-comedian Beppo Grillo’s party is just about the largest single party (the others being coalition groupings of smaller parties) in both houses, and they are refusing to co-operate with any other party, being anti-politician. And secondly, the message from the polls was strongly anti-eurozone austerity.
If Bersani manages to form a government, it is unlikely to last long and is likely to be wrecked on the rocks of austerity. Italy therefore joins France in left-wing economic policies that stand at odds with the interests of their creditors, particularly Germany. For Germany, this outcome is more serious than the election of France’s Hollande, because they can at least lean on the French President. But now that their Italian place-man (Monti) is out in the cold, the new man, if it be Bersani, is bound to be unreliable, because he is not in a position to deliver.
The consequences for Italy’s economy will be important. Her government debt levels are extremely high estimated at 126% of GDP, and non-Italian European banks have about €500bn of exposure. The cost of funding new debt as the old is rolled over will be crucial, and the jump in bond yields on the election results is a red flag. With government debt in excess of GDP, nominal growth of GDP has to exceed the interest cost for the debt-to-GDP relationship not to deteriorate, even assuming the government runs a balanced budget. This is why Italy’s cost of funding is so important, currently standing at 5% for ten-year bonds. There is no way the economy can deliver that level of nominal growth.
Her pension costs will rack up the problem, being proportionately second highest to Greece in the Eurozone, with the equivalent of 33% of the working-age population receiving pensions with 11% unemployment (for comparison, the United States figure is 21% and 7.8% officially unemployed). It will be virtually impossible for Italy to finance her requirements without external help.
While none of this is new, when Mario Monti was in charge, markets were prepared to ignore the arithmetic of Italy’s finances. With a left-leaning, powerless government, this is likely to change for the worse.
Spain is re-emerging into the news as corruption at the highest levels has been uncovered. While all corruption is to be abhorred, we should note that the political fall-out was badly handled, showing a worrying degree of incompetence at the heart of government. Prime Minister Mariano Rajoy was elected in 2011 with a clear mandate to deal with Spain’s economic and financial crisis, but he didn’t take the opportunity to deal with the biggest problem at the time, the property bubble and the insolvency of the cajas, or mortgage banks. Instead, he sanctioned the consolidation of seven major cajas into Bankia, which then required a series of bail-outs, which with other banks’ needs we are told has been “informally agreed” with EU finance ministers to be €100bn.
These losses should be added to the government deficit announced on February 19th, which came in at 7% of GDP, as against the target of 6.3% previously agreed with the European Union. This takes general government debt-to-GDP (including the regions) to as high as 100% (including the €27bn fund set up to pay off the backlog of unpaid bills incurred by regional governments), past the Reinhart & Rogoff’s 90% tipping point referred to earlier.
Spain has its problems, with the rate of youth unemployment at 55% and general unemployment at 26%. When she entered this crisis, national debt was less than 40% of GDP, so it has more than doubled over the crisis. But above all Spain has been an example of an economy that could have been put on the right track, with pain limited to the after-effects of the housing bubble. Instead, the best of the likely outcomes is years of grinding financial repression.
This is, of course, so long as economic and political difficulties do not escalate. Spanish economist Felix Moreno de la Cova believes that Spain might be the first big country to trigger the next Eurozone crisis as the cost of supporting her escalates. He makes the point that both Italy and France have learned to live with high government debt levels. I would add that perhaps markets are more adjusted to them and less so to Spain’s.
Only time will tell. Meanwhile bond yields on Spanish government debt are rising again, and without economic recovery it is hard to see how Spain will get out of its debt trap.
The chart of USD/GBP tells the story:
The solid support levels of the last two years between 1.5300 and 1.5400 were breached by the current sharp move down. So what’s happened?
Perhaps the thing that has changed most since the start of this year, when sterling was over 1.62, is the outlook for price inflation. The price of petrol has increased from 122 pence per litre to nearly 150p today, a rise of 18% in less than three months. Separately, the prices of meat products have had a boost from the horsemeat scandal, as cheap burgers are withdrawn and demand diverted into more expensive unadulterated meat products. And lastly, there is a growing feeling that Mark Carney, who is to replace Mervyn King as Governor of the Bank of England later this year, will be more “adventurous” with monetary policy as he seeks ways to get the economy moving.
Seemingly paving the way for more monetary stimulus, Paul Tucker, Deputy Governor of the Bank of England told the Commons Select Committee on 26th February that the Bank was considering charging negative interest on balances held at the BoE by commercial banks. This approach, whether it succeeds in getting banks to lend or not, is likely to undermine sterling further.
The UK has been lucky so far, because markets have accepted both an inflation rate consistently above target, and quantitative easing, a combination that in normal circumstances would be expected to lead to a sterling crisis. It appears this honeymoon is now over, given the rise in energy and food prices and the uncertainty over future monetary policy. Unless it is nipped in the bud, a cycle develops whereby falling sterling leads to higher price inflation, and when the man in the street begins to expect higher prices, he increases his preference for goods relative to cash, bringing forwards his future consumption. And because neo-classical economists do not properly understand the theory of price formation, both the Bank of England and the Treasury are caught off-guard by the sudden and unexpected increase in prices.
The way to stop sterling falling is to raise interest rates sharply enough to quash inflationary expectations at the outset, and the longer this action is delayed, the higher rates have to go. This was the experience in the 1970s, but in those days the government borrowing requirement and existing debt were not nearly as great relative to GDP as they are today. Even then both politicians and their Keynesian advisers’ instincts were to ignore this reality, only raising interest rates too little and too late.
This has the appearance of a similar old-fashioned sterling crisis in the making, which we have not experienced for over thirty years. The script goes like this: The Bank of England pegs interest rates too low, which eventually creates a run on the currency. The Bank is slow to respond, insisting that its interest policy is right for the economic conditions. However, the run on sterling demands otherwise, and the markets take charge. The Bank is unable to sell bonds to fund the government’s deficit without raising rates. Money supply growth starts to accelerate because money is not re-absorbed by government bond sales.
Eventually, the Bank cautiously raises interest rates insufficiently to satisfy the markets, giving the appearance of a central bank losing control. The result is renewed selling of the currency, and the bank has to raise the rates again to stop the rot, but is again unable to sell bonds to fund the government deficit. It is always too little, too late. Eventually the Bank has to raise rates substantially to force a bear squeeze on the sterling short positions and to get sales of government bonds going again.
This time, if selling pressure against sterling develops, it will be against a backdrop of government finances that are considerably more fragile, and it would probably lead to a political crisis by undermining the Conservative-Liberal coalition. Furthermore, the British banks are barely solvent, taking into account zombie-debts, and would have considerable difficulties in surviving an interest rate hike. In short, the conditions for an old-fashioned sterling crisis exist and cannot be allowed to develop.
Bear in mind that this is the backdrop to the Chancellor’s budget on March 20th, which is always a major political and economic event. So far, the official line has been that the Chancellor is working hard to contain the deficit. However, it is inconceivable that the Chancellor will be able to ignore the inflationary implications of sterling weakness. Currency developments in the coming weeks will determine whether or not he has to tighten his plans by imposing large spending cuts. The Liberals (who are in far-left in their economics) want the Chancellor to increase taxes on the rich instead of cutting spending. If he goes down that route, it is unlikely that markets will be impressed.
We must think through the broader implications of a sterling crisis. In the short run, it may be expected to divert attention from the Eurozone; however, British banks, which could come under adverse pressure particularly if sterling interest rates have to be increased, have over $1.1 trillion equivalent leant out in euros, which they may be forced to withdraw. Instead of starting with a Eurozone banking problem, a European banking crisis could easily originate in the UK. And here we also need to note that Britain’s shadow-banking system (which cannot operate without the official banks) represents a further $9 trillion in liabilities (according to the Financial Stability Board’s report into shadow banking).
The Eurozone crisis continues on its alarming course, no solutions have been found, and the finances of key countries – particularly Spain, Italy, and France – are deteriorating rapidly. The back-stop funder for the weaker states, Germany, will most likely not come up with the funds demanded of her, partly because of her own domestic political situation and partly because she no longer exercises control over her prospective debtors. Furthermore, there is a gathering crisis developing in the weaker nations over mandated welfare and pension costs, as a vicious combination of demographics and high unemployment hit governments’ finances. Markets are unlikely to ignore this accelerating problem much longer.
Future funding of government deficits will have to be covered by the ECB, doing, as Chairman Draghi put it, everything that is necessary . The precedent has been created, and the strict rules prohibiting money-printing have been overcome. The way is now clear for the ECB to fund Spain, Italy, and even France, so long as the inflationary consequences for prices are delayed.
We may conclude, therefore, that the Eurozone is now on track for a hyper-inflationary outcome rather than a deflationary collapse, similar to prospects for the other major currencies. The banking system is also extremely vulnerable to shocks with accumulated bad debts from prior bubbles and prospective bad debts from insolvent government debt.
The sharp fall in sterling is a new ominous development, and worryingly, senior figures at the Bank of England seem unaware of the dangers, as Paul Tucker’s evidence to the Commons Treasury Select Committee clearly shows. The conditions are in place for a full-blown sterling crisis, which has implications for the Eurozone – particularly France, since the UK is an important trading partner and both banks and shadow banks are dependent on London.
As always, the key indicator to watch is government bond yields.
~ Alasdair Macleod
 Interviewed 25th February for GoldMoney