Cyprus Mail

The stagflation trap

By Erol Riza

The future of the Eurozone has been left by the politicians at the mercy of the European Central Bank and Germany’s commitment to a zero deficit. The evidence is there to see: failure of growth to pick up despite very low interest rates, high unemployment and deflation being the three key risks facing the Eurozone.

Some well-qualified economists, not least the Noble Economics Professor Sir Christopher Pissarides, predict that unless the Germans revisit their internal devaluation approach and strict budgetary control the outlook is bleak. There are many who would disagree with the professor but the omens look quite bad.

In another paper to address the problems of Europe two eminent economists (Prof Henrik Enderlein and Prof Pisani-Ferry) have offered their solution in their submission “An Agenda for France, Germany and Europe”.

Their analysis is summarised in the following words “Europe is falling into a stagflation trap; growth is barely noticeable, private and public debt is heavy and euro area fragmentation has receded not disappeared. Europe is losing relevance internally and externally.”

In their view “investment to boost growth will not come from throwing more money as some have called the ECB to do in the form of quantitative easing. Europe needs reforms and demand support”; the key words being demand support.

The EU Commission’s answer to the lack of fiscal expansion, something which we saw in the USA in terms of increased infrastructural spending, is to come up with financial engineering.

The EU Commission came up with a prediction that its redirection of funds, already budgeted, would mobilise private institutional money to the tune of 15 euros for each euro spent by the Commission. One is not sure how the mandarins of the EU Commission arrived at such a forecast or on what empirical evidence it is based.

I am very doubtful that this will work. Unless the Eurozone gets its act together soon we shall be witnessing increased support for the anti EU parties and the periphery (as some rich EU countries call the south of Europe) will be condemned to a decade of slow growth, high unemployment and increasing costs of healthcare due to ageing.

The recent lack of interest by banks in the Eurozone to borrow from the ECB from the targeted long term refinancing operations (TLTRO) at a rate of 0.15 per cent is a rude reminder that the banking system is not interested in borrowing as credit demand is very weak; holding cash at the ECB is a costly affair now.

One would think that after the Asset Quality Review and stress tests conducted by the EBA the banks would start lending widely to businesses, especially small and medium enterprises.

This is completely a flawed expectation since there are two key issues: one is that the stress tests are in the eyes of some a fudge (see article by none other than former Bank of England director Willem Buiter).

Buiter agrees with Professors Viral Acharya and Sascha Steffen, who published an alternative estimate of capital shortfall for 39 banks of 450 billion euros as their benchmark as opposed to EBA under adverse scenario of 24 billion euros for 25 banks (main difference is the model used in the Comprehensive Assessment).

The professors argue that the EBA relies on national regulators which have underestimated the capital shortfall. Notwithstanding the differing views of financial observers, the system will be tested and we will soon see if the banks have ample capital to resume lending on a sustainable basis.

The more worrying issue is that with interest rates at historical lows, especially long dated bond yields, governments cannot borrow to lock in such low rates.

The two countries which have borrowed, the USA and the UK which are not hamstrung by severe fiscal discipline, are in the meantime enjoying growth and low unemployment.

If the European leaders, some already bickering in public (Germany with France and Germany with Italy), do not get over their different approaches to fiscal discipline, we will see more dissent and uncertainty in the Eurozone.

The recent financial market volatility as a result of the Greek election fears will be insignificant if the Italian and French governments resist German pressure.

The Italians have held a general strike calling for the government to step back from labour market reforms. Many young, educated but unemployed French and Italians are flocking to London which offers them job opportunities and a very entrepreneurial environment.

The European leaders’ reliance on the European Investment Bank, or the new Investment Fund for that matter, are not the answer to low growth and high unemployment although a small step in demand support.

The EU needs good old fiscal expansion to take advantage of low interest rates and to see investment in infrastructure which only the public sector can develop and finance cheaply.

The private sector institutional investors (pension funds and insurance companies) will not be attracted to investment in infrastructure unless there is a single European Capital market and government takes part of the risk; even if they invest in public infrastructure it will cost much more according to the experience with PPP.

Will this happen and how long will it take for project plans to be developed and get approved? Project finance of this nature will take time and private sector market experience in PPP or infrastructure finance in the UK has hitherto been disappointing.

The new president of the EU Commission would be well advised to take a bit more advice from Anglo Saxon economic management and some European economists calling for change in the fiscal discipline as the Eurozone cannot come out of the low growth trajectory if there is no change in fiscal policy.

Relying on Mario Draghi to help the Eurozone again via bond purchases will not work on its own. How much quantitative easing (in the form of bond purchases) and hence money pumped in the banking system will be required to reignite the economies of the Eurozone no one knows.

What if this fails and Draghi is out of ammunition? The governments of the Eurozone have to agree a fiscal stimulus which Willem Buiter puts at 1 per cent for two years. Using financial engineering proposed by Jean-Claude Juncker could end up being an excuse for inaction and an act of faith.

Another issue holding back growth, which the IMF heralded with such noise a couple of years ago from their silo thinking (Christine Lagarde’s words), has been debt sustainability.

How ironic when in Greece, despite debt forgiveness and a primary fiscal surplus, there is talk of a need for more debt forgiveness (talk is of converting all official debt to 50 year bonds).

If the Eurozone is to have the debt sustainability Angela Merkel wants, it would probably take a decade according to her estimates. Is this what south European politicians (France included) want? Nicolas Sarkozy certainly does not and neither does Marine Le Pen.

The debt issue can possibly be solved if Germany assumed the role the USA did when Latin America was in trouble. Clearly the issuance of very long dated fixed rate debt i.e. 50 years with zero coupon bonds (using German government bonds) being used to guarantee the principal of investors, would be a golden opportunity for Germany to save the Eurozone and assume some of the cost.

In such a debt relief programme, as in Brady bonds, the debt ridden countries will pay quite low interest on these bonds as the risk profile would be lower due to German risk on the principal provided by the zero coupon bonds.

In order to encourage Germany to partake part of the cost of the principal could be the responsibility of the Eurozone member states borrowing, plus the coupon on the bonds.

This would be attractive to such borrowers as it would allow countries to refinance their debt with longer duration and at very low cost and hence would amount to an overall lower cost of borrowing with a blended risk.

The market for such bonds would be very liquid if large bond issues are made to refinance all the official debt of such countries facing severe fiscal difficulties.

Making such bonds eligible for liquidity transactions with the ECB would make them attractive for banks but more importantly highly rated liquid issues would be of interest to institutional investors (pension funds and insurance companies) which seek long duration assets for their liability management.

In short, the reliance on financial engineering and TLTRO to reignite growth is futile and the sooner governments seek more drastic solutions, the Eurozone will struggle to get out of the slow growth trajectory and become even more irrelevant globally at a time when leadership is desperately needed.

The international economic environment is not very promising with China slowing significantly and the rise of the dollar will add to cost of emerging countries.

The Eurozone cannot rely on banking systems which are still plagued with high capital requirements and risk aversion. The financial engineering, if it picks up, will benefit the northern EU countries where projects are more efficiently planned and executed and not the “periphery”.

The Eurozone leaders need to give up on financial engineering as young people want a prospect of growth and jobs based on public/private investment and less regulation in some markets such as the capital markets of the Eurozone.

If they fail to take action soon, the politicians will have only themselves to blame and in the meantime the rise of anti EU parties will gather pace with all that means for the kind of society Europe was meant to bring to its citizens.
Erol Riza is a former managing director of DEPFA Investment Bank and served as vice chairman of the interim board of directors of the Bank of Cyprus

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