View of the month - French pills for EU ills: Edelweiss, PDF link

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To paraphrase Winston Churchill, “after exhausting all the alternatives, Europe is finally doing the right thing”. The verdict from election outcomes in France and Greece is loud and clear; stringent fiscal austerity has its bordered political limits. In other words, politics is now catching up with economic realities in Europe. In our view, the recent election results will turn the course of Europe in the right direction.

Since the onset of the debt crisis two years ago, European nations have pursued fiscal austerity fervently under the leadership of Germany with the hope that cutting fiscal deficits will promote business and market confidence, leading eventually to economic expansion. As it turns out, there is nothing like an expansionary fiscal contraction when the private sector is deleveraging. Premature withdrawal of fiscal stimulus is largely responsible for faltering growth in UK. This is no different in Europe where despite persistent and deepening fiscal cuts, large parts of the region are slipping back into a recession while debt dynamics of troubled sovereigns are deteriorating amid sustained rating downgrades. Clearly, Keynesians are proving to be more effective in the battle against the lingering economic maladies in Western economies.

The importance of these election results transcends national boundaries of France and Greece. Most importantly, Germany and ECB —bastions of fiscal austerity—need to heed to the harsh economic realities of fiscal austerity and changing political winds in Europe.  To be sure, both are already adjusting to new realities. Mario Draghi is now talking about the need for “growth compact” in Europe and even Angela Merkel is altering her tone, stating that Europe’s policy rests not only on budgetary discipline, but also on measures to promote jobs and growth. This surely needs to be taken forward if the Union is to survive.

As stressed in our note (“Will Europe eventually move towards a fiscal union?”, June 2010), space needs to be created for growth enhancing measures within the ‘fiscal pact’, starting with back-ending the fiscal cuts rather than front-loading them. This will reduce the drag on growth in the near term thereby supporting government tax revenues. At the same time, Germany can also initiate fiscal measures to boost its wages and thereby domestic demand which in turn will boost exports of peripheral economies to Germany. This will also assist in EU’s internal re-balancing.    

Similarly, ECB also needs to rethink the scope of its role. LTROs, no doubt, have been aggressive measures, but their benefits go only so far. They have been successful in averting an imminent banking sector collapse by providing unlimited liquidity to meet their refinancing needs. However, in effect, LTROs have actually incentivized EU banks to load more of the troubled asset (i.e., peripheral sovereign debt) on their balance sheets, thereby rendering their balance sheets even more toxic compared to pre-LTRO period. This is markedly different from Fed’s QE1 operations where it reduced the risk in the financial sector once and for all by making outright purchases of troubled assets (i.e. MBS). We believe that going ahead, the way out for ECB is to turn even bolder in its expansionary policies and play the lender of last resort to the EU sovereigns by buying sovereign debt from EU banking sector.

Such measures would keep the global liquidity conditions buoyant although these will have its own challenges for the EM world. Short-term volatility in EM assets will remain high. Expectations of QE will boost the risk appetite, leading to enhanced capital flows to EMs, but at the same time, commodities would rally too, giving rise to inflationary concerns thereby curbing the risk appetite. Renewed inflation concerns, in turn, will limit the headroom with EM central banks to cut rates thus hurting EMs' growth prospects. 

View of the month - French pills for EU ills

Regards,