06 May 2012

Paul N Goldschmidt: The financial crisis and the quest for growth

There is a broad consensus over the fact that the crisis is far from over even if – courtesy of the electoral propaganda of the President-candidate – some wish to believe that the worst is over. Similarly, recognition of the need for “growth” is also widely shared even if – courtesy of the electoral propaganda of the leftwing candidate – one deliberately overlooks the underlying significant divergences in its interpretation.  

Growth is a concept that can be as readily agreed upon as “motherhood and apple pie”, as the saying goes; it is therefore difficult to understand why it should be the subject of a renegotiation of the “Treaty on budgetary discipline”. This is all the more so that many object to the need for the Treaty in the first place which reiterates, in the main, obligations already in force under present European legislation (six pack) or its near term extension (two pack).

It is, therefore, to be welcomed that the June European summit will be largely dedicated to agreeing on policies aimed at stimulating economic activity without putting into question the imperative need of budgetary discipline. This implies, unavoidably, a number of sacrifices that should be shared equitably among citizens; in other words, austerity is unavoidable even if restoring growth is a priority. One can thus anticipate agreement on increasing the resources of the EIB (whose debt issues guaranteed by the EU 27 are in fact “eurobonds”), an improvement in the efficiency of the structural funds of the EU budget together with additional financial and budgetary measures at EU level aimed at stimulating investments. In parallel, the return to equilibrium in current expenditures at national level will be encouraged, among which the reduction of debt servicing costs (capital and interest) will constitute a particularly difficult challenge.

Indeed, the use by both French presidential candidates of the argument of historically low borrowing costs constitutes an emblematic example of deliberate disinformation of public opinion: in one camp one ascribes this situation to the recognition by the market of the budgetary efforts undertaken by the current government, insisting that the “downgrading” of France by one of the rating agencies has had no impact while, in the other camp, it is interpreted as a vote of confidence by the market, already anticipating a change of occupier at the Elysée palace.

Reality, however, is totally different: the historically low interest rates for 10 and 2 year “Bunds” (1.58 per cent and 0.08 per cent) as well as for French “OAT”s (2.85 per cent and 0.42 per cent) should be related to the current inflation rate (+/- 2.5 per cent) which is likely to continue, at least through 2012, to exceed the medium-term objective of “equal to - or slightly below - 2 per cent” set by the ECB. To make things perfectly clear, this indicates that investors are ready to lend to the German and French governments at rates that guarantee a loss in purchasing power over periods between 2 and 10 years!

Such behaviour appears to be totally irrational. However it seems to be confirmed by the day. Several reasons can explain this unusual situation: 

1. The investor has lost trust in the banking sector and is seeking a safe haven for his liquid assets. The accepted “loss” can then be assimilated to the cost of renting a safe in which to store bank notes. The purchase of sovereign debt instruments, as an alternative, safeguards the liquidity and reinvestment opportunities without having to justify the origin of the funds.
2. The excess liquidity looking for a home with which (thankfully) the ECB has flooded the market (LTRO) is benefiting Member States. The stronger ones (Germany) are collecting private investor funds as well as those representing the reduction in bank exposures to the weaker Members, while simultaneously the weaker States are benefiting from the unlimited resources provided by the ECB to their respective national banking sectors. This situation is holding a Damocles sword over the sovereign debt market as banks will (as planned) progressively use the ECB funds to meet their own refinancing schedules; at such time either a new intervention of the ECB will become necessary or else a hike in interest rates will be unavoidable making the quest for budgetary equilibrium even more difficult.
3. The investor has lost confidence in Europe’s growth prospects and is anticipating a double dip recession, already present in several countries (UK, Spain, Italy, Portugal and Greece). This sentiment is further underpinned by the unemployment level which has reached an all time high since the € was launched (11 per cent). Since a 2 per cent growth is the minimum level to stabilise employment, a reduction unemployment outlays can hardly be expected to contribute to budgetary equilibrium.
4. The investor realises that a stimulus programme based principally on investment (in research, innovation, education or major infrastructure projects) is only likely to bear fruit over the medium- to long-term horizon while budgetary austerity is required immediately.
5. The investor has read the message of the ECB, differing for the time being the implementation of any measures concerning its crisis exit strategy, as proof of the low level of confidence of the Central Bank in a significant economic upturn.

1. Growth will lead to a redirecting – as wished by the authorities – of bank lending towards the private sector. It should mechanically induce an increase in sovereign debt borrowing costs as States lose their current quasi monopoly as “debtor” of choice.
2. The ECB will be induced to implement rapidly its crisis exit strategy by progressively withdrawing liquidity and raising interest rates which will impact both public and private debt markets. Any hesitation leading to maintaining current short-term low interest rate levels will immediately fuel inflation expectations putting pressure on medium- and long-term rates and exploding debt servicing costs.

© Paul Goldschmidt