European developments have worsened substantially since the Merkel-Sarkozy Paris summit on August 16.
We discuss the new European developments below followed by the eight negative developments listed in our August 25 piece.
We think it will take dramatic action in Europe to break the downward spiral. On its present course, the risks have increased substantially of major European bank failures or nationalization, a European recession and a breakdown of the euro.
Each would be negative for global growth and would raise the risk of a U.S. recession.
- Some actions that would help: ECB rate cut from current 1.5% (next ECB meeting and Trichet press conference is on September 8); faster ECB bond buying (purchases remain small); European or national guarantees for bank borrowing (the FDIC did this for U.S. banks after the Lehman bankruptcy); greatly expanded fx purchases by Switzerland; eurozone bonds (this seems less likely than the others given Germany’s opposition.)
Negative developments since our August 25 piece:
- Italian yields rose above 5.5% on Monday on worries that the ECB might stop buying them. Italy is softening or revising its austerity program. The program is a condition for ECB purchases of Italian bonds. Italy faces national strikes on September 6. Its government says it will comply with the conditionality, but Finance Minister Tremonti won’t commit to a timetable. The lower house is supposed to approve austerity measures on September 20.
- Implementation of the new Greece package agreed to on July 21 has broken down. The IMF mission pulled out of Greece last week.
- On Monday, the euro weakened to just above $1.40 dollars per euro, a critical technical breakdown if crossed. Equities fell sharply. European banks again came under intense pressure over concern that their access to funding is drying up – the interbank market has deteriorated, bond issuance by banks has stopped due to wide spreads, deposits have declined; ECB bond buying (which is paid for by new term deposits at banks) has remained sluggish.
- On Sunday, a German state election weakened Merkel’s CDU and its FDP partner and strengthened the CSU and Green parties. Merkel’s setbacks in recent state elections make it likely that Merkel will have to give the Bundestag operational power in the EFSF to gain its approval of the EFSF expansion. This concession may spark similar negotiations in other eurozone national legislatures, delaying EFSF approval and hampering its operations. German parliamentary approval of the expansion of the EFSF is now scheduled for September 29 (the schedule keeps sliding). Slovakia says it might wait until December to approve the expansion of the EFSF. With the ECB reluctant to buy bonds, delays in making the EFSF operational or dilutions in its powers are a major negative development.
- The political impasse has deepened. Trichet is still calling for quick euro-wide approval of the agreement to strengthen the EFSF, which is instead moving slower. New IMF head Christine Lagarde has repeated her surprise Jackson Hole call for forced capital increases by European banks. On Monday, Mario Draghi, who will become ECB president in November, cautioned on ECB bond purchases, saying the bond-buying program is “temporary and fully sterilized; most importantly it cannot be used to circumvent the fundamental principle of budgetary discipline." In the midst of italy’s austerity battle and spike in bond yields, Italian Finance Minister Tremonti called for a change in the EU treaty and for jointly issued euro bonds (both non-starters.) He said: "The euro bonds will absolutely be done. Either we do euro bonds or we will have critical problems.”
Negative developments in our August 25 piece ‘No Good News Out of Europe.’
- Germany hasn’t tried to bounce back from the weak Paris summit.
- The ECB is not buying enough bonds or signaling that it will.
- Greece is being asked to collateralize its debt. The slower the bailout, the worse the legal obstacles become.
- There is a risk of long delays in getting parliaments to approve the expansion of the EFSF, which is a critical step.
- Structural reforms aren’t sufficiently growth-oriented. In Greece, Italy and now France, the “reforms” are mostly taxes.
- The short-selling bans aren’t linked to pro-equity reforms so they come across as anti-market.
- The European bank regime is still procyclical, with banks expected to raise capital as markets collapse. There’s talk of shot-gun weddings forcing banks to merge, undercutting equity values.
- Germany’s growth is slowing sharply.
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