The Take-Away From The European Elections

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What is the take-away from the French, German and Greek elections? Simply, austerity is no longer guaranteed. Those elected will attempt to stop the cuts to government spending, benefits and pensions. Instead they will try to retain or expand the European welfare state.

The problem with this move toward growth is that the markets may not allow it. These governments are already paying huge premiums (interest rates) over Germany and the United States. If the take-away from yesterday’s elections is “borrow more,” then these rates are going higher and will further stress European banks that are stuffed to the gills with European sovereign debt (see the chart below).

Are these “pro-growth” plans a realistic possibility? Unless the Germans agree to fund more spending, we do not believe so. The markets are likely to force interest rates on these countries much higher under such a scenario, making it prohibitive to borrow and expand the welfare state unless the Germans agree to fund it via a Euro bond market or some other such scheme. As stated above, however, the Germans appear to be pushing Merkel further away from this option and want an even harder line taken toward austerity.

Right now Europe is a stationary force (preserve the social welfare state) meeting an unmovable object (market’s ability to lend to European governments). The markets await a resolution to this stalemate.

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The Financial Times – Wolfgang Münchau: The only solution to the eurozone crisis
It is easy to solve the eurozone crisis on a piece of paper. I have done it many times. It is also easy to invent new institutions: a fiscal union, a treasury secretary, a common sovereign bond and a banking union. I would welcome most of these. But we must subject these discussions to a reality check. While these institutions will emerge from this crisis, none of them can solve it. That will have to be the job of the existing institutions.  This applies particularly to the idea of a common bank resolution fund. It is a great idea, but political resistance to it will be so big that it will not be implemented in full and in time. It will not solve the crisis.

Economist – Germany’s economy: Message to the Bundesbank 
If the euro zone is to survive, Germany must tolerate higher inflation
Asking a central banker to accept higher inflation may seem like asking a cardinal to accept more sin. All the more so in Germany, where the importance of price stability is etched on the collective psyche. Most of the time that German instinct is right. Tolerating higher inflation is risky. It can be hard to squeeze down again. Yet Germany will need to live with slightly frothier prices for the next few years. Both the arithmetic of euro-wide inflation and the mechanisms of rebalancing growth in the currency union demand it. If the Bundesbank resists, the single currency could come apart.

Dow Jones – Spain Signals U-Turn, May Pump Public Funds into Banks
Spain may pump public funds into its banking system to revive lending and its recessionary economy, Prime Minister Mariano Rajoy said Monday, signalling a policy U-turn. The government had pledged to not give money to the banking industry that is struggling in the wake of a collapsed, decade-long, housing boom. “If it was necessary to reactivate credit, to save the Spanish financial system, I wouldn’t rule out injecting public funds, like all European countries have done,” Rajoy said in interview with Onda Cero radio stations. The weakness of Spain’s banks is weighing on the economy that contracted 0.3% in the first and fourth quarters, meeting most economists’ definition of a recession. The unemployment rate is at an 18-year high 24.4%, data showed April 27. Banks have sharply reined in credit in the face of rapidly growing bad debt and problems getting finance on international markets. Government borrowing costs soared as investors fear the price tag of a banking-sector clean up could break already strained finances. Yields on Spanish debt, up five basis points at 5.78% Monday, have risen above 6% this year, a level seen as unsustainable in the long run. The government is cutting costs to lower its budget deficit to 5.3% of gross domestic product this year from 8.5% in 2011.

Source: Bianco Resarch