The euro zone infernal machinery: a story of collective suicide

Posted on 29. nov, 2011 by Riskelia in Weekly Focus | Commentaires fermés

In the unfolding euro zone tragedy, all protagonists involuntarily feed an infernal machinery as the inefficient euro zone institutions are driving it to a certain death. Here are the players of the tragedy with their motives:

  • The ECB is ‘independent’. It fights against inflation and it has extended its mandate, providing liquidity to the financial system. Thus, it increased interest rates twice in 2011 before lowering them by only 25 bps. The euro zone has one of the lowest expected growth rate in 2012, yet one of the highest interest rates among the OECD countries (US, Japan, Switzerland, UK, Canada…). This makes the euro a ’strong currency’!
  • The European Commission is the unelected institution controlling the action of elected governments. After disregarding fiscal imbalances accumulated over years in some euro countries, its grip on fiscal deficits has tightened since 2010.
  • The IMF is a partner of the European Commission in setting up « bailout » plans intended for distressed countries which can’t fund themselves in financial markets. Such plans have been designed for Greece, Ireland and Portugal. The aim of the IMF, the European Commission and the ECB is to avoid debt restructuring at any cost in order to avert a systemic crisis in the financial sector… It has failed for Greece and it is about to fail for Portugal. Spain is about to find external support as reported last week.
  • Germany defends the fiscal integrity of Germany, refusing to proceed to Euro bonds. It recently proposed fiscal integration under the condition that European treaties are modified to prevent fiscal indiscipline.
  • France defends its fiscal sovereignty and its triple AAA rating against all odds. The French debt is already downgraded in the market, making the French AAA rating another Maginot line.
  • The banks are supposed to provide loans to the real economy. However, crippled with depreciating sovereign and consumer debt holdings, facing tougher capital requirements and a run on their short-term debt, they are condemned to deleverage, which results in a credit contraction. Now, the banks are losing faith in the euro sovereign debts and sell their long term holdings, in turn worsening the debt crisis.

Each player plays its role to the perfection and thinks it is the ‘good one’, rejecting the fault on the others. In the end, this scenario is sure to end up in a Greek tragedy as there is presently no way we can change the roles of the characters.

The doom loop is described in figure 1. We show that the doctrines of the euro zone are fulfilling its own demise. The Germans promote fiscal austerity but the austerity applied in recession is counterproductive. The ECB cannot play the role of buyer of last resort in virtue of its claimed ‘independence’. Therefore, all euro debts are subject to self-amplifying defiance spirals, as showed Figures 2 to 4. If not stopped in the coming weeks, the hemorrhage on the TBTB ( »too big to bail ») Spanish or Italian debts will sign the end of the euro system as it currently exists.

Now that the confidence in the euro zone debts is eroded to the point that even the German bonds start looking suspect, investors would be well-advised not to place too much hopes on the Dec 9th summit and prepare for an imminent euro break up.

Figure 1: the euro doom spiral mechanism



Figure 2: the beginning and the end of the euro?

Figure 3: Germany 5 years CDS vs. UK 5 years CDS

Figure 4: Riskelia’s trends on core countries’ debts

Tags: , , , , , , , , , , , , , , , , , , , ,

Comments are closed.