Europe's Outlook Worsens

Europe Outlook Dims as Bank Meets

Downturn Deepened Over Summer, Complicating Choice for ECB Officials

WSJ,

5 September, 2012

The euro zone's economic downturn accelerated during the summer, economic reports Wednesday suggest, raising concerns that even aggressive anticrisis measures from the European Central Bank won't be enough to keep the euro bloc from sliding into a deep recession.

The figures, which included a slide in retail sales in July, came as the ECB's crisis steps have taken shape. Officials meeting Thursday will weigh a plan to purchase government bonds with maturities up to around three years, people familiar with the matter said, with a possibility they could extend slightly longer. The proposal wouldn't place limits on the amount of bonds purchased, the people said, giving the ECB maximum flexibility to stabilize financial markets.

The ECB declined to comment.

The euro zone purchasing-managers' index fell to 46.3 from 46.5 in July, data company Markit said Wednesday. Sub-50 readings for the index, which is compiled through a survey of purchasing executives at European firms, signal falling output and employment. August's figure was revised from an earlier reading of 46.6.

Official data on retail sales were also poor, suggesting consumers remain cautious and aren't likely to drive an economic recovery. Volumes of sales in the currency area fell 0.2% on the month in July and slid 1.7% on the year, according to the European Union's statistics agency, Eurostat. Sales were notably weak in Germany and Spain.

The reports raise a vexing problem for ECB policy makers. Even if they announce detailed plans to buy government bonds as a means to lower borrowing costs for crisis-hit countries, the measures' effectiveness may be limited by high unemployment, weak consumer confidence and stagnant growth prospects.

"In the next three to six months, there is nothing the ECB can do to prevent a further slowdown from materializing," said Carsten Brzeski, economist at ING Bank.

A particular concern is Germany. Germany's purchasing-managers' index fell to 47.0 last month, its lowest level in more than three years. Germany has weathered the crisis so far, posting growth rates of 3% or more the past two years. If Germany buckles, the euro zone would lose its main growth engine. It may also weaken Germany's willingness to put its own finances on the line to protect its southern neighbors.

Italy and Spain suffered a sharp fall in business activity in August, Markit said, albeit less pronounced than in previous months. The countries are in recession and seeking to avoid the need for funding assistance from international partners. Spain has already requested a credit line for its banks.

Other data in recent days have shown a rise in unemployment to record levels and a plunge in consumer and business confidence. Many economists expect the ECB to respond by loosening policy, possibly as early as Thursday. The bank could lower its key interest rate, now at an all-time low of 0.75%.

However, officials may wait until financial conditions stabilize in Southern Europe to ensure that any rate cut feeds throughout the 17-member currency bloc.

The ECB isn't likely to set formal targets for bond yields as part of its new bond-purchase plan, people familiar with the matter said. Rather, the central bank could informally guide investors toward preferred yields by communicating more specifics about the types of bonds they buy.

The ECB plan doesn't envision giving the central bank preferred creditor status among bondholders, meaning that in the event of a debt restructuring, the central bank would face losses just as private bondholders do. The presumed senior status of the ECB's past bond buys was seen by many analysts as limiting the purchases' effectiveness. Private investors may have been reluctant to buy bonds of vulnerable countries such as Spain because they assumed they would be first in line for any losses.

The central bank's repeated insistence that past bond buys were limited and temporary also weakened the effectiveness of the program in financial markets, where investors sought signals of a greater commitment. The ECB is unlikely to make such a cautious declaration this time. However, pledging unlimited purchases could stoke the ire of German politicians who have so far cautiously backed ECB President Mario Draghi's bond-buying plans.

"The ECB must be deliberately vague on the topic while promising to do 'whatever it takes,'" said analysts at Citigroup.

The plan, hammered out over the last month by ECB committees at Mr. Draghi's instigation, is the centerpiece of Mr. Draghi's new strategy for fixing the euro zone's broken financial markets.

ECB officials have signaled that they will likely insist that governments agree to strict deficit-reduction and economic reforms as conditions for central-bank aid. That could delay any bond purchases for many weeks.

Spain, which is seen as one of the euro-zone countries most in need of ECB help, has been unwilling to ask for assistance from the euro zone's crisis fund, saying it wants to see the ECB's plan first. The ECB wants the rescue fund to intervene in bond markets before it acts.

Mr. Draghi will have to overcome fierce resistance from Germany's central bank in order to finalize any bond-purchase plan. Bundesbank President Jens Weidmann was the sole ECB board member to oppose the broad outline of the proposal that was unveiled last month, Mr. Draghi has said. Mr. Weidmann has criticized the idea repeatedly since. The Bundesbank thinks buying government bonds puts the ECB in the realm of fiscal policy, weakening its independence.

Mr. Draghi would almost certainly have the votes to overrule Mr. Weidmann's objections. Still, dissent from the ECB's most powerful member bank could raise doubts about how far the ECB is willing to go to prop up Spain and Italy.

In a sign of Thursday's high stakes, Jean-Claude Juncker, the head of the Eurogroup of finance ministers, will attend the ECB meeting to present an analysis on the economy.

Senior European officials have urged the ECB to take action to address some countries' sky-high borrowing costs. European Council President Herman Van Rompuy said Wednesday that "short-term measures" from the ECB were now necessary to temper the debt crisis.

Europe Funds the Last Ponzi Game Standing

By Lee Adler

Financial Sense,

5 September, 2012

For the past year or so I have espoused the opinion that chaos in Europe is good for the US because of capital flight from Europe to the US. That capital is funding the Last Ponzi Game Standing, the US Treasury market and US economy.

Here’s how that works. As Europe destabilizes, big money exits the problem markets of Greece, Portugal, Ireland, Italy, and particularly Spain. Ireland and Italy have stabilized somewhat in recent months, but money is still pouring out of Greece, Portugal, and Spain. Much of it is transferred to the US to purchase Treasuries and probably big cap stocks to some degree. These purchase funds flow into the US Treasury and US bank accounts. The Treasury subsequently spends the cash it borrowed from these sources, and it ends up in US bank accounts.

Of every dollar the US Government spends, on average over the course of the year approximately 35 cents comes from borrowing. Some of that borrowing comes from domestic sources. About 8% of it over the past year has come from foreign central banks. Of the rest, the US Treasury TIC report says that Europeans made net purchases of $76 billion of US Treasury Bonds in the second quarter. That was equivalent to 30% of the new Treasuries issued. In other words, it appears that European capital flight accounted for 30 cents of every dollar of debt the Treasury raised. That debt accounted for 35 cents of ever dollar the government spent. Therefore, roughly 10 cents of every dollar of US government spending driving the US economy came from European capital flight.

Given those cash flows, anyone who argues that what’s bad for Europe is bad for the US is simply wrong. If Europe somehow manages to ameliorate its problems, or even create the impression that it is doing something to solve them, then these flows would slow down or even stop. The obvious effect would be that long term US bond yields would be forced to rise in order to attract investors. Alternatively, the US government would need to spend less or tax more in order to reduce borrowing. Any of those outcomes would slow the economy. The other option would be for the Fed to step into the breach to monetize the debt. No doubt that would have an immediate response in the commodities pits, driving the cost of energy, materials, and food into the stratosphere, which in turn would crush the US economy.

So the last thing the US needs is for the European situation to improve. In fact, the worse things are over there, the greater the capital flows from there into the US.

It is true that some of the capital flooding out of Spain, Portugal, and Greece heads to Germany. As a result European bank deposits in total have remained relatively stable. But that doesn’t account for all of the capital flowing from those countries. Some of it heads for the UK and elsewhere, and it seems clear that some of it heads for the US where it funds the Last Ponzi Game Standing.

The following excerpts from the Professional Edition Fed Report for September 3 show ECB data on bank deposits for the Eurozone as a whole for the period through July 2012. Total deposits declined in July. Deposit growth has essentially stalled since October 2011. The right axis shows the 12 month rate of change.

The charts of the problem countries are shown below. The run on Spanish banks accelerated in July. Italy’s deposits were flat after growing since January.

Portugal saw another fall in deposits while Greece had an uptick. Ireland has been stable.

As this chart shows, some of the outflows have gone to Germany, but the rest have probably gone mostly to the US, with some to the UK.

The correlation of outflows from some European countries with US bank inflows, strong Treasuries, and modest growth in US economic data suggest that, contrary to the conventional wisdom, what’s bad for Europe has been good for the US. It has funneled money into the US Treasury Ponzi scheme economy that has kept US economic activity afloat. The ending of these outflows, whenever they occur and for whatever reason, should be bearish for the US markets and economy.

Deposits in US subsidiaries of foreign banks are available weekly with a lag of about a week. They are a near real time, indirect measure of the degree of stress in the European banking system. Declining deposits in US branches of foreign banks suggest outflows of deposits from Europe, which means that more capital is probably pouring from the Eurozone into US banks. Conversely, an uptrend in these deposits would signal a lessening of stresses and outflows to the US. That could be bad news for the US which is dependant on a constant influx of capital to keep the Treasury market, and by extension the stock market and economy afloat.

After a dramatic collapse in 2011, foreign based bank deposits in the US stabilized for much of 2012, then dropped in June. They stabilized in July, but began another modest rebound in August when hopes for stabilizing the situation in Europe began to grow on the heels of ECB head Mario Draghi’s sweeping statement that the ECB would stabilize the situation by whatever means necessary. That brought foreign based bank deposits back to the levels where they had been throughout most of 2012. Meanwhile, domestic deposits surged to a new high in early July then pulled back a bit in August. As of the week ended August 22, domestic bank deposits pulled back from a record level.

The drop in Eurozone bank deposits in July corresponded with deposits in US domestic banks reaching a record level. Correlation does not prove causation, but a reasonable case for linkage can be made. As long as the run on deposits in Europe’s biggest trouble spots apparently flow into the US, then the US Treasury Ponzi will continue as the Last Ponzi Game Standing, enabling the US economy to continue to look relatively good compared to the rest of the world.