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Kim Cramer Larsson
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Article / 18 November 2011 at 12:54 GMT

Is Europe set to declare a Chapter 11 in early 2012?

Chief Economist & CIO / Saxo Bank
Denmark
Europe may need to pull a Chapter 11 – a US-style bankruptcy, which would permit a market shutdown and Euro Zone reorganization before reopening for business.
 
The EU desperately needs a break from market pressures in order to allow the political apparatus to really gather its forces and finally move Europe and its debt crisis ahead of the curve. Here we are just a couple of weeks after the feeble attempt to apply an EFSF plaster on the problem and we’re already back to Square One: the EU debt crisis has reached the point at which none of the readily available tools or institutions are sufficient to match the magnitude of the crisis. This dictates the need for an out-of-the-box solution.

EU policy makers played the extend and pretend game for as long as they could  - but now the writing is on the wall: popular outrage is on the rise and putting increasing pressure on the political process  - as we are seeing increased demonstrations and grass-root activity taking over both the political agenda and the media. And markets are now balking as empty promises and now a real lack of funds are seeing bond yields beginning to spike out of control. The self-reinforcing cycle of downgrades and austerity and recession are taking us to the very brink of a full scale Crisis 2.0.
It’s important to point out that politicians will only do something drastic in a true state of emergency, so one catalyst we’ve yet to see to prompt action is a serious drop in the stock market.

Looking back at the implementations of non-conventional measures since the Global Financial Crisis got underway clearly shows that stock markets need to be down in excess of 20 pc from recent highs. The policy makers, wrongly, continue to buy the argument that stock markets reflect confidence- and faith in the future, ignoring the fact that the middle class has been the big loser since 2008 – The middle class is also the political establishment, so while “risk takers” in banks and the like continue to see no crisis ahead, the Main Street guy is feeling the crisis day in and day out. The consequences of this paradox will likely come to a head sometime in early 2012.

So what form might a Chapter 11 for the Euro Zone take? It is increasingly likely that some kind of total “bank holiday” is enforced to put a stop to market pressures – and then to reinforce and relaunch a stricter EU Growth and Stability Pact as a price for cranking up the ECB printing presses to full speed.

Before accusing me of lunacy on my idea of a market holiday, it’s important to point out that banking holidays are not without precedent. In 1933, President Roosevelt declared a bank holiday that ran for an entire week in March of 1933, during which he passed the Emergency Banking Act and the Federal Reserve moved to supply currency to banks.

After 9/11 we also had a “forced” bank holiday. The banking panic of 1907 saw massive illiquidity and bank closings as can be seen in this excellent link. The main point for 1907 however remains: The biggest and most solvent banks survived, the small ones failed – 73 banks failed but it created a rebirth which catapulted the stock market higher.  

Germany and Northern Europe understand that printing money at the ECB will not solve anything, as it would only throw more debt on an already back-breaking load. But if this bloc countries wants to buy time to implement stronger constitutional changes, the most path is a quid-pro-quo solution in which Germany gets a stronger Growth and Stability Pact implemented, not only into EU law, but also ratified as part of a new standard for restrictive fiscal policies with built-in debt breaks for all individual countries. Germany gets it “discipline leads to growth” for the long term, while the Keynesians get their “liquidity fix” from the ECB.

Clearly, if the ECB goes down the road of printing money, it’s more credible if such a solution came with new debt breaks. Still, how would this help to make Europe competitive? Yes, it could lead to lower interest rates across the stressed sovereigns of Europe, but considering that we have had lower rates for more than 10 years and falling productivity and growth in the same period, there is not any obvious correlation. Maybe rates (steering rates) are even too low?

There are several layers in credit markets now – banks get credit for free, AAA companies effectively do as well. Everyone else, meanwhile, has seen considerably higher interest rate margins and gross yield levels. This means that by “subsidizing” some sectors, others pay excessively in a relative sense.  Is this the best way to allocate capital and credit? Hardly. If the unconventionally low rates were increased to their natural level (inflation + real rates), then the market would be more likely to allocate capital more efficiently and evenly relative to marginal returns. The zero interest rate policy has killed the distribution of risk and capital, unfortunately. The unintended negative consequences of the endless printing of money are inflicting tremendous damage.

The objective problem we need to deal with is to get more rules for debts, eliminate negative yields on government debt, get political backing for changes to the EU Treaty and secure democratic support for this.

The extend-and-pretend policies that have continued through 16 EU Summits have only led us to a Catch-22 in which everything that is done with good intentions (or not) is to the detriment of something else.


In short, the main issues are the following (in no particular order of prioritization):
  1. Time is up – the market needs solutions, not plans for plans. The timeline for Political Europe is way too slow for market comfort.
  2. Interbank funding is starting to freeze over. Every day sees risk factors pointing higher and a systemic liquidity crisis could develop at any time.
  3. Financing gap. EFSF has 440 EUR 440 billion (though it has never been funded). Some estimate that Italy and Spain need EUR 400-500 billion per year to refinance and recapitalize its banks – per year! Talk about mismatch of supply and demand.
  4. Lack of constitutional frame-work to establish or enact changes.
  5. Democratic and constitutional rights are close to being violated, if not in the letter of the law, then certainly in the eyes of the voters.
As we head into 2012, I am increasingly convinced  that we have an almost perfect economic and political storm brewing on the horizon.

Chart: EU growth forecasts - consensus estimates (YoY)



Now remember the “consensus” is always optimistic, that’s the rule of the game, so adjusting for the positive bias, we are looking at best at zero growth for Europe next year and most likely negative growth. This will mean a further strain on fiscal imbalances, higher unemployment, lower taxes, higher funding needs – you get the idea.

Now the interbank market is starting to freeze over and here is the real concern – the same happened in 2007/2008 and it was when currency basis swaps crossed the  -100 basis point that the crisis escalated:


The basis swaps blowout reflects the distrust between interbank players and as such the car is running out of gas and could hurt the engine.

So the solution the market needs to at least partly solve the five problems I listed is to consolidate the need for “someone” to print and help out, while at the same anchoring the debt breaks and rules into the EU treaty, but also more importantly into the 17 nations that use the single currency.
This is going to prove such a difficult task that my rather radical call of a Chapter 11-like temporary shutdown is the only option I know of which could work. Somewhere inside the next three months we need to see a major change in politics, economics and investor will to look forward – the only way is to first feel and see the true Crisis 2.0, then to start thinking about ways to grow ourselves out of this crisis. Austerity will only work if done in environment of productivity and innovation, for that you need capital and transparency on outlook.

The alternative to my Chapter 11 is yet another cycle of what we have already seen - buying time and praying for better weather. But this route leads quickly to social disorder and a political backlash at election time. The moves in Europe by technocrats are increasingly been seen by voters as unconstitutional and in violation of democratic rights. The middle class across Europe was the big losers in the Financial Crisis of 2008/09. Now, with disposable income down, no outlook for jobs, and higher taxes on the way, no wonder there is renewed focus on the need for change.
We will get through this crisis – but it seems our democracies need to smell fear before making bold moves - that’s been the history of modern democracy, perhaps one of its best attributes. Regardless, in the end, the micro-economy will always take charge.
 
Safe travels,
 
Steen  

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