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Thursday, August 25, 2011

Life On PMI Cold Comfort Farm.

As the heat wave which has been hanging over Southern Europe for the last couple of weeks steadily eases off there is little sign that any of the warm air which is disippating is reaching the chilled motors of the European and Chinese economies. The results of this months flash PMI readings are at best more of the same, and at worst show continuing deterioration. While current conditions stabilised in some areas, new orders, and especially new export orders often hit new post-recovery lows. There is every likelihood that the final August global readings will be much more of the same.

The Eurozone story is one of read the details carefully. The composite index was unchanged at 51.1, which means a very sligh expansion in activity (50 is the neutral point), so the sharp deterioration seen in recent months did grind to a halt. But to understand the "why" of this we need to drill down into some of the individual country aspects.

French services activity would be a good place to start, since it is here that the greatest improvement was to be found. The services activity index rose from 54.2 in July to 56.1 in August, showing that despite the recent stagnation in French GDP there is life in French consumption yet awhile. At the same time manufacturing conditions deteriorated, and at 49.3 the indicator fell into contraction mode.

In Germany things were a little bit the other way round, with services falling back sharply and scarcely expanding (50.4), while manufacturing held steady at the July level of 52.

But then again, drilling down within the German manufacturing data we find even more interesting details. In the first place the current output reading was up (from 51.8 to 53.1 - it is important to remember that the PMI is a composite of several different components of which current output is only one).

At the same time, survey participants reported weaker growth of overall business activity which they primarily attributed to lower intakes of new work in August. As the PMI report notes, "although the decline in new business volumes was relatively modest, it represented a change of direction after a two-year period of continuous expansion. Both the manufacturing and service sectors registered falling levels of incoming new work".

In particular the fact that manufacturers suggested that weaker export sales had contributed to the reduction in new orders in August is more than worthy of note. In fact, the latest data pointed to the fastest drop in new work from abroad since June 2009. So the indicator remained stationary due to the combined impact of heavier current output and deteriorating export orders. What we call in Spain "pan para hoy, y hambre para mañana (bread today at the price of hunger tomorrow).

Basically the rise in manufacturing output this month seems to have been largely the result of inventory increases. According to the PMI report, "the forward-looking new orders to stocks of finished goods ratio in the manufacturing sector deteriorated again during the latest survey period. It was at its lowest level since April 2009, following a survey-record accumulation of post-production inventories in August".

This general picture is confirmed by other recent German surveys. The IFO index - and most notably the businesses expectations part - fell back again in August. indeed, German business morale posted its steepest drop during the month that at any time since the aftermath of the Lehman Brothers collapse in late 2008.

The Munich-based Ifo think tank said its business climate index, which is based on a monthly survey of some 7,000 firms, fell to 108.7 in August from 112.9 in July, well below the Reuters consensus forecast for a 111.0 reading. The last time the index fell so sharply was in November 2008, just after the collapse of Lehman Brothers when the German economy was in its deepest post-war recession. This month's was the lowest reading for the index since June of last year. Even more importantly there was a sharp decline in the Ifo's expectations subindex which fell to 100.1, its lowest in almost two years, and down from 105.0 in July.

German consumer confidence (as measured by the GFK survey) weakened again.

This drop in German consumer confidence forms part of a much wider European pattern, since Eurozone consumer optimism also plummeted in August at the fastest rate for 20 years The European Commission said its consumer confidence indicator fell 5.4 points to minus 16.6 in August – a larger monthly fall than was seen in October 2008 after the collapse of Lehman Brothers.

Just as importantly, there are signs that the German labour market may now be turning. Survey respondents reported a slowdown in job creation across the service sector, and the latest increase in employment levels was the slowest for 12 months. Across the German private sector as a whole, jobs growth was the weakest since October 2010, despite a further robust rise in manufacturing workforce numbers.

In addition the impression offered by the survey data is confirmed by the employment numbers released by the German Statistics Office, which show that new job creation peaked in February/March, and that the rate has been slowing since. If this trend continues then Germany will experience a real change of economic course.

It is here that it is important to understand the key difference between the two main Core Euro Area economies. Germany is export dependent, and subject to conditions in external markets. France has a stronger domestic consumption dynamic (hence the recovery in services activity) and is to some extent shielded from sudden movements in external conditions. Having been stationary in the second quarter, it is by no means a done deal that France will contract in Q3.

Contraction Continues On The Periphery
Turning from the core to the periphery, given that the overall PMI remained unchanged, and that the core deteriorated slightly, it may well be that some of those on the periphery did slightly less badly than they did in July. This would not be totally surprising, since many of these economies have significant tourist industries, and the season so far, according to reports, has not been an especially bad one, and in general terms an improvement over 2010. However, what we are talking about here are economies which contracted rather more slowly in August than they did in July.

On the inflation front, price pressures eased again markedly during the month. Average prices charged for goods and services showed only a modest increase, the rate of inflation moderating further from April’s high to reach a nine-month low. Service sector charges showed a particularly weak rise, the smallest monthly gain since services charges began rising in February. But, according to the report, it is in manufacturing where the steepest turnaround in price pressures has been evident. Prices charged for goods showed the smallest monthly increase for a year in August, in marked contrast to the survey-record high seen back in March.

Respondents suggested that the slower rate of increase of selling prices reflected a combination of sluggish demand and a further substantial easing in input price inflation. Service sector input costs rose at the slowest pace for ten months, while manufacturers’ input price inflation eased to a 20-month low, taking the overall rate of increase across both sectors down to the weakest since February of last year.

Which means, Monsieur Trichet and his team have even less justification than previously for proceeding with their ridiculous rate increase programme. It is now very unlikely that we will see any more of these in 2011, and an even bet whether the next move will be up or down.

China Hovers In The Limbo Between Growth And Contraction

Finally, moving briefly on to the Chinese reading, conditions seem to have improved slightly in August, and even the decline in export orders was to some extent arrested, but it is far too soon to draw any definitive conclusions on this count.

Commenting on the Flash China Manufacturing PMI survey, Hongbin Qu, Chief Economist, China & Co-Head of Asian Economic Research at HSBC said:

“The flash manufacturing PMI reading picked up slightly to a level close to the break-even mark in August, which is still consistent with around 13% y-o-y IP growth. Despite the turmoil in global financial markets, the new exports orders index rose to a three-month high, albeit still marginally below 50. All these data suggest that the hard landing risk is still remote. This provides leeway for the PBoC to keep the current tightening measures in place.”

Thursday, August 18, 2011

Eastern European Growth - Coming Rapidly Off The Boil?

The latest round of EU GDP data, brought to light a reality which many who have been closely following the economies of Eastern Europe already suspected: that the heavily export dependent economies in the region would almost inevitably be dragged down by the rapid slowdown in Europe's principal economic motor, the German economy (see this post for background).

Wednesday, August 17, 2011

The Policymaker's Fear Of The Italian Penalty Shot

“While the impact of service-sector liberalization and privatizations may be positive on medium-term growth, the budget cuts are likely to have quite negative effects on the short-term GDP dynamic. We expect Italian GDP growth to slow to close to zero in 2012 and 2013.” Giada Giani, Citigroup

According to one anonymous German official speaking off the record to reporters from Der Spiegel, "a country like Italy can't be saved". We will have to trust that he was referring to the country's size when he made the statement, and not its existential core. If he was, he may well be right, at least under the Euro Area's current institutional arrangements. Let's take a quick look at why.

The ECB Backstop Works For Now

The Italian debt markets are a lot calmer this week than they were the week before last. Evidently there is a simple explanation for the phenomenon, and that is that the level of Italian bond yields is now more or less completely guaranteed by the European Central Bank (the ECB). Systematically and meticulously, the Italian ten year bond yield is being maintained at or around the 5% level by a team of dedicated bond traders in national central banks dotted around the Euro Area.

The process whereby this result is achieved is not that dissimilar to other more common central bank interventions, for eaxmple to target a certain exchange rate, or a given overnight interest rate. Basically, when the yield rises above a given threshold the ECB's representatives simply step in and buy bonds. This happened last week to the tune of some 22 billion euros, with bonds being acquired from a set of 5 EU peripheral countries, although we don't know how the purchases were broken down at national levels. One thing was for sure, there were a hell of a lot of Italian bonds tucked in there somewhere.

The problem for the bank now is that once you initiate a programme like this, there is no easy way to stop. Despite many voices who argue the contrary, Italy's problem is not simply a short term liquidity one (funding a deficit), it is a long term solvency one (servicing an enormous pile of debt and growing at the same time). While the country has long maintained a primary surplus, the weight of the debt has drifted steadily onwards and upwards. Italy is caught in a conundrum. With low growth you need inflation to be able to make the books balance, but this excess inflation makes the country's competitiveness problem steadily worse. If you implement the reforms needed to make the economy more competitive then you don't get the inflation, and if you take away the deficit in the meantime then you simply don't get growth. This is a zero sum game in which all the numbers don't add up.

At the push of an ECB "buy" button, Spanish and Italian sovereign bonds have effectively been taken out of the markets, and it is now hard to see how (without some sort of restructuring or other) they can now ever get back in again.

In ceding to pressure from Europe's leaders to take this decision, the central bank has now gotten itself locked onto the horns of a huge dilemma, and they are going to have great difficulty finding a way to extract themselves from it. Monsieur Trichet has lodged his finger well and truly inside the wall of the dike, and should he even momentarily take it out again, the whole structured could easily rupture, with many of the things we now know and love getting carried away in the ensuing flood.

Of course, the mere threat that he might one day do this does serve to concentrate all the various minds involved, but what is involved is a form of brinksmanship which could in itself one day become a problem.

A glimmer of what the bank is now getting itself involved in can be seen in last week's ECB balance sheet reading, since it grew to the year-to-date high of 2.073 trillion euros last, largely as a result of increased lending to eurozone financial institutions and additional sovereign bond purchases.

The balance sheet was up by 68.736 billion euros over the previous week, and 119.94 billion euros over the same period one year ago. In part the balance sheet surge was due to an increase in net lending to credit institutions (which increased by 98.3 billion euros to 393.3 billion euros). And in part it was up due to the 22 billion euros spent in bond purchases. Curiously the weekly fixed term deposit levels remained unchanged at 74 billion euros (the quantity spent in periphery bond purchases to date), which sort of settles the issue of whether the bank were going to "sterilise" the new purchases, or create additional money to pay for them. For the time being at least they seem to be doing the latter, since going by the size of the banks current account holdings (which jumped to 286.783 billion from 159.814 billion euros a week before) they seem to have offset the purchases through money creation.

Basically central bank bond purchase intervention is deemed to be "neutral" in monetary policy terms if an equivalent quantity is drawn back from the banking system by attracting new term deposits at the central bank. That the bank may be carrying out a "money printing" exercise (and especially one to monetarise the debt of certain countries in particular) is raising fears of impending inflation. My feeling is that, in the context of heavily over a leveraged private sector and congenitally weak domestic demand, this is not a real concern at present for the Euro Area. I think the ECB's own inflation alert was always overdone, since most of the inflation we have seen of late has either been imported (via rising energy and commodity prices) or adminstratively generated via consumption tax increases. There has been very little in the way of second round effects.

The real worry then should not be inflation, but whether or not the Italian government will ever be in a position to honour the bonds in full, and on time. At the present time this is only a theoretical question, since additional bond purchases can always enable the Italian state to meet its obligations, with the ECB facilitating debt rollovers by using the commercial banks as proxies in the primary markets. But just how deep in do you want to get? At the present time the bank owns something like 20% of outstanding Portuguese, Irish and Greek debt. 20% of Italian debt would be something like 380 billion euros, a volume of bonds which would already be difficult to pass over to the EFSF (or its heir the European Monetary Fund). But in this case the force of tradition is not strong, and there is no real reason why the bank need stop at 20%. The sky could be the limit, and the ECB could be transformed into the new Bank of Japan, effectively light years away from the earlier visions of the Bundesbank founding pioneers. And, of course, we would all be into one of those processes which can go on for just as long as they can.

The Balanced Budget Ammendment

At the heart of the recent ECB decision lay something known as the balanced budget ammendment. First introduced in Germany in 2007, this is a constitutional change which (in the German case) makes a deficit of over 0.35% of GDP illegal as of 2016. One of the conditions the ECB imposed on Italy was that they also change their constitution, but in this case outlawing deficits as of 2013. Effectively, and at a single stroke, this brings to an end a whole era of Keynesian counter-cyclical fiscal policy and economic management. So the implications are large, and hard to separate from the rapidly ageing population phenomenon.

While it was the size of the latest package of cuts which hit the headlines (Rome orders €45bn in cuts and taxes), the key issue was really the balanced budget ammendment, since this has one clear implication: as of 2013 there will be no new bonds. So at least now the outer limit of ECB exposure is a known fact.

Chronicle Of A Crisis Long Foreseen

While the Italian crisis may have crept up on markets all at once and unexpectedly, issues about the sustainability of Italian debt are not new. As FT Alphaville's James Coterill noted when the latest wave in the Italian crisis broke out: "In the original ‘why the eurozone will break up’ papers of the 1990s and early 2000s, it was never ever high Greek deficits, or Irish (or Spanish) bank losses going on to public balance sheets that were forecast to destroy the single currency. It was always Italy. High-debt, low-growth, Italy".

Exacty, Italy was always the greatest worry on everyone's minds, including the ECB's. Indeed, the now long forgotten minimum rating requirements for collateral posting at the bank were first muted by them with precisely Italy in mind. I myself wrote one blog post after another (see links below) warning of the danger which was looming, buried in Italy's toxic combination of low growth, rapidly ageing population and high accumulated debt. It was simply a crisis waiting to happen, and now it has. As the New York Times' Landon Thomas noted in the Blog Prophet of Eurozone Doom article he wrote about my work, "Mr. Hugh’s demographic thesis is not airtight: in fact, it was Italy, not Greece, that attracted his early attacks. But Italy, perhaps because its overall debt level was already so high and its population was older, pursued a policy of greater fiscal rectitude than its neighbors and avoided a real estate bubble".

Not airtight, but nearly-so it seems, since behind the short term obsession with fiscal rectitude there lie the longer term preoccupations about solvency and debt. And here Italy (and eventually Japan) jump right back into the cockpit. As Landon mentions, Italy didn't have a housing boom worthy of mention, so private debt didn't surge during the first decade of the century, and during the crisis Finance Minister Tremonti pursued a policy of flying under the radar by keeping deficit spending low. But now short term deficit issues are waning, and longer term solvency questions are surfacing in the wake of the renewed Greek crisis. Thus, while historians of the future may well struggle to understand just how it was that a simple fiscal deficit bailout programme was so badly handled that Greek sovereign debt shot up from around 110% of GDP entering the crisis to around 170% by the end of the "rescue" period (and this without even having enjoyed a real housing bubble, ie with a private sector that was not massively in debt), the Italian case will raise few eyebrows, since every thinking economist had seen it coming for so long (Japan too, see my Italy blog here, here, here and here).

Low Growth and Ageing Workforce Are A Troubling Backdrop

Italy's problem is not its fiscal deficit, in fact in every year since 1991 Italy has run a cyclically adjusted primary balance (that is before interest payments are taken into account), it is the weight of the accumulated debt burden and low growth. The country's trend growth rate has been falling for decades, and during the first decade of the present century it only managed to grow at an average rate of about 0.6% per annum.

Even though the quarterly GDP growth rate accelerated slightly in Q2, and reached a quarterly rate of 0.3% (up from the 0.1% expansion achieved in the first three months of this year), the slowdown in core Europe, and the readings on the most recent PMIs leave little doubt that the respite will be short lived. At this point even the current IMF forecast for modest 1% GDP growth in 2011 is looking very optimistic. And if the country now slips back into recession (certainly not excluded) then the under-performance would be much greater.

The worrying thing is how Italy has been able to get so little growth out of so much. This is especially the case when you take into account the fact that during the last decade the country's labour force grew steadily, following the arrival of several million new migrant workers. Between 2002 and 2010 the number of non-Italian citizens officially residing in Italy was up by 3 million (or 200%).

During this time the labour force grew by about a million:

while employment was up by around 1.5 million.

Yet GDP barely rose. In fact, since Italy left recession the number of those employed has hardly risen, while the percentage of those who are formally unemployed has remained near its crisis highpoint, which has been good for productivity, but not for consumer consumption. The ideal combination would be to see both output and employment growing in tandem, but with output growing faster than employment. At the present time employment is hardly growing, and the rate of increase in output is slowing notably. That is to say we do not have "lift off".

Slamming The Debt Brake Pedal Down To The Floor Won't Work

Despite the fact that the real leverage M Trichet now has over the Italian government is being exercised in order to obtain the constitutional change required for the balanced budget rule to be put in place, the severity of the fiscal tightening that Italy will now experience should not be taken lightly. In the first place something like 45 billion euros in new cuts will be implemented in 2012 and 2013, and this will be on top of the previously agreed package of 47.8 billion euros in cuts between now and 2014 agreed in the July budget.

In addition Italy will now aim for a general budget deficit no greater than 0.2% of GDP in 2013 (Germany will not achieve this result till 2016), and will maintain that ceiling into the indefinite future. Basically, this will mean the post 2012 Italian budgets will need to aim for an average primary surplus of just under 5% of GDP during the subsequent years, as the weight of the debt is gradually ground down, and the burden of interest costs reduced. This is a difficult, but not impossible task.Between 1995 and 1998, when Italy’s undertook its maximum effort to enter the monetary union, the average primary surplus was 5.0% of GDP. However, during the second half of the 1990s Italy was benefiting from both decreasing interest rates and also from the depreciation of the Lira. In addition the Italian government also implemented a significant privatization programme which helped to reduce the debt/GDP ratio. Most of these positive tailwinds will not be available this time round.

As Deutsche Bank analyst Marco Stringer puts it: "While there are no doubts that Italy needs to maintain a very prudent fiscal policy, there is a risk that an excessive fiscal consolidation could be counterproductive were it to have a significant negative effect on growth".

There is a very real possibility that Italy's fiscal consolidation, like Greece's, is so sharp as to be counter-productive, with the low inflation, low growth and revenue shortfalls making it extremely difficult for the country to reduce to debt to GDP level, even if the ECB maintains 10 year bond yields around 5%. Writing in the Financial Times, International Monetary Fund managing director Christine Lagarde makes exactly this point. “We know that slamming on the brakes too quickly will hurt the recovery and worsen job prospects. So fiscal adjustments must resolve the conundrum of being neither too fast or too slow. Shaping a Goldilocks fiscal consolidation is all about timing. What is needed is a duel focus on medium-term consolidation and short-term support for growth and jobs", she said.

So we really do now have a very high risk stand-off, with Monsieur Trichet and his colleagues holding the whip hand for the time being, as the threat to take the finger out of that dike concentrates attention on the issue in hand. But this upper hand has a definite sell-by date looming if the implementation of the debt-brake principal in a context of global slowdown (or recession) proves too severe for Italian voters to accept. Then the Italian politician's fear of the penalty shot from someone on his own side might just become stronger, despite his apprehension before the technical superiority of M. Trichet's footwork. In which case, someone should remind them over at the ECB that, as Paul Krugman puts it, "once once a country takes on the fixed cost of default, it might as well impose a big haircut on creditors". As the United States discovered in Vietnam, it's easy enough to get yourself bogged down in a mess, but a lot harder to extricate yourself from one subsequently.

This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".

Monday, August 15, 2011

Going Dutch - One Possible Solution To the Euro Debt Crisis?

Looking back over the last 18 months of Europe’s debt crisis, European Central Bank Executive Board member Lorenzo Bini Smaghi recently invoked Winston Churchill’s famous quip, “You can always count on Americans to do the right thing -- after they’ve tried everything else.”

Europeans too, he assured his audience would also get it right, eventually. Unfortunately all the coming and going, procrastination, denial and half measures we have seen since the Greek crisis first broke out have not come without a cost, and this cost can be seen in the growing lack of confidence in the markets that a lasting solution to the underlying problems of the common currency will finally be found. Only adding to the problems, even the Americans seem to be having difficulty finding the right thing to do this time round, or at least doing it at the right moment, as the market turbulence following the S&P downgrade has served to underline.

It’s probably too soon to say whether what Europe’s leaders are about to agree on what will ultimately be the “right thing”, but at least there now does seem to be a general recognition that a defining moment is fast approaching, and fundamental changes to the continent’s institutional structure are now on the table. Among the options now being openly advocated and debated is to be found a measure thought unthinkable a year ago -- ending Europe’s 13 year experiment with a single currency. But even if this ultimate possibility – the so called nuclear option – were to come to pass, as always there would be a right way and a wrong way of going about it.

Few Now Doubt The Gravity Of The Situation

The latest round in the European sovereign debt crisis has been, without a shadow of doubt, the most serious and the most potentially destabilising for the global financial system of any we have seen to date. Pressure on bond spreads in the debt markets of the countries on Europe’s troubled periphery have become so extreme that the European Central Bank (ECB) has been forced to make a radical and unexpected change of course, intervening with “shock and awe” in the Spanish and Italian bond markets. During the first week following the change in policy the bank bought bonds worth a minimum of 22 billion euros. To put this number in some sort of perspective, the entire bond purchasing programme to date for Greece, Ireland and Portugal has only involved some 74 billion euros, and this in over a year of intervention.

Along with earlier interventions in Ireland, Portugal, and Greece, the central bank has become the “buyer of last resort” of peripheral Europe’s bonds, but this can only be an interim measure, since the volume of bonds which would need to be purchased on an ongoing basis simply to stop the Spanish and Italian bond yields rising is so massive that it would put the bank well outside the limits of its original founding charter. It would also put the central bank in need of substantial recapitalisation should Italian and Spanish debt need to be restructured at some point.

And as if all this was not enough, adding urgency to difficulty even core countries like France are now finding themselves drawn into the fray, while the risk of contagion spreading to the East is now far from negligible. The French spread, the extra yield investors demand to buy 10-year French debt rather than German bunds, has jumped to 87 basis points, even though both carry AAA grades from the major rating companies. According to Bloomberg data, this is almost triple the 2010 average of 33. Credit-default swaps on France now trade at around 175 basis points, more than double the rate for protecting German securities.

In addition pressure in both the US and Europe over the debt issue have lead other currencies like the Swiss Franc or Yen (in addition to gold) to very high levels, which in the case of the Franc has a direct impact on households and companies in those East European where borrowing in CHF has been prevalent. This surge in the Franc has already produced worrying repercussion in Hungarian financial markets raising the spectre of contagion spreading to the East.

The gravity of the situation was highlighted when the European Commission President Jose Manuel Barroso explained to waiting reporters at the height of the latest crisis that the current "tensions in bond markets reflect a growing concern among investors about the systemic capacity of the euro area to respond to the evolving crisis."

To be clear, the issue involved is no longer one of the mechanics of Greek debt restructuring, or of the extent of private sector involvement in any such debt adjustment, or even the of the value of the already agreed upsizing of the capacity of the European Financial Stability Fund (EFSF, the bailout mechanism). The current crisis is an existential one, which if left unresolved will rapidly become a matter of life of death for the single currency. In a portent of what may now be to come, at the very same moment in which the board of the ECB was reaching agreement on its latest programme of bond purchases preoccupations were already being aired in Berlin that the sums involved in a generalised rescue might be too large for even the richest countries in the core to accept.

In fairness to Mr Barroso, what he was suggesting was not that the Euro itself was on the verge of collapse, but that there had been a deep and significant shift in market perceptions of the crisis, and that this shift required a new and much more fundamental response from Europe's leaders and institutions. It is the capacity of these leaders to agree on even the broad outlines of a viable and effective response which is at the heart of all the market nervousness, and in this sense the recent decision by the rating agency Standard and Poor's to lower downgrade the US sovereign has only served to complicate further an already complicated situation.

So why this abrupt and dramatic change in the way the game is being played? Undoubtedly the lion’s share of the explanation is to be found in the arrival of a new, and to many unexpected, elephant in salons of European power. With something like 1.9 trillion Euros in outstanding debt, Italy is the planet's third largest issuer of sovereign bonds (following Japan and the United States) and although the relatively high savings rate of the Italian private sector (both families and corporates) means that much of the debt is in Italian hands, the deep interlocking of Europe's financial system (which is a by-product of the deep and liquid bond markets which came into existence following the creation of the common currency) means that a considerable portion is not.

In a certain sense the Italian crisis has crept up on market participants and caught them unawares. The reason for the relative unexpectedness of the scale of Italy’s problems is in part historical accident (that it was Greece, and not say Ireland, that got into trouble first) and in part a reflection of the need for market discourse to find a single and unified focus, and in this case the focus was on deficit and not debt. To put it simply, all too often market discourse could be described as suffering from some kind of “one track mind” syndrome.

The high profile given to the Greek issue meant that to a large extent Europe’s problems were perceived as being fiscal deficit ones, with more fundamental issues like lack of convergence, current account imbalances, cumulative debt and low economic growth all being pushed well into the background. Now things have changed. As former UK Prime Minister Gordon Brown put it recently: “Now no number of weekend phone calls can solve what is a financial, macroeconomic and fiscal crisis rolled into one”. Solving the crisis involves “a radical restructuring of both Europe's banks and the euro, and will almost certainly require intervention by the G2O and the International Monetary Fund”.

Historic Issue With The Euro

Perceived by many as being ill-gotten and ill-born, the issue of Euro parentage has long been a topic of intense debate and controversy, most notably between economists on one side of the Atlantic and those on the other, and between micro- and macroeconomists. There simply has been no consensus on what in fact the problem is, and criticisms from the United States of the way the crisis has been handled in Europe are often felt to be unfair and misplaced. As ECB Executive Board Member Lorenzo Bini Smaghi put it in July speech to the Hellenic Foundation for European and Foreign Policy, in the United States a significant financial crisis does not call into question the whole institutional and political set-up, and the dollar itself is not considered to be at risk. In Europe, in contrast, a crisis is often considered by outside observers as putting the euro, and the Union itself, at risk of disintegration. “Academics and other experts deliberate on whether the euro area is viable and how it can be rescued. Closet eurosceptics suddenly reappear, dusting off their I-told-you-so commentaries”.

Whilst Mr Bini Smaghi undoubtedly puts his finger on the core of the issue in this statement, and most certainly reflects the level of frustration felt by key players in European decision making, analogies with individual states in the Union simply fail to get to the heart of the reason for much of the preoccupation. It is not simply a question of “closet” (or open) eurosceptics suddenly reappearing, but of the monetary union repeatedly showing fault lines exactly where many of those much berated macroeconomists had expected they might appear. This is why Mr Brown is undoubtedly right to focus on the fact that beyond an immediate fiscal crisis, what we have in Europe is also a crisis of macroeconomic management and of financial stability. As he so eloquently puts it, what many were worried about was the fact that the initial Euro design contained "no crisis-prevention or crisis-resolution mechanism and no line of accountability when things went wrong".

Naturally Gordon Brown is far from being the first to have voiced such views. The fact that economies in Europe’s core and those on the periphery far from having converged have actually been diverging under the watchful eye of ECB monetary policy has long been a cause for concern in macroeconomic circles. In particular, at the heart of the monetary union’s current problems lie the huge imbalances which have been generated between the economic “surplus” countries in the core, and the external deficit ones on the periphery. Europe’s leaders have long avoided biting the bullet, and indeed could be considered to be in deep denial, over the significance of this issue. Referring to the prevailing voices among European policymakers former IMF Chief Economist Simon Johnson put it this way:

“I vividly recall discussions with euro-zone authorities in 2007 — when I was chief economist at the I.M.F. — in which they argued that current-account imbalances within the euro zone had no meaning and were not the business of the I.M.F. Their argument was that the I.M.F. was not concerned with payment imbalances between the various American states (all, of course, using the dollar), and it should likewise back away from discussing the fact that some euro-zone countries, like Germany and the Netherlands, had large surpluses in their current accounts while Greece, Spain and others had big deficits”.

The fig-leaf of Europe’s nations being somehow equivalent to US states has long been held up to justify the idea that the common currency was in general working well, and that the problems involved in managing it were being greatly exaggerated. With the arrival of the Italian elephant onto the centre stage at a stroke this argument has become as outdated as the institutional structure which lay behind it, since few of core Europe’s leaders are really willing to accept the responsibility for giving full and lasting guarantees for the country, quite simply because it is not just one more state in a fully integrated union, but a sovereign nation with all that that implies.

Having said this, there can be no doubt that Europe’s leaders have made huge strides forward in their attempts to get to grips with the issues as they have presented themselves, even if the measures taken so far continue to fall woefully short of what will eventually be needed. As the crisis has moved on from the initial concerns about Greek accounting methods, the piecemeal approach adopted by European policymakers has lead them to erect what is now a veritable production line of crisis resolution instruments and departments, with each of the needy patients being situated at different stages of the treatment process. In the Greek case the underlying issue is now acknowledged to be a solvency one and teams of experts are hard at work in a seemingly endless struggle to try to decide just what degree of restructuring (and/or reprofiling) Greek debt will finally need. In the Irish and Portuguese cases the task still remains one of monitoring programme implementation, with the focus being on whether or not they will eventually require (Greek style) a second stage bailout package. Meanwhile in the antechamber, the Spaniards and the Italians patiently wait their turn, while the doctors and health system administrators hold a heated debate as to whether there is enough space available in the emergency ward, and whether the patients have sufficient insurance to cover them should the surgery need to be drastic.

Too Big To Fail (Or Save)

What now brings a renewed sense of urgency to the whole process is the question of whether Spanish and Italian bonds could soon find themselves shut out of the financing markets in the way their smaller predecessors were before them. The latest ECB decision to intervene in their bond markets would seem to make it more rather than less likely that they eventually will be, since it is hard to see how they can now move back to unsupported market prices.

One of the curious anomalies about how the debate is currently being framed is the way in which banks and money funds who have invested in Europe’s periphery are being told that it is only right they should now assume some part of the anticipated debt restructuring burden due to their earlier policies of “irresponsible lending”, while these very same investors are also being urged to purchase new issues of just this very debt, on the argument that risk is exaggerated since the countries concerned have essentially sound economies, and are only suffering from short term liquidity and balance of payment type problems.

The underlying dilemma for such institutions has been highlighted by the decision of the Italian market regulator Consob to request information on the recent move by Deutsche Bank to reduce its exposure to Italian government debt. Banks have some responsibility to their clients, and will not normally knowingly take decisions which will lose money for them. So it is only rational for them to try to “lighten up” their positions on some of Europe’s weaker sovereigns. What isn’t credible is for political leaders to at one and the same time tell the banks that they are lending irresponsibly and urge them to purchase debt which may well end up being restructured. Thus the recent insistence on private sector involvement in Greek restructuring is often not unnaturally seen as one of the triggers for financial institution flight from Spanish and Italian bonds.

The Deutsche Bank case is a good illustration of the problem being faced by both the banks themselves and by those trying to maintain confidence and stability in the sovereign debt markets. According to data from the bank’s quarterly results it reduced its net exposure to Italian sovereign debt from 8 billion euros in December 2010 to 997 million euros at the end of last June. To put this in some sort of perspective, over the same period it cut its exposure to Spanish debt by some 53% (to 1,070 million euros) while the reduction in their Italian debt holdings was of the order of 87.5%. It is this difference in velocities of sell-off which in large part explains the recent surge in Italian bond yields, making it now potentially more expensive for Italy to finance itself than it is for Spain. And the reason for this is simple: previously Italy was seen as effectively isolated from contagion problems on the periphery, while Spain was not.

While yields on 10-year Italian government bonds have now fallen back significantly from their earlier euro-era highs, Spain’s have fallen further, and before the ECB intervention Italian yields had risen 1.26 percentage points since the end of June while Spanish yields had only risen by about half that amount.

Really the Italian situation is by far the most complex one facing the Euro system at this point in time. In the years prior to the outbreak of the financial crisis in 2007 Italy’s debt had long been a focus of attention among those who were worried about the effectiveness of the Euro Area’s Stability and Growth Pact whereby countries were expected to maintain deficit levels below 3% of GDP annually, and cumulative debt levels below 60% of GDP. In fact, according to IMF data, gross Italian government debt hasn’t been below 100% of GDP since 1991, and the country entered the financial crisis with a level of around 103% of GDP. During the crisis the country remained beyond the searching gaze of financial market interest by keeping its annual deficit at comparatively low levels, but a combination of recession, low growth and a substantial interest payment burden on the already accumulated debt has seen the level rise steadily to an estimated 120% of GDP this year.

Effectively Italy is poised on what is often termed a “knife edge”, since in order to stop this percentage snowballing upwards the country needed a growth rate in nominal GDP (that is uncorrected for inflation) of around 3% a year, and this at the rates of interest being paid before the recent surge. This effectively means a growth rate of 1% and an inflation rate of 2% (on average, and over a significant period of time). This growth number may not sound too ambitious, but as the Italian economist Francesco Daveri points out, Italy’s average annual GDP growth rate has been falling by around 1% a decade since the 1970s, and average growth between 2001 and 2010 was only around 0.6% per annum.

After falling by something like 6.5% during the crisis the Italian economy did manage to grow by 1.3% in 2010, but growth in the first half of this year has already been weak, while all forward looking indicators suggest it will be weaker in the second half. Thus analyst estimates of an eventual 2011 0.8% growth rate seems if anything optimistic, and with the IMF forecasting 1.9% inflation during the year, the numbers just don’t add up.

And that, of course, was before interest rates started to rise. While the new higher interest rates won’t have a huge impact in the short term, as existing debt needs to be steadily refinanced the extra cost will simply mount and mount. Which is why the Italian government is in a huge bind. It doesn’t have a debt flow problem, it has a debt stock problem, and as the risk premium charged on Italian debt rises and rises, and as the growth outcomes fail to meet the often optimistic targets, then the snowball of debt steadily slides its way down the mountain side with little the government can do to stop it growing as it moves. Like some modern Sisyphus, they are condemned to struggle with a monumental task where advance seems well nigh impossible. Out of good taste it would be better not interrupt them in their labours to ask whether, Camus style, they are still able to maintain a smile on their face.

They Ain’t Coming to Bailout, No..., No..., No..., No..., No!

Those who most definitely are not smiling at this point in time are German politicians and voters. As Christian Reiermann comfortingly informed Der Spiegel readers recently: “The euro zone looks set to evolve into a transfer union as it struggles to overcome the debt crisis. There are a number of options for the institutionalized shift of resources from richer to poorer member states -- and Germany would end up as the biggest net contributor in every scenario”. These are emotive times, but feelings of outrage are not necessarily the most reliable guidelines to steer by in the search for durable solutions to complex problems.

The Italian hit may well be the most recent and the most spectacular the common currency has suffered in the 10 short years of its existence, and it may have created the problem which is quite literally too big to handle with the present institutional structure, but it really is only the latest example of that complex mix of fiscal, macroeconomic and financial issues that have come to plague the Euro which Gordon Brown draws attention to, and these issues do, by and large, go back to a design fault which was in there from the start. So while Europe’s unhappy families may all be unhappy for a variety of different reasons, the root of the problem is that the project as it was set up contained all the mechanisms for creating the problems, but few of the ones which would be needed for resolving them.

Large structural distortions were able to build up over the earlier years of the currency’s life, but now it is very hard to see where the much needed remedies are to come from. Some sort of fiscal union is now widely if belatedly seen as forming a necessary part of a well-functioning monetary union, but trying to introduce one at this stage in the game, when many of the countries along the periphery have suffered a substantial competitiveness loss in relation to those in the core seems to lead to only one conclusion, the kind of transfer union that so worries Christian Reiermann and so many of his fellow citizens.

Europe already has examples of just this kind of transfer union between higher growth and richer regions and their lower growth and poorer neighbours in Germany, Italy and Spain, and in no case can it be said that such arrangements have proved popular with those who are asked to be the net contributors. So it is not hard to reach the conclusion that this kind of fiscal union would be simply unsustainable in the Euro Area context at the present time.

The only real way forward is for those who have lost competitiveness to somehow regain it. This, as we are seeing, is far easier said than done. Most of the proposals which have come from the EU Commission and the IMF to date involve some kind of micro-level productivity-enhancing structural reforms, but these are not able to raise growth rates sufficiently quickly (indeed there is very little real evidence of the extent to which they are able to do this in any event), and inevitably involve the countries involved trying to “out-Germany” the Germans, which culturally on the face of it seems to present them with an almost impossible challenge, especially when German companies are hardly marking time themselves.

Normally, the classic solution in this situation would have been some kind of devaluation, but obviously these countries have no currency left to devalue. Another possibility would be the kind of “internal devaluation” process which has been tried in the Baltics, and a number of macroeconomists (myself included) have been arguing for this, but the complete lack of any kind of positive response makes the viability of even this approach hard to contemplate, and anyway, systematic deflation would in many cases only make the debt problem worse.

Euro At The Crossroads

So the Euro is now at the crossroads, and important decisions need to be taken. Preserving the Eurozone -- as it is now -- might be workable if it were possible to transform the Eurozone into a full fiscal union where budgetary policy was coordinated across nations by a central treasury in the way major programmes are between states in the US. But such an arrangement is a now a political impossibility, as Europe’s core economies would inevitably reject what would be seen as a permanent transfer union between high-growth regions and their poorer neighbours.

However the present debate about creating Eurobonds is resolved, these alone will not solve the problem at this point, and, as many observers are noting, may even make matters worse by weakening the sovereign credit ratings in the core. In the longer run they could form part of a more general solution, but the moral hazard dimension they entail means that in the absence of a fix for the immediate competitiveness problems on the periphery they only risk making the common currency project even more politically unstable. Such is the price for so much procrastination and denial. As Citibank’s Chief Economist Willem Buiter so delicately put it recently, attempts to transform the current bailout mechanisms into a transfer union would be doomed to failure since “the core euro area donors would walk out and the periphery financial beneficiaries would refuse the required surrender of national sovereignty”.

So, with fiscal union effectively off the table, there are basically three possibilities. The first is to stay more or less where we are, maintaining and even expanding the bond purchasing programme of the ECB, and simply trying to hang on in there. The stability fund could be increased, but the more numbers start being accounted in detail the further away the various parties get from being able to agree. If this continues the ECB is likely to reach a ceiling beyond which it will be more than reluctant to continue buying, since the bank takes the view that the resolution has to come from the politicians.

But with Italy and Spain’s combined sovereign refinancing needs between now and the end of 2012 totalling something like 660 billion euros, and the financing needs of the banks to take into account on top, reaching agreement to expand the bailout mechanism on this scale looks like a pretty improbable outcome, especially when you consider that once you are that far in you will simply have to continue all along the road. So at some point the spreads will start to widen again as markets force the issue, with the inevitable outcome that the monetary union is pushed towards the brink of breakdown.

The second possibility would be to disband the union entirely, leaving everyone to go back to their own national currency. This would be a disastrous outcome for all concerned, and for the global financial system. Coordinating the unwinding of cross country counter liabilities would be a nightmare given the level of interlocking in the corporate and sovereign bond markets, and the sudden disappearance of one of the major global currencies of reference would cause havoc in financial markets. The dollar would most likely be pushed to unsustainably high levels in the rush for safety, and it is only necessary to look at what is currently happening to gold, the Swiss Franc and the Japanese Yen to catch a glimpse of what would be in store.

Evidently this kind of violent unwinding would never be undertaken voluntarily, but that does not mean that it is an eventuality which might not take place, if solutions are not found and the force of market pressure continues and even augments.
Fortunately there is a third alternative, even if it is one that at first appears no more appetising than either of the other two: the Eurozone could be split in two, creating two different euro currencies. Naturally the composition of the groups would be a matter of negotiation, since some countries do not easily belong in either one group or the other. The broad outline is, however, clear enough. Germany would form the heart of one group, along with Finland, Holland and Austria.

In addition Estonians have been making it pretty that they would also be up for the ride. Spain, Italy and Portugal would naturally form the nucleus of the second group, with Slovenia and Slovakia being possible candidates. Some countries, Ireland and Greece for example, might simply choose to opt out.

The big unknown is what France would do. In many ways it belongs with the first group, but cultural ties with Southern Europe and political ambitions across the Mediterranean could well mean the country would decide to lead the second group. Naturally if what was involved were not ultimate divorce but temporary separation, then French participation with the South would also have a lot of political rationale. The term Franco-German axis would gain a whole new meaning.

Naturally the technical challenge would be enormous, but it would not be insurmountable. The great advantage of such a move would be that two of the major burdens under which the monetary union is labouring – the lack of price competitiveness on the periphery and the lack of cultural consensus between the participants - would be resolved at a stroke.

No one knows the values at which the two new currencies would initially operate, but for the purpose of a thought experiment let’s assume a Euro1 at around U.S. $1.80 (the euro/USD is currently around US$ 1.40), and a Euro2, at around $1. Obviously, in the short term the winners of this operation would be the members of Euro2, who would get the devaluation their economies have been yearning for. Why would this be? At a time when the countries concerned are loaded down with debt and domestic demand is correspondingly weak, export growth is the only way for their economies to move forward, and the change would allow cheaper labor and production costs, giving them an enormous push in this direction.

And it would encourage growth in other ways. Take Spain as an example. The country has at the present time a large pool of surplus property, on many estimates of around 1 million unsold new housing units. Many have criticised the banking sector for not dropping prices sharply to enable the market to clear, but the banks are understandably reluctant to do this due to the impact this would have on their balance sheets, and due to the knock-on effect on their existing mortgage books. The beauty of this solution is that no further drop in price would be needed, since for external buyers the real price of all this housing would suddenly become much cheaper.

The case of tourism would be somewhat similar, since not only would more tourists come to Spain, they would come for longer and they would spend more. The shopping bags would certainly not be empty on the plane home.

Spain’s troubled savings bank sector has been desperately looking for foreign investors to help them recapitalise, but while many have shown interest virtually none have participated to date. After the devaluation all this would change since they would be able to buy shareholding at attractive prices, and without having to worry about a sudden drop in prices and hence loss of capital.

Spain’s 4.5 million unemployed would gradually start to go back to work, new investment could steadily be attracted for other productive projects in manufacturing industry, no one would doubt the solvency of the Spanish state, and the private sector would be in a better position to start paying back its debts as the economy grew.

Now obviously, as we all know, in economics as in life there are no free lunches, so there must be a catch here somewhere, and of course there is. In fact there are two big “catches”. In the first place those countries who joined together to form Euro1 would be making a big sacrifice, since many of them also depend on exports for their livelihood, and their manufacturers would suddenly and sharply find themselves at a disadvantage. In particular Germany would suffer.

However, assuming that all can agree at some point that the current arrangements are unworkable, and that going back to individual national currencies would be a disaster, then the German sense of responsibility and the country’s commitment to the European project might well make the acceptance of some sort of sacrifice (and especially if it were a sacrifice which offered longer term solutions) bearable. Fortunately, recent German historical experience provides us with two concepts which might just help everyone see their way through this. The first of these is the Treuhandanstalt, the Privatisation institution (and bad bank) which was created to handle East German assets between 1990-1994. The second is Lastenausgleich, or burden sharing, and this refers to the mechanism which was used to share the unequal outcome of WW II between Germans who found themselves living in the West: between those who had come from the East and lost everything and those who were from the West and had retained something.

The Treuhandanstalt experience is useful in helping us to think about how to handle the common set of assets/liabilities acquired during the initial Euro stage. Think about Spain’s banks and their property assets. These would now be sold in Euro2, but many of the liabilities which correspond to them are in fact liabilities with institutions who will find themselves in Euro1. Marking them to market immediately, and in Euro2, would produce sizeable losses in the Euro1 financial sector. Some of these losses are inevitable and to some extent correspond to the kind of restructuring haircuts which are now being contemplated. But in the initial period (and for reasons which will become clearer below) it would be advisable not to mark them to market, but to hold them for a specified time in a common institution of the Treuhandanstalt kind.

As I say, some losses are now inevitable, and this is where the second concept from recent historical experience – Lastenausgleich, or burden sharing – becomes important. Despite protests to the contrary from Lorenzo Bini Smaghi (link) the Euro experience to date has not been a success for any of the participants once you add-in the potential losses which are now looming. At the same time the common currency has been a shared experience, in which all have taken part, so it is not unreasonable to assume that all should share when it comes to the downside. The problem with the measures adopted to date is that they are perceived on both sides of the fence as unfair. Those who are funding the bailouts feel that they are being asked to pay for the “excesses” of the recipients, while those who receive feel that what they are getting is not help, but loans which make it easier for the financial sector in the donor countries to avoid declaring losses. This “communicational impasse” is one of the major reasons the current approach won’t work.

What is needed at this point is an appeal to the European spirit of the Euro1 countries, in a way which helps them to see that some costs are unavoidable, but that any agreed costs will be shared, and above all that the game-changing solution is workable and offers some sort of constructive positive future for all Europeans. Put in other words, what we need is a mechanism which contains both realism and idealism in just sufficient proportions.

The advantage that the split Euro option has over all the other proposals on the table at the present time is that it would address the growth issue head on. The countries on Europe’s periphery could return to growth, and once the economies involved start growing rather than shrinking the proportion of the liabilities incurred during the earlier period which they will be able to pay rises significantly. It is much more difficult to collect debts from an unemployed household than it is from one which is gainfully employed.

Another attractive feature of this proposal is that no “in principle” decisions would need to be taken about the long term structure of the European financial system. The ECB could be retained as a kind of holding entity and clearing house for the outstanding financial mismatch, and the current national central banks could be grouped into two separate sub-entities. This would leave open the possibility of reconvergence at a later date should conditions obtain which would make the move viable. The first stab at creating a currency union has failed, but this doesn’t mean that any possibility of creating one in the future should be abandoned. Hard and costly lessons have been learned, and what is now needed is a full and open discussion of the reasons for failure, precisely to avoid similar mistakes being made in the future.

Having the move co-ordinated by pan-European institutions has another advantage, and that is to do with the degree of conditionality the process must involve. Devaluing their currency would, as I have suggested, give a great short term boost to growth in countries along the periphery, but this short term boost would only be converted into a long term sustainable improvement in trend growth if a lot of other things were done too. It is very easy to laud the great advance Argentina made on breaking the dollar-peg, but look where Argentina is today. This “short sharp shock” treatment only has a lasting impact (as it did in Scandinavia in the 1990s) if measures to improve institutional quality (reformed labour and product markets, productivity and innovation drives) are implemented and maintained. Here again partnership is needed, since while giving back to the periphery “ownership” over its own reform programmes would be another significant advantage of the arrangement, the reform process would need to remain under the auspices of a common European project, one which could lay the basis for a consensually grounded lasting political union, a union which would be the essential precondition for any future attempts to move back towards greater monetary integration.

Effectively Europe’s leaders are caught in a kind of Pavlovian trap. There are no easy choices, although there are good ones and bad ones. Staying where they are leaves them in a kind of permanent electric shock zone where their constant feeling of failure only serves to further deteriorate their own sense of personal and political worth. Advancing also seems painful, but more than the intensity of the shock it is the sensation of fear and angst which dominate. Still there is no alternative but to advance, since you cannot stay where you are. Simply applying administrative measures to force stability onto a financial system which resists with all its might will only result in increasingly destabilizing behaviour (read “speculation”) by the agents within the system. Administrative fiat simply represses and pushes forward instability (read” kicks the can down the road”), leading the system itself to become ever more inefficient. In any malfunctioning financial system, as the late Hyman Minsky famously said, “stability is itself destabilizing”.

Perhaps it is appropriate to close this essay where it started, with a quote from ECB Board member Lorenzo Bini Smaghi: “as J.K. Galbraith observed: “Politics consists in choosing between the disastrous and the unpalatable”. To see disaster looming before choosing the unpalatable is a dangerous strategy”.

This article is an expanded version of one which was originally published on the website of the US magazine Foreign Policy, under the title "The Euro and the Scalpel"

Appendix - The Way To Split The Euro

This article was written during 4 days I spent in Marbella earlier this month in the home of my friend and colleague Detlef Gürtler (author of the recent book Entschuldigung! Ich Bin Deutsch (Sorry, I'm German, Mermann Verlag GmbH, Hamburg).

While I was busying myself with the text, Detlef was working on the images (which can be found above), and on some illustrative material for the technical side.

These graphics only give some illustration of just how complex any unwinding of the commen currency would be, given how interlocked the financial sectors of the participating countries have become.

Some sort of holding entity would need to accept responsibility for a whole range of problematic assets during any transitional period. This entity could be the ECB. The though behind the idea that not everything should be marked to market immediately is that the Euro2 countries are nothing like so weak as the initial value of the new currency would suggest, nor are the Euro1 countries so strong as is often thought. So inevitably the parity at which the two would exchange would converge towards a much tighter band, which would be much closer to the real competitiveness difference between the various countries. Naturally it would make a lot more sense to mark to market at this point, since the losses to be borne on both side would be that much smaller.

It is also worth stressing that this solution is far from perfect. We do not live in an ideal world. It is only one possible way of breaking the vicious circle into which the Euro Area countries have now fallen. It is one possible way, and as far as I can see the only viable and realistic one.

This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".

Is The Risk Accompanying Estonia's Eurozone Membership Really So Low?

"But the go-ahead Estonians are already scenting the next challenge. Should the single currency crumble, they are determined to be on the inside track for any new German-centred “super-euro”. Goodbye “eastern Europe”; welcome to the “new north”."
Edward Lucas, writing in The Economist

Estonia's economy put in another sterling performance in the second quarter of this year, even if the expansion rate fell back to quarterly 1.8%, down from 2.4% in Q1, and 2.5% in the last quarter of 2010. Well, you didn't expect the economy to keep growing at such strong rates for ever, did you? Evidently not. The interannual rate peaked at 8.5% in the first quarter, and dropped back slightly during the last three months to 8.4%, still this is no mean pace.

But given that the good things in life don't last forever, the real question now facing analysts and policymakers is not whether a fall of a tenth of a percentage point is significant, but rather the much more critical one of just how long the Estonian economic expansion can be kept going in the face a a more general European slowdown, given that the economy is now almost entirely dependent on export expansion for GDP growth?

Exports have been very strong so far this year. Although imports have more or less risen in lock-step.

Consequence, while the goods trade deficit has been substantially reduced, what remains stubbornly resists being eliminated.

Which draws attention to another feature of Estonian goods exports, a lot of them are processed products which are effectively re-exports of previously imported components, hence the value added component supplied by Estonian manufacturing is comparatively small. The share of value added in manufacturing (as a % of GDP) has risen sharply in recent quarters, from the earlier crisis lows, but at around 19.5% it is still up only about 1.5% on the pre-crisis levels. However, within this the share which is oriented to exports has undoubtedly risen.

Still, with value added in manufacturing under 20% of GDP, driving growth forward in the future is not going to be easy, especially now that a Europe-wide slowdown is gradually taking hold. And in a sign of what may now be to comme, exports fell sharply in June, to around 950 million Euros, from an average of 1.1 billion euros in the March to May period.

Indeed industrial output hit a local high in March, and has subsequently fallen back.

Retail sales are barely up from their sharp drop, and are unlikely to give much momentum to the economy in the months and years to come due to the substantial debt overhang which the household sector is still struggling with.

Likwise there is not much sign of a return to life in the construction sector outside government sponsored infrastructural activity.

Unemployment has fallen, but continues to remain high, and in fact the 7,000 drop between Q1 and Q2 is really quite small when seasonal factors and the fact exports were growing furiously are taken into account. It would thus not be surprising to see the numbers of unemployed once more rising going into the winter.

So the big question here is not whether Estonians worked hard to contain their fiscal deficit (which they obviously did), or whether they carried out some form of internal devaluation (they surely did). The key question is whether their internal devaluation went far enough, and whether the exchange rate with which the Estonians entered the Euro was not too high for their needs (a mistake the Germans made in the late 1990s, and which they subsequently paid for in quite costly fashion).

What does not seem to be generally understood in this whole "Estonia" debate is what the expression "export dependence" means. It doesn't simply mean that exports will play a significant part in forthcoming Estonian growth (I think that all parties are now agreed that this will be the case). It means that the level of household indebtedness coupled with the ageing population phenomenon means that domestic consumption driven growth is now a thing of the past, and what is worrying about the Estonian situation is the comparatively small size of Estonia's manufacturing industry.

New credit growth has all but disappeared in Estonia.

Something which is in many ways reminiscent of what happened in Germany following the unwinding of their 1990s consumption boom.

People are still waiting for the return of a housing boom in Germany (see mortgage chart below) but they will wait idly, demography virtually guarantees that, just as they will wait idly in Estonia for a return of the good old days, and meanwhile precious time is being lost.

Estonia's current account has now corrected:

Just as the German one did before it.

But Estonia still has some way to go before it realises CA surpluses on the scale which Germany does. And it still has even more way to go before it recovers the level of economic output attained before the onset of the crisis. Despite the strong recovery of the last year, Estonian GDP is still 10% down on its earlier peak.

Which is why it is worrying that Estonian inflation continues to run above the Euro Area average. This is not the way to improve competitiveness, and it is horribly reminiscent of the path which was trodden by peripheral economies to the West and the South after they joined the common currency. It doesn't really seem that too many lessons have been learnt here.

Strangely, as a country which has recently entered the common currency, country risk seems to have followed a path which is rather nearer to that of its Baltic peers than to that of equivalent Euro Area countries. Credit Default swaps on Estonia have fallen and remain down, whilst those of its East European Euro peers (Slovenia and Slovakia) have risen as one might expect as the crisis of confidence in the currency has grown.

It is not my intention here to single out Estonia for special - negative - treatment (that would not be warranted) but the value being placed on the CDS really is incredibly low for a country that just entered a Euro Area whose outlook could, at the very least, be considered as reasonably uncertain. It is being priced as part of core Europe, when in reality it forms part of Europe's periphery. Evidently, were the Euro to break in two, Estonia would incline towards riding with the German lead group, but given the fact that the country now has a totally export dependent economy, and a currency which was arguably over valued at the time of Euro entry (and continue to have ongoing above-Eurozone-average inflation) it is not clear how prepared the country would be to handle the challenges of being attached to the new, and ultra-high value, currency which would be created.

Thus we find that a country which two years ago was being valued as having the third-riskiest sovereign debt in the European Union is now trading in quite another league, and finds itself included among the European "top ten" sovereigns in terms of price. Last week, while French CDS were hitting Euro era highs of around 160 bps, Estonian ones were sitting pretty at around 115. And just after S&Ps downgraded US sovereing debt, they upped the Estonian rating by two notches to AA-.

Their Valour Is Not In Doubt

"That he which hath no stomach to this fight,
Let him depart; his passport shall be made,
And crowns for convoy put into his purse;
We would not die in that man's company
That fears his fellowship to die with us".
William Shakespeare, Henry V, the Saint Chrispin's Day Speech

So the question I ask myself (as I did in this earlier post), is whether this kind of realignment in valuations makes any kind of economic sense? Of course positive comparisons with the United States and France are flattering, but am I the only one to see something funny going on here? Is contagion risk being reasonably priced in, is the risk of Euro Area break up being adequately priced, and if it isn't, do we not face the risk of a sudden (and hence destabilising) adjustment in the not too distant future?

Is there now nothing left to economic life but fiscal policy, or have we all collectively lost our sense of perspective? How can an economy which still shows the living scars of its earlier sharp distortions be so highly rated?

Obviously, it is clear that the Estonian Sovereign was never, even during the worst moments of the financial crisis, and under the most severe of worst case scenarios, the third riskiest to be found within the frontiers of the EU (Estonia was the only EU country to have a budget surplus last year - worth 0.1 percent of GDP - while public debt totaled a mere 6.6 percent). On the other hand it is the case that Estonia faced an extremely challenging crisis in 2008/09, and had the Euro peg collapsed in one of the four East European countries who had one at the time then the pressure of private debt could certainly have confronted the country with some very complex and difficult choices.

But Their Wisdom, And Sense Of Foresight.........

Following the argument along a bit, it is far from clear that the current level of Estonian CDS prices risk in in any more satisfactory way than it did at the height of the crisis, since membership of the Eurozone has brought with it both positives and negatives. The 0.28% contribution of the country to any future EFSF bailouts may not seem like a very big deal, but in comparison to Estonian GDP the sums involved may well be far from trivial. The country does not have, and is not likely to have, either a fiscal deficit or a sovereign debt problem, nor does it have a home grown banking system which might need bailing out. The risk to Estonia comes from elsewhere, from its association with Ireland, Spain, Greece, Portugal and Italy. Depending on how far the core EU countries are willing to finance debt and absence of growth in those countries the Eurozone's future is far from clear. If, as Edward Lucas speculates, a division to go with the strong currency German lead component which could be created in the case of break-up, Estonia's leaders may live to rue the day they missed the opportunity to make a substantial devaluation in the currency before entering the Eurozone.

This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".