Getting that sinking feeling

by David Taylor

It’s been talked about to death over the past 12 months, but the reality is that very little genuine progress has been made to stabilise Europe’s ailing economy. This weekend G8 leaders met in the United States to try to find a coherent message (or strategy) to take back to members of the euro zone in the hope of building some level of confidence. Even that’s a tall order though given the political wedges that have now become all too apparent.

To bring you up to speed, during the week: Spain joined several other European countries (including Britain) in recession; Greece’s credit rating was downgraded further into “junk” status territory by one of the international credit ratings agencies; several banks in both Greece and Spain were also downgraded (contributing to what looks like developing bank runs in both countries); Greece failed to form a government - leaving a judge now running the country (fresh elections are set for the 17thof June); increasing signs that Greece will no longer implement the austerity plans that enable organisations like the International Monetary Fund to support its economy; and increasing signs of international political frustration from European leaders like British Prime Minister, David Cameron, who told parliament the euro zone needs to “make-up or break-up”.

Perhaps the most disturbing trend though is the increasing political pressure being applied to the German chancellor, Angela Merkel. It seems that now both the French and American presidents are calling for Mrs Merkel to change her approach to solving the economic crisis from an austerity bias, towards policies that instead promote growth in the euro zone periphery countries struggling to stay afloat.

The reason more leaders are starting to question the wisdom of the original German-led recovery plan is the now growing understanding that austerity leads to countries falling further into the debt trap. That’s not to say that growth policies are indeed the solution, but it is a recognition that what’s currently being implemented is not working.

Unfortunately the reality is that no one seems to have a solution just yet. Part of the reason for that, as David Cameron pointed out, is that we’re in “unchartered territory”. It’s creating a growing sense of panic in financial markets. When Argentina got into trouble in late 2001 and early 2002, the currency (pegged to the US dollar) was left to its own devices. It then plummeted which gave the country a lifeline out if its economic crisis. But Greece, and Spain for that matter, don’t have that ‘luxury’ because they are both locked into the single currency block.

The obvious answer then is that Greece leaves the euro zone and returns to the drachma. It’s set adrift and is given the space to re-establish itself (mainly through working on its international competitiveness). Think of it as ‘swimming sideways to get out of the rip’. Again though, that’s still far from a fix-all because it would no doubt lead to a full blown bank-run (as Greek deposits tumble in value after the drachma/euro conversion), and a credit freeze ( given the number of debt contracts that would dramatically fall in value – in the euro bond market - and the short term panic it would create).

Global share markets have had a particularly rough week too because the US (previously considered to be on the right track for an economic recovery) showed signs of engrained fundamental economic weakness (especially in regard to the country’s manufacturing sector – the engine room of economic growth), and China revealed some less-than-inspiring figures on its economy.  See the interesting point to make here is that Europe is not necessarily the biggest problem facing China’s economy right now. It could be China itself - specifically, the growing uncertainty around whether its transition to domestic consumption (and away from export-led growth) as the made contributor to economic growth is working. Of course fears of a property market bubble are also no doubt weighing on the minds of policy makers.

Australian resources stocks were among the worst performers on the local share market this week given their dependence on a strong Chinese economy. Of course there are still those that argue the mining boom has a long way to go (including Allan Trench from the University of Western Australia), but there now seems to be a growing number of sceptics.

Those sceptics have of course contributed to a fall in consumer confidence, and now more talk of some aggressive interest rate cuts in the near term by the Reserve Bank.  Current forecasts are that the official cash rate may bottom out around 50 basis points (0.5 per cent) below where it rested during the global financial crisis.

As you can see it’s all looking rather unstable, unpredictable and volatile. That to me suggests one thing: Markets are pricing in another developing crisis.

David Taylor

Disclaimer

The content in my blog is non advisory, please do not interpret this as advice in any way shape or form. These are just my thoughts and nothing I say should be acted upon.