The EU at a Precipice

Disintegrating From the Inside Out

Europe as we know it is disintegrating.

Despite more than two years of summits, pronouncements and agreements, the European Union has been unable to do much more than delay the economic consequences of the sovereign debt crisis.

Worse, EU economic diktats preaching strict austerity as the path to growth and prosperity have thus far only deepened recessions within the bloc, weakening national finances and causing widespread social unrest that will soon be registered at the polls, leaving Europe’s future course uncertain at best.

And this matters.

The EU collectively has a GDP of over $16 trillion. That’s larger than the United States, which itself is the single largest national economy in the world.

In an integrated world economy, where goods and services – and crucially investment- move at the speed of a mouse-click, it is simply impossible to believe that a major economic disruption in Europe will not have knock-on effects in the US and the rest of the world.

This deepening crisis that Europe is experiencing is not for a lack  of the continent’s best minds trying to find a comprehensive solution. Literally trillions have been expended trying to nurse the EU back to health.

But it has become increasingly clear that the EU ship of state will ultimately fail because the very proposition of the EU is the main problem; a tight monetary union of sovereign states without the political or governance authority to manage and enforce common fiscal/economic policies.

The two obvious solutions – a new political treaty among the members, delegating significant national economic and budgetary sovereignty to the EU – or creating a succession mechanism to allow struggling EU members to exit the Union and re-establish their own currencies, are either too time-consuming or politically untenable or both.

A third path, for Germany and other frugal northern European countries to use their excellent credit to back Euro-bonds that would effectively guarantee all the bad debt of at-risk countries under the current EU framework is as economically feasible as it is politically impossible.

So we are left with the half-measures that have been implemented to date.

Indeed, the EU has come together with a bailout fund of over $1 trillion for at-risk nations, subtly backstopped by the IMF and their financial resources.

Operationally, the Greeks have been bailed out – twice – and EU leaders effectively created a suspension of disbelief by insisting that a take-it-or-leave-it 50 percent haircut imposed on private investors of Greek debt did not constitute a national default. In addition, leadership changes, bailout money and/or national economic restructuring have calmed markets as problems brewed in Portugal, Ireland, Spain and Italy.

But as trailblazing as these steps were, they were ultimately reactive policies designed to address symptoms and not the disease.

Indeed, some of the Euro solutions have made things worse.

Consider that in an effort to recapitalize European banks weakened by bad loans on their balance sheets, after Greece had been stabilized, the European Central Bank (ECB) lent out over a trillion dollars to Euro banks at near zero interest rates for a three year term. Flush with capital, the thinking went, these banks could then extend credit to businesses that would help catalyze economic growth.

Instead, and not entirely by accident, the banks took their nearly free money and invested it in sovereign debt, earning a handsome profit where spreads could be as high as five points. In so doing, the private sector banks helped the EU manage the confidence crisis in Italy and Spain earlier this year, when interest rates on ten year bonds for those countries exceeded the six percent sustainability threshold, effectively containing a potential financial contagion.

But the ECB’s Long Term Refinancing Operation (LTRO) is a wolf in sheep’s clothing.

There has been little commercial lending, given the recession or near recession in most EU countries, and the strict credit standards that apply in an uncertain marketplace.

At the same time, while the banks have made short term profits on sovereign debt investment, the end of the second trauche of the LTRO has left the banks with no additional money to invest in the sovereign bonds. That places those bonds back at the mercy of the international bond markets, whose influence was artificially dampened and obscured by the avalanche of ECB euros.

Now there is a double danger.

Without ECB money to temper bond interest rates, the price of Spanish and Italian debt will likely spike, as the economic fundamentals in these two countries return as the true source of risk premium associated with the bonds. An increase in bond yields will instigate a separate and opposite drop in confidence, which will create it’s own, unvirtuous and destructive cycle.  And like a tornado, it will not stay in place, but will likely impact other struggling economies where there is uncertainty.

Worse, as the price of Spanish and Italian debt rises, the value of the bonds that the Euro banks have already bought will fall, placing the private banks in potentially greater jeopardy than when the ECB f lent out the money in the first place. Now they are tied closer than ever to the prospects of their struggling sovereigns.

The threat is real.  Spain was downgraded by S&P last week.  Today, 16 Spanish banks have had their credit rating downgraded.

And this is not something that is a threat six months from now.  It is real now.

From a broader perspective, the actions by EU officials and the ECB have taken place against the backdrop of widespread economic pain as a result of austerity measures designed to put EU member countries on a paying basis again.

The EU region itself is in the midst of a mild recession. The UK recently announced that it had fallen into recession (defined as two consecutive quarters of negative economic growth).

In the deeply struggling PIIGS – Portugal, Ireland, Italy Greece and Spain – the damage has been much worse.

After five years of recession, the Greek government announced that the economy would contract again by a staggering 5.5% in 2012. Unemployment in Greece is over 20 percent, with no immediate end in sight.

In Spain, also in recession, the unemployment rate is nearly 25 percent.  Youth unemployment is near 50 percent. Meanwhile, unemployment in Ireland and Portugal is over 14 percent, while those economies remain mired in recession.

In Italy, recession keeps unemployment near 10 percent while austerity measures by the government have  been unsuccessful in reigning in Italian budget deficits to levels agreed to with EU officials.

Austerity, without component seeds to catalyze economic growth, are wreaking havoc across the European continent, impacting the ability of governments to deliver on austerity pledges as they must deal with legions of unemployed, and with the likely backlash against the policies at the polls.

Here, economic austerity has run headlong into democracy.

The debt crisis has already cost the former Prime Ministers of Greece and Italy their jobs, but in both cases, those leaders were replaced by technocrats, committed to the austerity agenda, championed by Germany and France.

Now, months into the austerity regime,  the situation has changed.

The Slovak government fell in March, due in no small part to the government’s continued commitment to the EU austerity plan. Last week, the Dutch government fell after a debate on a funding bill that would fulfill the EU austerity program, amid a shaky national economy.  The Romanian government fell the next day.

In Greece,  the economic crisis and the austerity measures required for the EU bailout have been so severe  that Greece’s two establishment political parties cannot command a majority when they are combined. New political parties, established specifically to oppose the EU austerity plan or take Greece out of the EU altogether – both on the left and right – are gaining strength in advance of the May 6th election.

At a time when Greece needs strong united leadership to follow through on promises that guarantee its economic lifeline, the result on May 6th may result in more toxic political paralysis.

In France, President Nicholas Sarkozy is fighting for his political life.

As the co-architect, with Germany, of the Euro-austerity measures, Sarkozy’s defeat on May 6th at the hands of Socialist Francois Hollande – who has publicly committed to renegotiating the Euro austerity treaty – would be a stinging rebuke to Euro efforts to control the debt crisis.

All of that occurs before the Irish hold a referendum on the new EU austerity treaty at the end of May, another event that has the potential  to destabilize political understandings and financial markets.

These many reactions point to an existential crisis for the EU.

Austerity measures and targeted bailouts have not had an appreciable impact on the EU zone debt levels. Indeed, recession has made national budget reconciliation with EU finance targets all the harder, while EU easy money has locked the banking sector and at-risk sovereigns into a potential economic death spiral. All the while, increasing social unrest point to the human costs of austerity, that will find voice in the polls, which may undo even the modest steps so far taken to bring Europe back from the edge.

Where from here?

That is now anyone’s guess.

But its a good bet to prepare for rough sledding that will eventually wash up on America’s shores.