As Cyprus draws nearer to the EU-IMF deadline and complete bankruptcy, Germany remains ever in denial about the danger this situation poses. Foreign businesses and investors are already feeling the effects of frozen accounts, and fears of potential losses from the deposit tax and higher corporate tax rates are growing. It’s as if the world outside of Europe is gearing themselves for what Germans say won’t happen: the outflow of contagion from Cyprus into the weakened financial sectors of Southern Europe. Despite palpable market fears, the ECB and IMF look poised to follow Germany through the fiscal looking glass where austerity programs aren’t dismantling economic growth, deepening unemployment and leaving deflation in their wake. Truth be told, the last thing the Eurozone needs is further treatment from Germany’s “Henry Goose” school of economic recovery.
1. Austerity alone is a self-defeating strategy
Greece is probably the best example of this particular problem. Remember in early 2010 when Athens first asked for €45 billion and was denied emergency funds until its debt/spending levels reached an acceptable level? Greece responded by slashing the minimum wage, imposing salary caps, spiking income taxes and raising VAT rates, all of which did nothing but send the Greeks into a tailspin. Over the next 10 months, Greece held the lowest possible rating on its sovereign debt, its debt to GDP ratio ballooned from 130 percent to 165.4 percent, and unemployment soared to 22.6 percent.
Let’s not forget that a political crisis erupted during that same summer after the consortium of lenders held out after the austerity measures failed to produce enough income. It wasn’t until October 2011 that emergency funding arrived to prevent a complete collapse, but with Greece still unable to come up with enough collateral for its loans, foreign holders of Greek debt took a near 53 percent haircut. Austerity somehow managed a media victory while investors were left holding the bag.
2. The debt contagion has yet to actually remain contained to where panic starts
The German austerity bloc continually tries to tamp down market fears over European bank debt by holding the sides of the, “it’s small, not vital to the Euro economy”, canoe. Problem is they’re already behind the curve, because global markets only seem to view the Euro in its parts when the news is good. The moment renewed fears of debt contagion arise, the market starts to remember the links between the economies of each member state, allowing negative press from deposit taxes in Cyprus to move equity markets in Italy and Spain.
Again, looking at the Greek debt crisis from 2009-2011 is a perfect example as bad press from Athens, coupled with inaction from the ECB and IMF prompted a string of credit rating downgrades and bond yield increases in economies much larger than Greece’s (Spain, France, Portugal and Italy just to name a few). Look for more with the finalizing of Cyprus’ rescue package.
3. Germany directly profits from the floundering of other economies under deflationary austerity measures.
That’s right, Dr. Goose is indeed dishing out the poison and getting plenty of return on investment. As bigger European economies like Italy and Spain continue to shrink under rising unemployment, high debt interest, and low credit ratings, investors flock to safe haven bond issuers like Germany, or Austria. So while they’re leading the charge of deficit reduction and spending cuts, German banks enjoy better borrowing rates and a pass from markets to keep issuing new debt .
The Wall Street Journal has a great interactive table with historical bond yields for most of the Euro-area states and the data is pretty telling. Look at the rates on 10 year debt at the end of November 2009 (when a reliable number for Greek debt surfaced) for Italy, Spain, Germany, and Austria the range isn’t all that wide.
- German 10-year: 3.151
- Austrian 9-Year: 3.342
- Italian 10-year: 4.003
- Spanish 10-year: 3.755
If you go to the end of October 2011 when the Greek restructuring deal passed, with two years of contagion having coursed through Southern European banking systems, the picture is markedly different.
- German 10-year: 1.995
- Austrian 10-year: 2.996
- Italian 10-year: 6.001
- Spanish 10-year: 5.533
Fast forward to the end of last week’s trading session and the pattern emerges further. German 10-year debt has a nice 1.386 yield, and Austrian 10-years are near those levels at 1.671. Spanish 10-year bonds are still high in comparison at 4.996 and Italian 10-year debt yields closed at 4.570, which is an improvement, but high nonetheless.
Are the Germans completely off base with demands for better fiscal management? No they aren’t. Poor management (or a complete lack thereof) of banks and government budgets is a core symptom of Europe’s difficulties. However, the German austerity plan lacks designs for renewing growth, and seems preoccupied with dishing out penalties versus paving paths to reform. Europe has no more need of that brand of medicine.