It probably wasn’t President Barack Obama’s fault. Europeans generally favored him over Republican challenger Mitt Romney and cheered his re-election. Nonetheless, markets fell last week in Europe, due to concerns about Greece and some very poor unemployment data.
The European Central Bank (ECB) also didn’t help. At its monthly meeting, President Mario Draghi downgraded the economic outlook for the Eurozone, but did not provide further monetary easing.
As a consequence, the EURO STOXX Index 50 points, or 2.6 percent, to 2,479 and the euro dropped 0.8 percent to $1.2728. As usual, financial stocks and the Spanish market lagged, falling 4.4 percent and 4.2 percent respectively.
Groundhog Day All Over Again
If you have been following the situation in Europe, you will have seen a pattern emerge. Greece does not deliver on promised reforms and budget cuts and the creditor nations subsequently mull over not handing over the next payment installment to Greece.
After more or less successful negotiations and a dramatic vote in parliament, Greece promises to do better. It then gets the payment from the European Union and the International Monetary Fund just in time to avoid defaulting on its debt payments.
We had just such a scenario play out again last week, where the ruling coalition of Greek Prime Minister Antonis Samaras just about got the vote for another round of budget cuts and tax hikes. While not officially confirmed, the creditor nations will pay Greece the $40 billion it needs in November to avoid a default. This ongoing saga thus continues.
Economy Remains Poor in Greece, Spain
While the Greek government on the surface wants to comply with the demands of its creditor nations, in practice this is almost impossible.
The country is marred by frequent strikes and riots. The Finance Ministry, which collects taxes, has virtually been shut down. Extremist parties, such as the neo-Nazis and Communists, are on the rise in the polls.
This is no surprise as the economy in Greece continues to spiral out of control and into a deeper depression. Data released last week showed that youth (age 25 and below) unemployment in August stood at a record 58 percent. Total unemployment was at 25.4 percent. According to The Hellenic Statistical Authority, in 2010 2.34 million Greeks (a little more than 20 percent) lived below the poverty line. According to more recent data by the U.S. CIA, it currently stands at exactly 20 percent of the Greek population.
One needs to grasp the hidden social tragedy behind these numbers to understand that the Greek economy is largely beyond the control of the central government.
Spain, another troubled nation, is not far behind. Youth unemployment in Spain is around 54.2 percent and total unemployment at 25.5 percent. Young people are supposed to provide for future livelihood of their respective nations. For Greek and Spanish youths, they can only hope.
More Pain to Come
The main goal of the European Union is to preserve the euro currency. This is why Greek creditors have not allowed Greece to default, and as a consequence, leave the Eurozone since it could set an example and other nations may follow suit.
Leaving, however, would give Greece considerably more options, including devaluation of its currency, defaulting on its external debt, and starting with a clean slate.
Devaluing a national currency has two functions. One is to inflate away debt. The other one is to produce and sell more domestically made goods to foreign buyers, without increasing real productivity. A side-effect of this policy is the unfair wealth transfer from savers to debtors which leads to misallocation of resources. Greece, however, does not have many good options left, so this is a viable one.
The only way to restore competitiveness within the Eurozone is to “devalue internally.” This means that prices in Greece need to go down instead of up. This way, a euro earned in Germany or France has more buying power in Greece. It makes sense for Germans and French to go on vacation to Greece or buy agricultural products from there.
UBS estimates that the price level in Greece needs to drop by around 20 percent and in Spain by 15 percent relative to other European countries in order to restore competitiveness of those nations. The problem with this sort of devaluation is that wages have to fall substantially for it to work, dragging down consumption and GDP along with it.
This method would not solve another problem, which is the country’s debt. Lower GDP would mean a lower ability to service external and internal debt and the rate of defaults of businesses and individuals would increase. This would again cause problems for the banking sector, as was the case in the United States during the Great Depression of the 1930s. It becomes a vicious cycle.
Historically, this policy has worked only on very few occasions and under very special circumstances. It normally ends in social unrest. Unfortunately, the beginnings of this phenomenon can already be seen in Greece and Spain.
The Week Ahead
Another meeting of European finance ministers is not likely to shake the markets, but third quarter GDP could be market-moving, especially if it surprises to the downside. Markets expect a contraction of 0.3 percent compared to the second quarter, so expectations are already rather low.
In Portugal, a country that has so far avoided big negative headlines, the largest trade union confederation will launch a strike against government austerity measures. This is another example of how difficult it is to push through wage decreased and take away government entitlements.
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