The War in Europe Escalates—No Guns, Just Butter

The War in Europe Escalates—No Guns, Just Butter

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It took exactly two days for European markets to cast a negative vote on the agreement eurozone countries reached in Brussels last week. It took a couple more for the eurozone countries to begin bickering with Britain, that is isolated because of its veto of the agreement. By the end of the week, Christine Lagarde, the new and highly regarded head of the International Monetary Fund, was warning of “economic retraction, rising protectionism, isolation, and what happened in the ’30s.” She may as well have used the “D” word.

Happy holidays! Is that the phrase I’m looking for?

There are reasons for the grim tidings. Standard & Poor’s now has 15 European nations, including France and Germany, on a negative ratings watch. Moody’s Investor Services has advised European capitals that it may follow suit, and Fitch is not far behind. The reigning sentiment seems to be that the Brussels pact will simply not be enough to pull Europe back from a crisis.

There are also concerns about just who is going to be able to sign onto the agreement. Because it is “intergovernmental,” meaning it is outside the European Union’s institutional framework, every nation joining it will have to push it through its parliament, and some may not succeed. In the case of Ireland, Dublin may have to call a national referendum.

It is in no one’s interest that London now stands alone because of Cameron’s emphatic “No!” in Brussels.

On this latter point, one has to look back and say German Chancellor Angela Merkel was right. She had wanted a formal E.U. treaty up until the last minute, when she caved in on the point. Had she held her ground, it would have made passage of the agreement much easier while (just possibly) settling the markets a little better than the deal as it stands.

Then we have the British case. It is in no one’s interest that London now stands alone because of Prime Minister David Cameron’s emphatic “No!” in Brussels. While Cameron’s intent was to protect the U.K. financial markets from Brussels regulation, London could still suffer as a financial center because of its isolation.

Last Thursday, the governor of the French central bank, Christian Noyer, took a swipe at Britain that suggests just how nasty things have become on the other side of the pond. Referring to the credit-rating agencies, Noyer said, “They should begin by downgrading the United Kingdom, which has bigger deficits, more debt, higher inflation, less growth than us, and where credit is shrinking.”

British officials, naturally, went ballistic.

At the root of all this grousing, which does have a disturbing 1930s ring to it, is the question of funding. It is simply not clear that there will be enough liquidity in European debts markets to match outstanding obligations. Moreover, banks remain wary. This week, the European Central Bank will begin offering cheap three-year loans to banks to enable them to buy some of the sovereign debt now flooding the markets. But it is not clear this will work: Banks have reduced exposure to Europe’s peripheral nations by 10 percent or so since the start of the year.

Christine Lagarde’s warning notwithstanding, we are not in for a depression with Europe as the sinkhole.

But it is possible to get carried away with these negative perspectives, especially in the first few days after an important agreement is passed, like the one negotiated in Brussels. Nobody said the E.U. summit was the end of all our worries. But it is the foundation for an arrangement that will enable Europe to save the common currency and climb out of its financial crisis—over time and with considerable pain. Christine Lagarde’s warning notwithstanding, we are not in for a depression with Europe as the sinkhole. 
“Given the failure of policymakers to staunch the crisis to date, we doubt that the eurozone can avoid recession in 2012,” writes Paul Sheard, an economics commentator at Nomura Securities. “Further, we expect the escalation of market pressure associated with that malign outcome to elicit a more forceful and effective policy response, including full-scale quantitative easing by the E.C.B. As long as such a policy response is forthcoming, we judge that a 2008-like crisis, this time with the eurozone as the epicenter, can be avoided, and the global economy as a whole can continue to expand, albeit at a slower rate.”

Sheard is right on the money, although I am not sure about a recession next year. It has been clear for some time now that the E.C.B. is the key to a solution in Europe and that circumstances will force its hand. With its headquarters in Frankfurt, the bank has in its genetic makeup a compulsive preoccupation with inflation. But with austerity plans throughout the continent and unemployment running at 15 percent to 20 percent, it is deflation the E.C.B. should worry about. As Sheard suggests, circumstances will eventually force a change in the E.C.B.’s internal culture.