Since Drahi’s infamous “whatever it takes” warning in the summer of 2012, European bond yields have been a one way street lower, and until the recent Trumpflation rally, had tumbled to all time lows, in many cases well below 0%. There are two catalysts, however, that may be ending Europe’s QE-driven free ride, and according to a recent report by Barclays, their names are Donald Trump and Mario Draghi.
First, when looking at the impact of Trump, Barclays notes that his election as US president may have created an additional burden on European budgets: defence spending.
The president-elect has suggested that European NATO members should reach the 2% GDP military spending target, as pledged under the NATO treaty. In 2015, the 22 EU countries that are also NATO members spent on average only 1.4% of GDP on defence, or 1.3% excluding the UK, while the US spent 3.6%. This is a shortfall of USD94bn, or 0.7% of the total GDP of EU-NATO members.
Those countries whose debt to GDP ratios already exceed 100% (Italy, Spain and Portugal) are also the ones with low defence spending and would need to add 0.7-1.1% of GDP in defence spending if they were to reach the 2% target as shown in the figure below.
In Trump carried out his threat and enforced a mandatory topping of contributions, and Italy had to boost its annual defence spending permanently to 2% of GDP (all else equal), its primary surplus would more than halve, from 1.7% currently to 0.7% of GDP. For France, Fillon and Juppe are arguing to increase military spending progressively to 2% of GDP by 2025, while they do not envisage any significant change in stance towards NATO.
It’s not just Trump’s NATO policies: there is also the impact of the ECB’s QE which sooner or later will be tapered off. That, however, will result in the tide going out, and exposing just how naked Europe’s economies have been all along.
As Barclays also writes, “the ECB‘s QE has been an important driver of EA growth and public debt dynamics, but at the cost of moral hazard.”
Barclays finds that QE-generated growth, more so than low interest rates, has significantly contributed to a slowdown in the rise of the public debt, particularly in Italy and Spain. As shown in Figure 2, public debt would have risen an alarming 12% in these countries without QE.
The British bank’s analysis also suggests that those countries with the most significant bond market pressure also pursued the most reforms. But rather than using the temporary relief created by QE to reform and repay public debt, fiscal policy in Italy and Spain became expansionary and reforms ground to a halt. In other words, as we warned all along, all QE does is kick the ball into the ECB’s court, while giving lazy, incompetent politicians the justification to do, well, nothing – certainly nothing that may threaten their careers – and simply watch as the stock maret rises, giving the false impression that “things are good.”
Debt sustainability issues will likely therefore resurface not only due to higher interest but also, critically, because long-term growth prospects are poor without reforms, and it is now entirely recognized that it was the ECB’s fault why Europe’s nations – all badly in need of structural reform – abandoned all such efforts; after all why bother when “Mr. Chairman will get to work.”
Here are Barclay’s details on why solvency concerns will re-emerge for Europe the moment Draghi even whispers a hint that QE is about to get tapered, let along end:
With funding costs at historical lows and QE expected to remain in place for the foreseeable future, few investors are worrying about the long-term sovereign solvency of the euro area. But this could change. Draghi reminded us of the obvious in September, namely that “QE is not forever”. When the tide turns, many euro area sovereigns may very well be confronted with higher “r-g”, not only because of higher r (as monetary policy tightens) but, critically, because of low g, as long-term growth prospects are dismal without reforms.
Compounding the problem of sensitivity to the assumptions (for r and g) is the issue of interdependence across variables. Primary balances and fiscal stances in general affect both interest rates and growth rates while growth rates affect the fiscal performance. If it is indeed the case that low interest rates – supported by ultra-accommodative monetary policy – delays necessary fiscal consolidation and supply-side reforms, arguably low r means low future g. Growth plays a critical role into debt dynamics through direct and indirect effects: the largest public debt contribution of QE came from the growth channel. If our assessment is correct, and governments fail to raise the long-run growth rates of their economies owing to complacency, it is plausible that the European economy will remain stuck in a low-growth equilibrium, where permanent QE is required to keep funding costs down, which coincidentally leads to delay in important reforms.
There is another problem, in fact the biggest problem of all from day one: massive debt loads, which were never reduced in the aftermath of the great financial crisis, and which need soaring prices to be reflated away, however in the process of rising rates, those same debt balances effectively assures a financial crisis. Quote Barclays:
The political landscape across the euro area argues against very high primary balances; in fact, we have seen how the primary balance has recently worsened and fiscal accommodation has increased. For Italy, public debt is currently at 134% of GDP, the primary balance at 1.5% of GDP, nominal r is at c. 3.2% and g is c. 1.5% (i.e., r-g = 1.7%). A small increase of r-g to say 2 or 2.5% would put debt/GDP along a rapidly growing path.
In theory high debts do not necessarily imply a sovereign crisis, especially if the government spends its money wisely and collects taxes efficiently. But if it does not, solvency concerns could re-emerge, sovereign interest rates quickly rise above the average funding costs, and the 2010-11 adverse market dynamics could return. The big difference is that this time there would be far less monetary, fiscal, and political space to confront them.
Two conclusions: i) as Barclays puts it, “the great fiscal success of QE could therefore turn out to be its biggest downfall in due course” and ii) everything that has happened since Draghi’s infamous “whatever it takes” gambit nearly 5 years ago, has been one great can-kicking detour, and the moment he market even gets a whiff that Draghi will punt on record QE, Europe’s crisis is back with a bang.
On, and there is the whole “Trump” wildcard, not only as a result the wildcards from his NATO funding policies, but also because should the global reflation scare accelerate, then the ECB may have no choice but to tighten/taper/end QE sooner than anticipated as inflation worries spread to Europe, which in turn will catalyze the next leg of the Europea solvency crisis, which is inevitable as Europe failed miserably to engage in reform in the five years since Draghi’s words pushed European interest rates to all time lows.