Euro Zone Crisis

Anti-austerity populism may be on the rise in Euro zone

PUBLISHED : Sunday, 01 November, 2015, 12:00pm
UPDATED : Monday, 02 November, 2015, 7:44am

“The European Union is not going very well,” admitted Jean-Claude Juncker, President of the European Commission on October 22, although you might not know it judging by the scale of investor demand for euro zone members’ government paper that has led to negative yields on many of the member nations’ 2-year sovereign bonds.

That said, markets have reacted rationally, understanding the European Central Bank’s (ECB) efforts to ease the euro zone’s economic problems, including a possible expansion of quantitative easing via asset purchases, necessarily lend themselves to yet higher prices for euro zone government paper and thus lower yields.

But it also reflects a touching belief in the ECB’s capacity to manage events while ignoring signs that, as Juncker put it, there are “cracks and fractures” in Europe.

The catalyst for the latest rally in euro zone government bond prices was ECB President Mario Draghi’s announcement on October 22 that the European Central Bank was contemplating the introduction of new stimulus measures as soon as December. The yield on 2-year Italian paper went below zero for the first time ever on Draghi’s comments.

Although a rising tide raises all ships, it could be costly to assume all vessels were equally seaworthy

Meanwhile, equally understandably, the euro nosedived in value as foreign exchange traders reacted to the fact that euro zone monetary policy settings appeared on track to become even looser.

International investors, purchasing euro zone government paper, might also have wished to hedge their currency risk by selling euros, fully understanding that the ECB’s intentions support the bloc’s bond prices but could equally weigh on the external value of the euro.

And while the ECB would never formally admit a weaker euro is an overt policy target, surely such an outcome would be welcome as the central bank seeks to ignite some inflation after consumer prices in the 19-country euro zone dropped by 0.1 per cent in September.

So far, so rational but perhaps investors have to ask themselves if it is all quite that simple.

Should investors necessarily have blind faith in the success of an expansion of policies that to date, aside from asset price inflation, have not proven to be materially successful in achieving the macroeconomic objectives for which they were designed?

Wasn’t it Einstein who said the definition of insanity was doing the same thing again and again in the hope of a different result?

At the very least, investors should compute that in an economic but not a political union, such as the euro zone, individual elected national governments will not necessarily always entirely agree with policies pushed on them alone or in combination by the ECB, officials in Brussels or indeed other member countries.

Buying, for example, an Italian or Portuguese bond in the rational belief that an expansion of ECB asset purchases represents a rising tide that raises all ships cannot disguise the fact that ultimately the risk being carried by the investor is that of Italy and Portugal.

Already both those countries are pushing back, albeit in different ways, against what others in the euro zone think is the right way for them to proceed.

In Italy, Prime Minister Matteo Renzi said on October 16 that while he did not expect the European Commission in Brussels to reject Italy’s proposed 2016 budget, if that were to happen, Rome will re-submit it “as is.”

Greece’s ex-finance minister Yanis Varoufakis, in an October 23 Project Syndicate piece, said “Renzi’s defiance of fiscal rules that push Italy into an avoidable debt-deflationary spiral is understandable” but felt in the current situation it “leads nowhere.”

Yet Renzi, a consummate politician, clearly believes defiance is just what is needed.

As for Portugal, an inconclusive election result on October 4 has led to a situation where anti-austerity parties control a majority of seats in the parliamentary assembly even as Portugal’s President has asked the pro-austerity incumbent Prime Minister to form a minority government.

Leaving constitutional arguments aside, the situation is hardly a recipe for stable government at a time when Portugal’s economy still faces tremendous challenges.

Across the border, Spanish Prime Minister Mariano Rajoy will be hoping the Portuguese result is not a trial run for Spain’s own national election on December 20, where the anti-austerity Podemos party is on the ballot.

Investors holding Spanish paper should share Rajoy’s concerns as anti-austerity populism may again be on the rise inside the euro zone

The euro’s slide and the rally in euro zone government bond prices following Draghi’s comments was perfectly understandable but with regard to the latter, although a rising tide raises all ships, it could be costly to assume all vessels were equally seaworthy.