The Euro Mess Gets Messier


I have not written about problems in the Eurozone and surrounding areas since last October since nothing had changed. The Eurozone is in the process of falling apart because what I called the “weak sisters” will never be able to compete with Germany, the Netherlands, and Austria. But Cyprus and the bank tax proposal is really special, so the entire subject is worth revisiting.


In past articles, I have relied primarily on data from the IMF and the World Bank. For this review and in the future, I will be using data from FocusEconomics. In my view, FocusEconomics is the best supplier of economic data on all regions of the world. In addition to collecting economic data from a wide range of sources, they provide projections (GDP growth, government deficits, etc.) from a large number of private banks, e.g., Goldman Sachs, Citibank Global, Nomura, et al.

New Developments – Cyprus

Back in October, I titled a piece “Euro Crisis – Will German/IMF Austerity Pressures Cause an Explosion?” Insofar of what is playing out in Cyprus, it appears the answer is yes: German-led demands for austerity resulted in the proposal for a huge tax on all deposits. A little background: Cyprus is a small Eurozone country, so it has flown under the media radar, including mine. But as we will see below, its economy is facing problems as serious as those facing the “weak sisters” – Greece, Italy, Portugal, and Spain.

So, just as with the “weak sisters”, a bail-out of €10 billion was being negotiated with the troika – the European Union, the European Central Bank, and the IMF requiring a €5.8 billion tax on bank deposits. News reports indicate that the original terms of the bailout called for a one-time tax of 6.75% on deposits of less than €100,000, and a 9.9% tax on holdings of more than €100,000. It is reported the Germans wanted a €9.2 billion tax!

IMF head Lagarde, clearly operating on a different wave length than professional IMF staff, said “Now is the time for the authorities to deliver on what they have committed to.” She went on to complain that critics have not recognized how much the agreement will force Cyprus banks to restructure and become healthier.

Austerity Analytics

Consider what such a tax would mean. Total government revenues are now €7.3 billion, or 41% of GDP. An additional tax of €5.8 billion would increase revenues to 74%.

Earlier research by the IMF concluded that a fiscal consolidation (tax increase, expenditure reduction, or both) of 1% of GDP results in an increase of .3 percentage points in the unemployment rate[1]. Oliver Blanchard, the chief economist of the IMF and Daniel Leigh just reviewed those findings. They concluded the multiplier in earlier studies was underestimated. Their research suggested that the effects of a 1% fiscal consolidation could result in as much as a .6 percentage point increases in unemployment.

So the new tax would raise government revenues by 33 percentage points. By the IMF’s earlier estimate, that would result in an increased unemployment rate of 9.9 percentage points taking the rate to 21.6%. Using the IMF’s most recent research, the unemployment rate could increase to 31.5%. Fortunately, the tax was rejected. The “austerity troika” is now demanding Cyprus figure out how to raise the €5.8 billion or all support will be cut off.

Question: What were the European Union, ECB and IMF negotiators thinking in suggesting such a tax on deposits? Have they lost their minds? The austerity effects are not tolerable. But beyond them, I can think of no better way to generate a run on banks in Cyprus, Greece, Italy, Portugal and Spain than to threaten impose a tax on bank deposits!

Background – Differing Paths to Trouble

Following the US bank collapse in 2008, most countries followed a similar pattern: stock market and real estate crashes, dramatic reduction in consumption and investment outlays leading to recession and recovery. But the now five “weak sisters” followed different patterns as shown by the rates of GDP growth shown in Table 1. Cyprus had a mild recession in 2009 but appeared to be recovering – until 2012. Starting in 2008, Greece went straight down with no end in sight. Italy followed the developed country model in having two bad years (2008, 2009) followed by the start of a recovery – until 2012. Portugal had two bad years, a slight uptick in 2010, and then a new downturn. Things turned bad for Spain in 2008 and have not really improved.

 Table 1. – GDP Growth, Eurozone “Weak Sisters”

Source: FocusEconomics and IMF

In contrast, the German pattern was different. GDP fell 5% in 2009, but growth picked up in the next two years. It has now stopped because of Eurozone problems.

More Details on “Weak Sister” Problems

Table 2 provides information on unemployment rates. The problems in Greece, Spain and Portugal are already severe, and as mentioned above, the austerity demands on Cyprus will make things a lot worse there as well.

Table 2. – Unemployment

Source: FocusEconomics and Haver Analytics.

Table 3 provides government deficit and debt data before the Cyprus crisis. On deficits, only Italy seems to be under control, even though there is political turmoil in the country. Government debt in Italy and Portugal is already high and growing. Putting together Greece’s deficit and debt data is absolutely chilling.

Table 3. – Government Deficit and Gross Debt as % GDP

Source: FocusEconomics

Growth Prospects

What does the future hold for the “weak sisters”? Table 4 provides GDP growth projections from the IMF and banks that FocusEconomics polls. The IMF appears more optimistic than the banks: In every case the average of the bankers’ projections is equal to or lower than the IMF’s. Note the Citigroup Global Markets projections’ for Greece: GDP projected to fall 6.3% in 2013 and 11.3% in 2014!

Table 4. – GDP Growth Projections

Source: FocusEconomics

Getting There

Following the latest meetings between the IMF and Portugal, the IMF concluded: “The roots of the current crisis can be traced to the failure to adapt to the rigors of monetary union….” What did the IMF mean by that, and does it apply to the other “weak sisters”? The answer to this question can be found in Table 5. It shows what happened to the local currency of each country relative to the German Mark from 1990 until the country converted to the Euro.

Table 5. – Local Currency Depreciation, 1990 Until Euro Adoption

Source: Oanda

In all cases, the currencies weakened significantly. These depreciations improved the competitive position of these countries’ products relative to those of Germany. The same thing happened in the US relative to Japan: since 1990, the dollar depreciated 41% against the Yen. This depreciation allowed the US to remain competitive with Japan in many product lines. What the IMF meant by the “rigors of the monetary union” is that with all Euro countries using the Euro, this mechanism for adjusting to difference in productivity and cost no longer exists.


I conclude with some troubling quotes from an article by Stratfor: I could not have said it better.

“Germany sees the European Union’s free trade zone as essential for its survival. Without free access to these markets, its exports would contract dramatically and unemployment would soar. The euro is a tool that Germany, with its outsized influence, uses to manage its trade relations — and this management puts other members of the Eurozone at a disadvantage….The idea that the Germany-mandated austerity regime will be able to survive politically is difficult to imagine….Until recently, default was the primary fear of Europeans, at least of the financial, political and journalistic elite. They have come a long way toward solving the banking problem. But they have done it by generating a massive social crisis. That social crisis generates a political backlash that will prevent the German strategy from being carried out….Germany sees itself as virtuous for its frugality. Others see it as rapacious in its aggressive exporting, with the most important export now being unemployment. Which one is right is immaterial. Fascism had its roots in Europe in massive economic failures in which the financial elites failed to recognize the political consequences of unemployment….

It is difficult to imagine a common European policy at this point. There still is one, in a sense, but how a country with 5.2 percent unemployment creates a common economic policy with one that has 11 or 14 or 27 percent unemployment is hard to see. The crisis of unemployment is a political crisis, and that political crisis will undermine all of the institutions Europe has worked so hard to craft.”

The failed negotiations over Cyprus are just the latest example of how dysfunctional things in the Eurozone have become. Sadly, there will be more political overthrows, riots in the streets and financial panics before the Eurozone ultimately collapses.

Investment Implications

Stay away from Europe – no European country can avoid being directly affected by the Eurozone collapse. The US is recovering. The momentum is growing. And sure, there will be the occasional sell-off as the latest crisis in Europe occurs. But keep in mind, the rest of the world is looking for safe places to invest its money, and the US market looks quite good. As I have been saying for some time, US real estate is finally recovering, and this is a good, safe place for you to invest. Take a careful look at US real estate mutual funds and ETFs. For more specific suggestions, take a look at the article by David Fry. I happen to like iShares NARETI Real Estate 50 ETF (FTY).

[1] “Will It Hurt? Macroeconomic Effects of Fiscal Consolidation”, Chapter 3 of the IMF’s October 2010 World Economic Outlook.

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