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The Globe and Mail

In Europe, ‘more kicking of the can down the road’

The other day I met a friend, the boss of a well-known private equity firm in London, at an outdoor café in obscenely wealthy Mayfair, watching as Rolls-Royces and Jaguars and executives clad in Armani suits glided by. There was nothing in view to suggest that anything was amiss in the European or global economies.

Yet my man (who did not want to be quoted by name) seemed as uneasy as I had ever seen him. "I've never in my life felt so uncertain about things," he said, admitting that his hunt for new investment opportunities has produced no compelling targets. He took no comfort in the European Central Bank's relaunch of a program to buy the bonds of troubled euro zone countries, dismissing it as "more kicking of the can down the road.'

Investors apparently do not share his anxiety. Equities embarked on a formidable summer rally when ECB president Mario Draghi said the bank would "do whatever it takes" to spare the euro from oblivion. Ditto the euro, which soared past $1.30 (U.S.), about 10 per cent more than its recent low. The bond yields of distressed countries sank.

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The relief rally may endure, though it could equally fizzle out. My bet, like my friend's, is on the latter. The ECB bond purchase program and the German constitutional court's decision to sanction the new bailout fund, the €500-billion European Stability Mechanism, have not changed the macroeconomic outlook one iota. At best, they have bought some time while prime ministers, presidents and finance ministers pray that benign aliens equipped with debt-vaporizing ray guns and free beer descend from the cosmos.

Indeed, the relaunch of the EBC bond purchases (which would be done with the ESM at its side) will not save Spain, which is quietly negotiating the terms of a rescue program with the European Commission. It will not elevate Greece from deep economic depression or improve Italy's debt to GDP ratio, which stands at an eye-watering 120 per cent. It will have no effect on demand or employment.

It will not make tax evaders turn honest. It will not convert German Chancellor Angela Merkel into a fan of euro bonds by Christmas or prevent Silvio Berlusconi from getting elected (again) next year as Italy's "crisis, what crisis?" prime minister.

Above all, it will not push flat or negative growth numbers into positive territory. To shrink debt, relatively speaking, growth has to accelerate and that is happening virtually nowhere on the planet.

You do not have to be George Soros or Ben Bernanke to understand why growth is stubbornly absent. It's because governments and consumers are suddenly afraid of debt after a cheap-credit-fuelled spending binge that had, with fairly minor interruptions, lasted since the Second World War. Economies and consumers that spend more than they earn can pull off that trick for only so long. At some point creditors, from credit card issuers to sovereign bond investors, will take the view that the Everests of debt cannot be repaid. They stop lending, or only lend on terms that reflect the borrowers' declining ability to repay. It appears that point has been reached.

When governments are spending less to keep debt from rising, growth falters. When consumers do the same at the same time, it doubly falters. Note that consumer savings rates are rising. That means they are spending less than they make so they can pay down debt – deleveraging, to use the economists' awkward term.

"These trends are healthy for individual borrowers' balance sheets, but they imply reduced consumption and thus are negative for GDP growth, " Howard Marks, the (bearish) chairman of Oaktree Capital Management of Los Angeles, said in recent note. "If everyone does these things at the same time, the results can be quite contractionary. Regardless of how you look it, less use of consumer credit implies less economic growth."

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The problem with public sector spending cuts, other than that they remove stimulus from economies begging for stimulus, is that they do not come easy. Politicians who take a meat cleaver to hospitals and schools and garbage collection tend not to get re-elected. As a result, national debt loads keep rising, albeit at a slower pace. In Europe, almost every country is running a budget deficit in spite of three or four years of "austerity." Britain, the alleged model of fiscal rectitude, is headed for a deficit of 6.3 per cent of GDP this year.

Meanwhile, on the other side of the Atlantic, the United States is running $1-trillion-plus deficits every year. Debt to GDP will soon be double that of the 2008 level. If 10-year U.S. Treasuries were at 5 per cent instead of 1.8 per cent, the United States would have to cut so much spending that Medicare and Medicaid recipients would be tempted to burn down the White House.

To be sure, what the ECB did is better than doing nothing, and there are some bright spots on the global economic map, such as the apparent bottoming out of the U.S. housing market. But as long as governments and consumers remain bent on spending less, economies will not come roaring back, which means the crisis, at least in Europe, will remain intact. If China and Germany, where business confidence has fallen for four months on the trot, slow down dramatically because of waning demand, today's exceedingly tepid recovery might become tomorrow's dream scenario.

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