What is the problem with Europe?

Constrained labour and capital built-in tensions hinder European growth

By Jean-Luc Burlone, M.Sc. Ecn., FCSI (1996)

Refugees and terrorism, credit and negative interest rates are all ingredients of current European difficulties. Political and financial leaders’ actions indicate desperation over an unprecedented situation that calls for a possible degradation of the European project.

In the wake of the Paris attack, when two terrorists blended with refugees borrowed the Balkan Road to hatch their schemes in Brussels, one European government after the other closed its doors, overwhelmed by the sheer number of refugees and the outburst of public opinion. France swiftly reinstated border checks while Hungary, Slovenia, Germany, Austria, Sweden, Denmark and the Netherlands took similar actions or added to those already in process. It is noteworthy that the Schengen Borders Code is being revisited.

Considering that for years, Europe was unable to answer, in an efficient and coherent manner, the challenge of thousands of defenceless refugees from North Africa, how could it now manage millions more, potentially cluttered with terrorists? There is no rally around the European flag in this matter: French officials sniped at Belgium, where political bashing is more popular than ever; Poland simply withdrew from accepting refugees; Slovakia’s election became an anti-migrant shouting match; Italy’s right-wing called for closed borders and Mrs. Merkel, whose decision to accept 800,000 refugees to rejuvenate Germany’s aging population was applauded for her open arms and forward thinking gesture, now has her leadership questioned.

It may be more than a comprehensible overreaction. The issue of asylum or social integration that pervaded politics for years, is now tainted with fear. Europe’s decision to tighten external borders and individual countries their national ones might trigger the unravelling of the European Union, whose raison d’être is highly dependent on open borders as its Charter “… ensures free movement of persons, goods, services and capital, and the freedom of establishment.” Over and above its ideal, European countries need young skilled migrants to brighten up their population since the current demography is clearly suboptimal for its economic future. Securing borders truly puts a dent on the free flow of labour — a basic factor of productivity with capital.

Europe’s decision to tighten external borders and individual countries their national ones might trigger the unravelling of the European Union, whose raison d’être is highly dependent on open borders…

Capital is plenty in Europe but borrowing capacity is rather scant. Crisis after crisis, from Ireland through Spain and Portugal, to Greece and Cyprus, Europe had to deal with looming deflation, low productivity, skeptical investors, large private and sovereign debts (often in foreign hands) and current account deficits. European authorities recapitalized the battered banking sector — hurt by the financial crisis — to ensure financial stability as it rescued, with sovereign bailout programs, countries affected by high budget deficit and debt, to debunk contagion to other countries and a possible break-up of the eurozone. The job was done but at what cost!

After years of low or zero interest rates, the European Central Bank (ECB) entered last year the perversive negative territory, where it charges interest on financial institutions’ deposits, penalizing them for hoarding funds in the ECB deposit facility rather than financing economic expansion. Clearly a desperate effort to get the money to stimulate economic growth and increase inflation but to no avail as demand remains tepid and the fear of deflation still looms. In fact, the ECB’s continuous supply of money has rather funded corporations to buy back shares or other businesses and producers to increase inventories to unprecedented levels. Abundant money has inflated, if not corrupted, financial products and depressed commodities pricing as excessive supply largely exceeds current demand. In the process, free money has resulted in an unprecedented level — not counting trillions of euros of public loans — of private non performing loans: one trillion euros on banks’ balance sheets plus another trillion in noncore assets (real estate and commodities mainly). European banks are now under pressure from newer, tighter regulations to improve their situation. Astute investors, with a keen eye for real inefficiencies, are particularly interested in these non-performing loans, ready to purchase them at bargain price once the banking community starts to deleverage, shrinking its share of the credit market to answer new capital regulations.

After years of low or zero interest rates, the European Central Bank (ECB) entered last year the perversive negative territory, where it charges interest on financial institutions’ deposits, penalizing them for hoarding funds in the ECB deposit facility rather than financing economic expansion.

Bailouts and schemes have bought time more than debt. All in all, a staggering shift in liabilities from financial institutions to European taxpayers has occurred but total debt in Europe now reaches over 57 trillion euros — 400% of GDP! In comparison, total US debt is at 269%, Canada at 247%, China at 282% and the world at 286% of their respective GDPs.

How this awkward social and financial situation will unravel is too early to tell. We are still in an expansion phase that may continue long enough to allow hiring by businesses and strengthen balance sheets sufficiently to cushion a downturn. Or we may enter into an early contraction period where deflation erodes corporate profits, triggering layoffs and where the financial bubble may implode while authorities have no longer the capacity to act.

Image: Eoghan OLionnain via StockPholio.net

Jean-Luc Burlone, M.Sc. Ecn., FCSI (1996)
Economist – Financier
jlburlone@gmail.com

The text above is solely my opinion on the current financial context based on reports and data from the financial press. It should not be viewed as promoting an investment action of any sort.
December 2015 — JLB