Making Matters Worse in Europe

Jeremy, thanks for being here.

Jeremy Glaser: Jason, sometimes I wish I could crawl into a cave when some of this is going on, but it's certainly been an eventful week.

Stipp: So, what do you have for the Friday Five this week?

Glaser: Well, this week, we're really going to focus in on Europe and talk about Greece's referendum, the European Central Bank, about Italy, about Eurozone manufacturing and growth, and finally about the EFSF.

Stipp: So, there were some ups and downs and some turmoil over this referendum in Greece. What was the referendum? And is it going to happen? And what's the impact?

Glaser: Well, out of nowhere earlier this week, the Greek prime minister came out and said that they're going to put to a vote of the Greek people if they should participate in this bailout process, if they should go through these extra austerity measures in order to get the next tranches of aid and to accept the write-down of the Greek government debt.

And this just really roiled world markets. People really weren't expecting this to happen. They figured that this was basically a done deal, had been carefully negotiated, and that they'd been busy kind of crossing the T's and dotting the I's, and this just comes out of nowhere.

Then we hear the referendum is off, then it's back on again. Now, it's off again. And I think, certainly, it just shows how bad the political turmoil is in Greece right now, that the government doesn't have a huge majority in Parliament. They don't enjoy a lot of broad popular support. The bailout and a lot of these austerity measures are very unpopular with the Greek people. You see the general strikes. You see people being really upset about this. And when you see the referendums coming and going, and you just don't know which way is up, it doesn't give a lot of confidence that Greece will be able to actually implement these measures that will allow the plan to go through and allow the plan to be implemented as it was.

For the first time, we heard Angela Merkel and Nicolas Sarkozy talk about the fact that Greece may have to leave the Eurozone, and maybe will choose or maybe forced to leave the Eurozone. That's something they've never mentioned before. I think, even them just talking about it really raises the question of, even if we don't have this referendum, is it too late for the Greek political system to really come together to implement these reforms?

Stipp: On Thursday, we had a surprise move by the ECB. They cut interest rates. What's going to be the impact of this? And is it really going to be enough to do anything?

Glaser: They cut rates because they said that there's a chance of a mild recession at the end of this year and into next year. I think, the rate decrease--although it was a surprise and markets weren't necessarily expecting it--is not some unbelievable new program that's all of a sudden going to create growth in the eurozone.

But I think the real question is, how much more is the ECB willing to do?

One of the things that is somewhat frustrating from a policy standpoint is that politically, it's very difficult to get the ECB involved in any of the measures to try to bail out some of the peripheral countries. If you think about the Federal Reserve's role in United States and the central bank, with things like quantitative easing and really making very aggressive steps to come in and stabilize the economy, that just doesn't happen so much in Europe. And the ECB's mandate and the way that they work, they just aren't able to give that kind of support. And I think that going forward, as we see there are a lot of issues with getting all the governments to agree, we'll have to see how far the ECB is willing to push that mandate, how far are they willing to push politically in order to create stability and really try to keep everything on track as best as they can.

Stipp: All this talk about Greece, you might tend to overlook the fact that a lot of investors are really fretting over Italy. What's the story there and how big of a threat are problems in that country?

Glaser: There has been a lot of action in Italy, the Italian bonds spiked out to over 6%, which is really what some people think is the point of no return. Once you start getting to those huge spreads over what you get from investing in Germany or even France at this point, then it’s very difficult to come back from that, and that becomes a self-reinforcing cycle where investors get more and more scared and demand a higher and higher interest rate. As that happens, it becomes very difficult for Italy to ever refinance debt, becomes very difficult for them to keep their current fiscal situation without making sudden moves and ways to really get their budget deficit under control very quickly.

Unfortunately, the Italian government is incredibly dysfunctional. Berlusconi has not really shown any leadership when it comes to these emergency measures. Certainly they’ve passed some things, but no true reforms that really are going to get the Italian economy back on track.

I think that if Greece falls or if Greece ends up leaving the eurozone and has a disorderly default, their focus is going to turn immediately to Italy as it already is, and it could be really challenging for Italy to come up with the political will to save itself. If Italy falls, that’s a much bigger problem and really could be something along the lines of the 2008 financial crisis, versus a Greece default, which should probably be more manageable.

Stipp: Meanwhile, in the background, the European PMI went down again. So is it possible that we are already having problems right now, that we are already headed down the road to recession, even while we are trying resolve this crisis?

Glaser: In the background is that European growth is pretty poor, and I think that this manufacturing data just reinforced that: Even beyond all this talk about sovereign debt, the so-called real economy isn’t performing all that well.

In the past, strength in Germany and strength in some other parts of Europe gave people some hope that they could roll out of this crisis--that as long as everything gets stabilized and we were able to have some confidence in the integrity of the euro, that the growth would come back, and that with more growth, that would help budget deficits come down and really make people feel better about the austerity measures that were coming in. So it's looking like that’s become a more and more remote possibility, and as we see more dire economic data come out of the Continent, it just doesn’t bode well for the entire situation.

Stipp: So the thing that everyone is hanging their hats on to help get us out of this, is this stability fund, the EFSF. How sturdy is that, actually, and how much hope can we really pin on it? Does it have any problems?

Glaser: One of the big hopes of the stability fund is that they'd be able to leverage it by selling bonds from the fund that other investors, possibly in emerging markets, or other rich investors who have the money to put into it, will be able to invest, get some nice spread on it, and that would help [policymakers] give the money that would be needed to bail out some of these other countries.

But the EFSF is having a lot of trouble selling these bonds; they canceled the 10-year offering this week because they really didn’t see any investor demand for it. The spreads on the bonds have really started to widen out. Even though these are officially rated AAA securities, the same as German bunds, they are trading at a pretty big spread to those German bunds.

So I think that really continues to emphasize just how difficult this situation is. You can create all of these great plans, but if you can’t find the money to actually fund them, and if you aren’t willing to use the ECB, like I talked about before, to print that money, it really becomes a question of, how are these bailout plans actually going to work? It’s somewhat concerning that the EFSF can’t really find those investors.

Stipp: Jeremy, unfortunately you had a rather unpleasant tour of Europe this week, but thanks for keeping on top of all the details.

Glaser: You are welcome, Jason.

Stipp: For Morningstar, I'm Jason Stipp, thanks for watching.