The euro may have rallied strongly yesterday, but I have my suspicions that it won’t last long. In this edition of Piponomics, I’m going to discuss my top 3 reasons why conditions in the euro zone will probably get worse!
1. Euro zone has austerity plans but no growth strategy
The austerity measures being implemented across the euro zone by debt-ridden nations have accelerated contraction. They have been so concerned about reducing their debt that they have forgotten that they also need a growth strategy going forward otherwise their efforts will be for naught. Now, the region hovers on the brink of its second recession in just three years.
Economists believe that the coordinated austerity across euro zone will only increase the number of unemployed people and make it harder for debt-ridden countries to reduce their deficits.
In addition, higher taxes and cuts in government spending hurt consumer demand, jeopardize consumer spending, and risk pushing the euro zone economy into a self-defeating vicious cycle.
2. The credit crunch is intensifying
While commercial banks in the euro zone don’ have a problem acquiring money due to the European Central Bank (ECB)’s Long-Term Refinancing Operations (LTRO), they do have a capital shortage. In other words, they have the funding needed, but they are not solvent.
Remember, European banks have to adhere to a 9% capital-ratio requirement. The capital-ratio requirement – also known as the capital adequacy ratio (CAR) – is measurement of a bank’s ability to meet its obligations. Essentially, it’s a ratio of a bank’s capital to its risk and its ability to withstand potential losses.
The problem is that in order to meet to the mandated 9% capital-ratio, banks must sell some of their assets or refrain from giving out any loans at all. This hurts business activity as businesses are unable to obtain the funds that they need to fuel expansion. Naturally, this doesn’t help the economic recovery at all.
3.ECB has backed away from easier monetary policy
Under the steady leadership of Mario Draghi, the ECB has steadily decreased interest rates and dumped over 1 trillion EUR into the European banking system in an effort to keep the euro zone afloat. These moves have helped reduce the pressure on debt-ridden nations like Portugal, Italy, Ireland, Greece, and Spain.
However, no thanks to a surge in oil prices over the past couple of months, there is now growing concern about the state of inflation. Last March, inflation checked in at 2.6%, which is way above the ECB’s target of 2.0%. Because of this, there are now rumors that the ECB may just back off its loose stance on monetary policy.
So despite the limelight now shining brightly on Spain and the belief that ECB may need to reintroduce other forms of liquidity into the market, many economists believe that the ECB will stay put and maintain a wait-and-see approach.
Am I too gloom-and-doom? If you agree or disagree with my analysis, feel free to share your thoughts about the state and outlook of euro zone in the comments section below!