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Komal Sri-Kumar
Senior Fellow; President, Sri-Kumar Global Strategies
Asia and California and Capital Markets and Europe and Finance and Global Economy and Public Policy and U.S. Economy
Dr. Komal Sri-Kumar is president of Santa Monica-based Sri-Kumar Global Strategies, Inc., a macroeconomic consulting firm that advises multinational firms and sovereign wealth funds on global risk and opportunities.
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Global outlook: Storm clouds remain
By: Komal Sri-Kumar
August 06, 2012
   
   
Global markets closed the week in a euphoric mood, boosted by the jobs numbers in the United States, and by expectations that European leaders would find a way to bring down unsustainably high Spanish bond yields. On the U.S. front, nonfarm job creation of 163,000 for July was above consensus expectations of 100,000. Coming after particularly poor employment figures in June, this set U.S. markets up for a rally. In Europe, Spanish Prime Minister Mariano Rajoy hinted that he may request a bailout of the Spanish sovereign after all. Until now, he had claimed that a,?100 billion in aid from European official sources would be channeled directly to recapitalize the Spanish banking system. And since European Central Bank President Mario Draghi had suggested that the ECB would buy debt in the secondary market only in the case of countries which had agreed to austerity conditions, Mr. RajoyaEUR(TM)s move cheered investors in Spanish debt.

Troublesome Features Below Headline Labor Statistic

Total jobs created in the United States last month were higher than consensus expectations, but they fell behind the momentum of the early months of 2012. Nonfarm job creation had run at an average monthly rate of over 200,000 in the first quarter which was probably due to unseasonably warm weather rather than to increased economic activity. Monthly job creation numbers need to run at between 200,000 and 300,000 for several months in order to meaningfully lower the unemployment rate and accommodate an increase in the number of job-seekers. Instead, the open unemployment rate (known as the U-3) rose from 8.2% to 8.3% last month as the labor force participation rate dropped again, and average weekly earnings barely budged.

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Even more important than the widely followed U-3 rate was the rise from 14.9% to 15.0% in the U-6 unemployment rate which includes those working part-time involuntarily, and those who quit the labor force because they cannot find a job. The U-6 rate is down only marginally from the all-time high of 17.4% set in October 2009. And the long-term unemployed, defined as those without jobs for six months or longer, remained at over 40% of the total unemployed, as they have been since December 2009. The continuation of long-term unemployment would suggest that joblessness has become structural and, therefore, less amenable to monetary policy easing.

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The significance of the persistence of high unemployment is that consumer spending, which accounts for over two-thirds of gross national expenditure, is unlikely to increase sufficiently rapidly to facilitate faster economic growth. Just as further monetary easing cannot cure structural unemployment, it will probably not succeed in encouraging households to increase spending and speed up the pace of economic expansion.

ECB aEUR" A Reversal of Position?

Spanish Prime Minister RajoyaEUR(TM)s hope that the a,?100 billion in capital that the European Union agreed to infuse in the banking system would obviate the need for a sovereign bailout has not been met. Spanish debt yields have continued to rise (see chart), and hit a high of over 7.50% on July 24. Such a debt yield is unsustainable given SpainaEUR(TM)s continuing refunding needs, and the large deficit in the countryaEUR(TM)s current account of the balance of payments. Fears that the Spanish government may be forced to follow Greece, Ireland and Portugal in seeking an official bailout led to ECB President DraghiaEUR(TM)s reassuring comments on July 26.

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In a widely followed speech in London, Mr. Draghi said that the ECB would do everything within its mandate to save the euro. The statement was taken to mean that the central bank would join the bailout funds, EFSF and ESM, in buying Spanish paper in the open market. Debt yields fell sharply during the final days of July aEUR" which investors would want to fight the ECB with its unlimited money printing ability? There was one major stumbling block to the marketaEUR(TM)s optimism. And that is the view of the Bundesbank which, despite the formation of the ECB and the Eurozone, still exerts a lot of influence, and treasures its independence. Mr. Draghi acknowledged in a press conference last Thursday that the Bundesbank was opposed to the ECBaEUR(TM)s purchases of the obligations.

Jens Weidmann, President of the Bundesbank and a former adviser to German Chancellor Angela Merkel, has remained opposed to bond purchases by the ECB, fearing that they would lead indirectly to financing the European nationsaEUR(TM) fiscal deficits and, thereby, cause more inflation in coming years. In a Bundesbank staff magazine published at the end of July, Mr. Weidmann emphasized the importance of structural adjustments that had ended GermanyaEUR(TM)s status until the middle of the last decade as "the sick man of Europe." His prescription to the crisis-ridden peripheral countries? Instead of further ECB easing, "if these countries go through adjustment processes which result in decreases in wages and prices, then this constitutes one-off shifts in the wage and price structure and not deflation."

Bundesbank opposition is probably why Mr. Draghi did not indicate at his press conference the specific steps he would undertake to resolve the crisis. He suggested that countries which may need ECB assistance in the future aEUR" probably referring to Spain and Italy aEUR" should first seek assistance from the EFSF and ESM funds which, in essence, means that they need to submit to the EU austerity conditions.

Storm in Spain Does Not Stay in the Plain

While resolving SpainaEUR(TM)s problems are sufficiently challenging, European authorities would face a further acceleration of the crisis if Italy is forced to seek a bailout as well. The Italian debt market has closely followed developments in Spain, and the Italian ten-year debt yield has moved up and down based on factors affecting the Spanish economy. This despite repeated emphasis by Italian Prime Minister Mario Monti that Italy does not have the same problems as Spain. The surplus situation in ItalyaEUR(TM)s primary fiscal balance aEUR" the balance excluding interest payments aEUR" is unmatched in the other crisis countries, for example. Mr. Monti recognizes that ItalyaEUR(TM)s weakness is slow economic growth resulting from poor labor productivity. He is focusing on making structural changes in the labor market to reduce youth unemployment and increase productivity.

The markets, however, do not appear to be receptive to the distinction Mr. Monti is making. Should Spain be forced to seek a sovereign bailout, investor speculation would shift to whether Italy can continue servicing its obligations, or if it can still access private credit markets without EU help. With the Italian recession deepening in the second half of the year, the political opposition to the Monti measures is also likely to increase.

It promises to be a long, hot summer in Europe.