The first quarter of 2009 saw the worst performance in the history of the 16-nation Eurozone since its establishment in 1999.   The 27 nation E.U. also marked the worst performance in its history as GDP shrank by 2.5%.  This annualized loss of 10% to Eurozone GDP is far worse than the worst case expectations of many economists.

Germany, the heavyweight of Eurozone economies, hit the mat even harder with a 3.8% plunge in the first three months of 2009.    (An annualized loss of 15.2%)

Even more alarming were the 1Q’08/1Q’09 performances of  Estonia (-15.6%), Latvia (-18.6%) and Lithuania (-10.9%).   What is notable about the Eurozone figures overall is that the Eurozone is getting far more bruised by the global financial crisis than either the US or the UK.

The credit collapse of both the US and the UK has led to an export collapse in the Eurozone manufacturing economies.  Even though Europe’s exporters managed to avoid the levels of credit bubble insanity experienced by their neighbors to the West, Europe’s export economies are the ones being hit the hardest by the crisis.

As it stands now, these frightening plunges in GDP have not yet resulted in widespread job-losses across the Eurozone, but in our estimation this quiet cannot last.  We foresee job-losses ramping up quickly towards the end of this year as Europe’s manufacturers see continued quarters of tepid demand for exports. There is no easy fix for the Eurozone’s economic problems, and macroeconomic problems are likely to be felt on a far more personal level across the Eurozone soon.

We continue to watch with concern as Ireland’s economic condition worsens.  The country is undergoing a painful economic deflation as liquidity evaporates and their monstrous housing bubble collapses.  A report released last Thursday showed retail prices dropping 3.5% in April as consumer spending waned.  The current deflation in Ireland is the worst the country has seen since the 1930’s.

The AP reports:

“Consumer Prices in April, as measured by the Consumer Prices Index, decreased by 0.8 percent in the month. This compares to an increase of 0.1 percent recorded in April of last year,” the CSO said in a statement.

“As a result, prices on average, as measured by the CPI, were 3.5 percent lower in April compared with April 2008.”

In January, a 0.1-percent 12-month decline was the first time the country had experienced falling prices since the early 1960s. The annual rate of inflation stood at minus 1.7 percent in February and minus 2.6 percent in March.

To date the Irish government has embarked on a massive program of borrowing in an effort to stabilize the downward plunge.    The government has increased social spending a whopping 63% since 2003.   Now the devastated economy is decimating tax receipts leaving the government with an 11% budget deficit — making Ireland the weakest economy in western Europe.

Barron’s reports:

The risk is that Ireland will lose control of its destiny. Some believe that if the government doesn’t soon begin to cut costs, it may not be able to borrow enough to meet its needs and then will have to be rescued by its European neighbors. This could destroy Ireland’s allure for foreign investors such as Intel, HP, Microsoft , and Pfizer that helped make it a shooting star for almost two decades.

“An international bailout will wreck our competitiveness,” says the blue-jean-clad O’Leary, sipping vending machine espresso bought with a euro bummed from a flight attendant. “For a company the only reliable way to restore profits is to lower costs. The government needs to get off its backside and radically cut spending.”

As its troubles mount, Ireland also stands in danger of losing a rare gift: its image as a beacon for talent – and as the EU’s leading land of opportunity. Chefs from France, construction workers from Poland, and accountants from the Czech Republic are heading home. In 2007, 67,000 more people arrived than departed. This year 30,000 more workers are expected to leave than arrive, reversing 14 years of strong immigration and raising fears that the curse of the ’70s and ’80s – the steady exodus of the best workers – is again exerting its grip.

We see Ireland’s mandate quite simply at this point:   The country must reduce it’s private labor costs, and steer clear of raising taxes as its government deficit soars.  Crucial to the latter, and to maintaining Ireland’s low tax environment will be a lowering of wages for public-sector workers as well.  Fortunately, the nation isn’t bound by the same labor and union regulations as its neighbors on the continent — a flexibility which should in theory allow Ireland to reduce labor costs with greater ease than many other nations in the Eurozone.   While the cure for Ireland’s ills may be simple to describe, the treatment itself promises to be painful both socially and politically.

To date, no equivalent of the US Treasury’s so-called “Stress Tests” has been conducted on Europe’s also troubled banking system.  The lack of similar tests is spawning concerns throughout the sector, and in the European media — that the European banking system may not meet the U.S. standards of banking “readiness”.

The Wall Street Journal reports:

Unlike in the U.S., there has been no major policy initiative to force banks in Europe to increase capital cushions, and governments have intervened only on a piecemeal basis. Meanwhile, as U.S. banks pile in with efforts to raise capital from investors, European banks aren’t taking advantage of a stock rally to do the same.

The IMF estimates that European banks have approximately 40% of the suggested $1 trillion needed to protect against any potential bout of economic flu.   By contrast, US banks have roughly 66% of the $666 billion cushion they require.

While stated levels of capital reserves may differ, a 1:1 comparison with the European and American banking systems based upon capital cushions is difficult to make.

We have already discussed the silliness of the Stress Tests in a previous post, but it should be re-stated that U.S. measurements of capital reserves should be treated as highly suspect.  Considering that the American banking system has abandoned accounting best-practices, thrown GAAP to the wind, and encouraged our banks to creatively portray their financial health — we are forced to wonder which data the IMF is using to compare the relative health of US and European banks.  One must also remember that the amount “needed” by US banks was originally estimated at over $1 trillion — but was adjusted down to $666 billion due to “push back” from the US banks themselves.  (If we adhere to Treasury’s original reserve requirement of $1 trillion, US banks also have just over 40% of what is required).

Ultimately, a comparison of systemic health between European and U.S. economies is an apples-to-oranges comparison, and cannot easily be made using the simple statistic of banking reserve ratios.   As the WSJ notes:

Weakened banks in Europe have a potentially bigger economic impact than U.S. financial institutions do, since some 80% of lending to companies in Europe is through banks, compared with only one-fifth in the U.S. If replenishing capital levels causes European banks to pull back on lending, it could slow economic recovery.

Particularly troubling for European banks are investments in Eastern Europe — a region undergoing an extremely serious recession.   We expect losses in Eastern Europe to exceed losses experienced even in the most highly distressed areas of the United States.  Unlike U.S. “Stress Tests” however,  don’t expect the results of a European equivalent to be made public.  Then again, if Europe’s tests are a mere public relations stunt like those in the U.S. — we won’t be placing much faith in the results anyway.

While economic conditions grow worse across Western Europe, Spain’s woes are particularly acute.   Coming down from housing and credit bubbles that dwarfed those of  neighboring nations, Spain’s deflationary collapse is now hitting levels of intensity which will soon have profound repercussions on greater Europe.  In Spain, no one is talking about a potential recovery in 2009 — or 2010.

The numbers are grim.  Once a primary engine of growth in Europe, Spain is now one of the leaders on  the way down.  Official numbers on unemployment are a staggering 17.5% and are expected to top 20.5% this year.  Bankruptcies have quadrupled this year, and industrial production has withered by an alarming 25%.  The construction industry, so vital to their economic health over the past 5 years, has imploded as construction projects are scrapped nationwide.

Zapatero has pledged 50 billion in stimulus, but there is widespread sentiment that such efforts may not be sufficient, given that the economy has contracted by 3.2% even with efforts to kickstart the economy.

Bloomberg reports:

“This has gone on a lot longer than a lot of people expected,” said Ben May, economist at Capital Economics in London. “There is much further to go in terms of the labor market downturn.”

Spanish bonds erased early gains after the report. The yield on Spain’s benchmark 10-year bond due 2019 rose 1 basis point to 3.92 percent, after falling as low as 3.89 percent in early trading.

Government Response

The number of unemployed industrial workers rose 62 percent in April from a year earlier, data showed yesterday, compared with 56 percent in the economy overall. Prime Minister Jose Luis Rodriguez Zapatero plans to hold a special cabinet meeting today in Madrid to discuss ways to curtail the rise in unemployment.

Zapatero’s government has already committed 50 billion euros ($66 billion) to stimulus measures for this year, wiping out three years of budget surpluses and putting it on track for a shortfall of 8.3 percent of output this year, according to the Bank of Spain.

The greatest number of companies that were in bankruptcy proceedings were construction or real estate firms, while 324 of the companies were industrial or energy businesses, the report from the National Statistics Institute showed.

Housing Bust

Spain’s housing boom had been the main driver of economic growth and allowed the economy to expand faster than the EU average for a decade through last year. Home prices, which almost doubled over about a decade, have fallen for five quarters, as banks rein in lending. Mortgage lending fell 37 percent in February from a year earlier, the 19th monthly decline.

Enagas SA, Spain’s natural-gas grid operator, said demand for gas fell 17 percent in the first quarter from a year earlier, led by a 31 percent drop in consumption from power producers. Acerinox SA, Spain’s largest stainless-steel producer, made a loss in the first quarter as sales tumbled 61 percent. The company said in February it planned to cut working hours at a Spanish plant by 50 percent.

Automakers are also cutting output and laying off workers as new car registrations, a proxy for sales, fell 44 percent in April from a year earlier. Ford Motor Co. said on March 16 that it plans to drop a production shift at its factory in Valencia, affecting 1,000 employees, even after the government pledged 800 million euros ($1.1 billion) in aid to the industry.

This Thursday, the European Central Bank purchased an additional 60 billion Euros worth of Eurozone covered bonds in an effort to shore up the rapidly deteriorating housing prices in Spain and Ireland.  At this point, national debt levels within Spain are past reaching critical levels and additional capital required to mitigate the economic downturn is becoming harder to come by.  Where the bottom is, nobody knows, but there are certainly no green shoots breaking ground in this corner of Europe.

Spain remains a critically weak pillar in the Eurozone.  We continue to watch this issue closely.

In an excellent piece published in Foreign Policy, historian Niall Ferguson illustrates the broad geopolitical ramifications of economic decline.  Ferguson contrasts the willful malice of George Bush’s “Axis of Evil”, against the less intentionally destabilizing influence of regimes undergoing waves of political and fiscal turbulence.

Ferguson’s “Axis of Upheaval“, as he calls it includes Russia, Somalia, Mexico and other nations desperately fighting to stay afloat through the gale-force winds of  political instability:  An instability magnified by a world undergoing economic deflation.

Now the third variable, economic volatility, has returned with a vengeance. U.S. Federal Reserve Chairman Ben Bernanke’s “Great Moderation”—the supposed decline of economic volatility that he hailed in a 2004 lecture—has been obliterated by a financial chain reaction, beginning in the U.S. subprime mortgage market, spreading through the banking system, reaching into the “shadow” system of credit based on securitization, and now triggering collapses in asset prices and economic activity around the world.

After nearly a decade of unprecedented growth, the global economy will almost certainly sputter along in 2009, though probably not as much as it did in the early 1930s, because governments worldwide are frantically trying to repress this new depression. But no matter how low interest rates go or how high deficits rise, there will be a substantial increase in unemployment in most economies this year and a painful decline in incomes. Such economic pain nearly always has geopolitical consequences. Indeed, we can already see the first symptoms of the coming upheaval.

As the economic conditions within his “Axis of Upheaval” disintegrate rapidly, so too do the socio-political moorings of society –  A deterioration which will likely result in radical power-shifts, militarization, social divisions and other bad eggs which are often mitigated during eras of economic prosperity.  Ferguson also points out that these ill-effects are compounded by our decreasing ability to intervene through the traditional means of financial incentive or military intervention:

The problem is that, as in the 1930s, most countries are looking inward, grappling with the domestic consequences of the economic crisis and paying little attention to the wider world crisis. This is true even of the United States, which is now so preoccupied with its own economic problems that countering global upheaval looks like an expensive luxury. With the U.S. rate of GDP growth set to contract between 2 and 3 percentage points this year, and with the official unemployment rate likely to approach 10 percent, all attention in Washington will remain focused on a nearly $1 trillion stimulus package. Caution has been thrown to the wind by both the Federal Reserve and the Treasury. The projected deficit for 2009 is already soaring above the trillion-dollar mark, more than 8 percent of GDP. Few commentators are asking what all this means for U.S. foreign policy.

The answer is obvious: The resources available for policing the world are certain to be reduced for the foreseeable future. That will be especially true if foreign investors start demanding higher yields on the bonds they buy from the United States or simply begin dumping dollars in exchange for other currencies.

Economic volatility, plus ethnic disintegration, plus an empire in decline: That combination is about the most lethal in geopolitics. We now have all three. The age of upheaval starts now.

Ferguson’s essay is an excellent read and highly recommended by The Analytic:

http://www.foreignpolicy.com/story/cms.php?story_id=4681