Europe Can't Kick the Can Much Farther

Evidently EUR 1 trillion does not buy very much in Europe anymore. Judging by the financial market's renewed unease about Italy and Spain over the past week it would seem that all that the European Central Bank's EUR 1 trillion liquidity injection in the European banking system bought was around four months of relative market calm.

In December 2011, in response to signs of acute funding problems for the European banking system, as well as in reaction to a marked increase in Italian and Spanish bond yields to unsustainable levels, the European Central Bank (ECB) embarked on a highly aggressive new round of quantitative easing. It did so by providing European banks, in two installments, unlimited amounts of three-year financing at a 1 percent interest rate through its Long-Term Refinancing Operation (LTRO). By February 2012, the European banks had availed themselves of this cheap ECB funding to the tune of a staggering EUR 1 trillion.

Yet, by early April 2012, Italian and Spanish bond yields were again rising towards unsustainable levels. Indeed, after declining to a low of around 4.8 percent in January 2012, the 10-year Spanish bond yield has again risen to 5.90 percent. Meanwhile Italian bond yields are back up to over 5.5 percent. Most economic analysts would consider that these bond yields are inconsistent with Italy and Spain's long-term public debt sustainability.

More ominously still, despite the European Central Bank's staggering largesse, the Italian and Spanish economies have now moved back into recession. Furthermore, high frequency data suggest that those economies' recessions are now deepening. The IMF current projection that those two economies will each contract by around 2 percent in 2012 might very well prove to be overly optimistic.

The increase in Italian and Spanish interest rates, coupled with the continued slump in their economies, sits very oddly with recent claims by European policymakers that the worst of the European economic crisis is behind us. To be sure, the ECB's LTRO program did avert a massive funding crisis for the European banking system by providing them with vast amounts of secure and very cheap three-year ECB funding. And the LTRO program also provided temporary support to the Italian and Spanish bond market and gave a sense of calm in the European financial markets by encouraging Italian and Spanish banks to use the cheap ECB financing to buy their governments' bonds.

However, what the LTRO program has not done is to restore the conditions for economic growth in the European periphery. In particular, it has not relieved countries in the European periphery from having to undertake draconian fiscal adjustment as part of the European Union's recently agreed fiscal pact. That pact is requiring countries like Ireland, Italy, Spain and Portugal to cut their budget deficits by between 2 to 3 percentage points of GDP a year in both 2012 and 2013. And this is being required of them in the middle of major domestic economic downturn and a deteriorating external environment, without the benefit of a currency devaluation to help boost their exports.

The LTRO program also has done nothing to address the European banks' capital shortage problem, which last June the European Banking Authority estimated at around EUR 115 billion. The latest ECB bank lending survey clearly shows that this capital shortage is inducing the European banks to restrict credit, which is compounding the deleterious impact on economic growth of major fiscal austerity. As the European economy sinks deeper into recession, one has to expect that the European banks' loan losses will only increase, which will cause these banks to cut back further their lending.

Far from being fickle as European policymakers are wont to portray them, markets are now correctly sensing that Europe's policy mix is highly pro-cyclical in nature and that weakening economies will make it very difficult for countries like Italy and Spain to address their public finance programs within the Euro straitjacket and without a debt restructuring. If the past is prologue to the future, however, one must expect that the European policymakers will blame the markets for delivering the message while they will continue to remain in denial about the bankruptcy of their policy approach to the European debt crisis.

Instead one must expect that the European Central Bank will find a way to pull yet another big rabbit out of the bag to kick the can further down the road. However, given how rapidly the effects of their massive LTRO program has faded, one would think that even the ECB must recognize that they are running out of road down which to kick the can.