Banks, Politics Seen Pushing Euro Zone Into Recession

More and more analysts looking at the euro zone predict that another recession is inevitable, as banking sector tensions combined with political wrangling over the debt crisis will depress consumer confidence further and will choke funding for business.

Photo: Bloomberg | Getty Imgaes

Disappointing government debt auctions this week – on Wednesday for Germany, where demand was very weak and on Friday for Italy, which saw yields hitting record euro lifetime highs – show that investors are losing faith in political leaders' ability to rein in bulging deficits and are punishing the whole area.

Economists at Goldman Sachs expect the euro zone to fall into recession in the fourth quarter, on the back of "a negative confidence shock and tighten fiscal policy, combined with private-sector deleveraging in the periphery."

They predict overall growth of 0.1 percent for the single currency area next year, but say that "funding difficulties for banks represent a clear downside risk to this forecast."

Tensions in the banking system are not yet visible in lending data for the area, but they could lead to a "significant" worsening of funding conditions for companies and households, the Goldman Sachs economists wrote in a research note.

They pointed out that the funding situation for banks in the euro zone is becoming more challenging because the value of banks' collateral has declined sharply after the accelerated sell-off of euro zone bonds over the past two weeks.

This is problematic for the private, inter-bank lending market but also for liquidity provisioning via the European Central Bank, because "the market value of the collateral is an important side constraint in determining the amount of liquidity banks can obtain from the ECB," Goldman Sachs economists wrote.

"Against this backdrop, the renewed tightening in lending conditions for the euro-area private sector comes as no surprise," they said.

"We think it reasonable to assume that the longer it takes to stabilize the situation in the banking sector, the greater the risk that bank lending behavior will at some point lead to a sharp decline in economic activity," the Goldman Sachs economists added.

No Quick Solution

Hopes for a swift resolution have been dampened after yet another inconclusive summit on Thursday.

German Chancellor Angela Merkel, French President Nicolas Sarkozy and Italian Prime Minister Mario Monti's meeting did not result in any new initiatives, with Merkel reiterating her opposition to issuing joint euro bonds and allowing the ECB to print money.

This means sorting out the euro zone debt crisis will take time and will be painful, some analysts said.

Besides the German obsession with central bank independence and fear of hyperinflation, the core of the German opposition is "all about conditionality," Carsten Brzeski, an analyst with ING, said.

"The German government does not believe in a quick fix of the crisis, only in structural changes," Brzeski said.

"In fact, chancellor Merkel has recently made several pleas for more political integration in the euro zone. However, it is obvious that the German government first wants to see more political integration before it would give structural access to German money. This explains the German emphasis on Treaty changes," he added.

Even so, a reversal of international capital flows and a fall in profit margins will be needed for sustained economic recovery, according to author Andrew Smithers, founder of research firm Smithers & Co.

"If things go well, investment will hold up despite falling profit margins and the higher labor share will support consumption, possibly with help in the euro zone from falling household savings," Smithers wrote in a market note.

"If things go badly, the developed world will fall back into recession. Either way profits will fall and are likely to bring down stock markets," he added.