Markets to eurozone: It's the growth, stupid

President Sarkozy and Chancellor Merkel Image copyright Reuters
Image caption Without economic growth, eurozone politicians' promises may not be worth very much

Investors believe eurozone governments when they say they are completely committed to keeping the single currency together.

What the financial markets - and most economists - now doubt is the ability for eurozone economies to achieve decent growth.

And without growth, the politicians' promises may not be worth very much.

This is the reality that is starting to weigh on eurozone leaders - and it is not a pleasant one.

They have given themselves until Wednesday finally to come up with a credible version of Plan A. But investors and analysts seem to be thinking more and more about a Plan B.

Exhibit one

Three pieces of recent evidence can help make this point.

Exhibit one is Monday's October PMI for the eurozone from Markit.

The composite index fell to 47.2, further than most were expecting, that's the lowest since the summer of 2009, and points to a flat or shrinking Eurozone economy in the last three months of this year.

France showed particular weakness in this survey, with a sharp fall in confidence in the service sector.

On this measure, only Germany is looking at positive growth in the last quarter, and even there, employment prospects are weakening and the manufacturing side of the economy has slowed sharply.

The lesson is that the recovery is faltering - even in countries that had previously been doing fairly well.

Two and three

Exhibit two is that confidential Troika report on Greece, leaked to the FT on Friday night.

This shows Greek debt peaking at a much higher level - 186% of GDP - than previously thought.

The implication was that Greece will need either a much more drastic write-down of privately-held debt or another €250bn in official resources.

What is the single most important factor explaining this decline in the country's fortunes? The answer is weak economic growth: the Greek recession is now going to be deeper than the Troika hoped, and the "growth dividend" from difficult structural reforms is going to take that much longer to arrive.

Exhibit three is what has happened to the share and debt prices of European banks over the past few months.

Outside Greece, bank shares have done reasonably well today. But as you know, over the past few months they have taken a hammering.

Shares in Credit Agricole, to take an extreme example, are now nearly 60% lower than a year ago.

On average, the stock market value of the 60 most important European banks has fallen by nearly a quarter since the start of July.

We tend to assume these price falls are due to worries about the losses that banks could take on their sovereign debt holdings, but an interesting analysis by Guntram Wolff, an economist from Bruegel whom I interviewed for the 10 o'clock news on Friday, suggests that this is wrong.

Wolff examines what has happened to bank share prices and finds that they have been importantly influenced by banks' individual holdings of Greek debt.

So Greek banks, naturally, have been particularly punished, and were punished again on Monday.

General worries

So far, so predictable. But he finds that banks' holdings of Spanish, Italian, Portuguese or Irish debt do not to seem to have played a big role in pushing down their market value.

Put it another way: French banks with small holdings of, say, Italian sovereign debt have been just as battered as banks who are holding vast quantities of the stuff.

So, it seems to be a more general anxiety that's pulling bank shares down, not a particular fear that other governments will follow Greece in restructuring their debt.

Another way to see this is to look at what's happened to the price of European bank debt, which has generally fallen by much less than their share price.

So, outside Greece, investors don't seem to be worried that sovereign debt will be written off, or that governments will allow private bondholders to lose out in any bank failures.

The worry is, rather, that banks may soon find out they are unable to make any money.

Wolff thinks that speaks to a general lack of confidence in the system. Others, like Andy Haldane, at the Bank of England, think it points to a lack of confidence in the real economy. (Which is why, incidentally, UK bank shares have also been hit.)

Bottom line? The bottom line is that investors believe European politicians when they say they will not allow another "Lehman Brothers event".

But they don't think that politicians can protect Europe's financial system from another recession.

And they don't think that the current approach to the crisis will rescue the region from years of very slow growth, especially in countries like Italy and Spain.

That, incidentally, was the conclusion of my piece for the TV bulletins on Friday night: that we might get a "deal" to save the Euro on Wednesday, but it does not look as though we will get a deal consistent with reasonable economic growth.

What might a "Plan B" for the eurozone look like? Watch this space.