Eurozone worries resurface, but are probably not significant

The outlook for the Eurozone has improved dramatically since late November, when Spanish and Italian 2-yr yields hit levels which suggested a serious risk of default (see chart above). But over the past month, Spanish yields are up some 80 bps and Italian yields are up almost 150 bps, reflecting concerns over these countries' ability to enforce necessary austerity measures. As one article puts it, "Spain is being drawn into a vicious circle of economic, fiscal and political collapse." Are things really that bad? Could this escalate into another bout of extreme Eurozone anxiety such as we saw in the second half of last year?

The rise in 2-yr yields is also reflected in a 10 bps rise in Eurozone 2-yr swap spreads, and this suggests that the concerns about Italy and Spain have for the moment stalled the progress that was being made towards reducing systemic risk and returning financial markets to more normal liquidity conditions.

The chart above compares Eurozone 2-yr swap spreads (orange) with the Vix index (white), and illustrates how the renewed concerns in Europe have infected the U.S. market with a modest (so far) case of the willies. Swaps spreads are up and the Vix is up, and the higher Vix has coincided with a (so far) modest decline in equity prices

The chart above shows that in the great scheme of things, all of these concerns are still relatively minor. U.S. swap spreads remain firmly in "normal" territory, so there has been no fundamental deterioration in U.S. fundamentals—it's mostly just a case of nerves.

This chart confirms that the problems of the Eurozone have not spread in any fundamental way to the U.S. economy, but they have been very painful for Europe. Since late November, when 2-yr Spanish and Italian yields hit their peak, the S&P 500 has outpaced the Euro Stoxx index by some 10%; since late June of last year, just before the Eurozone crisis started heating up, the S&P 500 has eclipsed the Euro Stoxx index by over 25%. The Euro Stoxx banking index is only 15% above its late-November '12 low, having given up more than half of its gains since then in just the past week or so.

From my supply-sider's point of view, Spain's plan to cut government spending is not a big problem, since Keynesian logic way overstates how contractionary this is. It's tax austerity that is creating the problem: Spain's desire to raise taxes in order to help reduce its fiscal deficit—at a time when the economy is struggling and unemployment over 20%—is likely to harm the economy and aggravate the deficit, rather than reduce it. Raising taxes is the problem because that is basically an attempt to validate a level of spending that is already way too high; furthermore, it asks the weakened private sector to carry an additional burden and spares the bloated public sector from needed adjustment. Spain would be much better off focusing on cutting spending (to boost confidence and return resources to the private sector) while cutting taxes wherever possible, to give the private sector an added incentive to work harder and invest more in growth-favorable activities. Spain needs to think outside the box: cutting taxes would most likely not aggravate the deficit, and it might well even contribute to shrinking the deficit if it helps the economy to grow. Will they do the right thing? I can't be sure, but it is clear that they are having a lot of trouble doing the wrong thing, so there is some hope.

Fortunately, Europe is not entirely stupid when it comes to taxes. The U.K. made the mistake of raising its top marginal rate to 50% last year, thinking that this would help reduce its budget deficit. Instead, they have discovered that the higher rate was not producing any new revenue, because upper income taxpayers were fleeing the country and high marginal tax rates were "distorting the economy." So they have now rolled back the tax hike, and this may help improve the situation. Spain could do the same thing.

What we are seeing is the slow, painful, supply-side education of Europe, administered by capital markets and, yes, by bond market vigilantes. In the end, Europe will have little choice but to cut back government spending while at the same time making life easier for the private sector by cutting taxes.