So, on Thursday the markets sold off because of bad data out of the eurozone. Is this really so surprising? No. While the acuteness of the eurocrisis has waned, much of the region is mired into a 1930s style deflationary trap that could ultimately produce every bit of a big crisis as the bondmarket crashes that have been prevented by the "whatever it takes" stance of the ECB.
It's fairly important investors understand exactly what's going on. At heart, this isn't terribly complex. The move to a single currency is largely responsible for the crisis, as well as for the inadequate (to put it mildly) response. Here a quick primer:
- The creation of the euro led to an economic boom and capital inflows in much of the periphery
- This led to an erosion of competitiveness
- Capital flows reverse
- Internal devaluation
- Deflationary bias
- Denominator effect
- ECB constraints
Before the euro, cycles of relatively high inflation and devaluations induced little trust in the monetary affairs of much of the eurozone periphery. The euro was supposed to amend for this by taking monetary policy out of their hands, and put it in the hands of a common central bank, the ECB, whose credibility was supposed to derive from its Teutonic design.
This trick actually worked, indeed, one could say, it worked all too well. Even in the run-up towards monetary union, you could see interest rates and bond yields converging, the result of declining risk premiums for peripheral assets
The increased confidence, low interest rates produced good economic growth. Relieved of the exchange rate risk, serious amounts of capital (mostly in the form of bank loans) started to flow from the center to the periphery, reinforcing the boom.
In some places, like Spain and Ireland, this led to housing bubbles, in others (Greece, Portugal), the cyclical improvement of the public finances led to carelessness with these.
Economic boom and capital inflows together stoked inflationary pressures. Over time, the accumulation of these led to a serious erosion of competitiveness. This loss of competitiveness could no longer be offset by the occasional devaluation.
While a current account is less of a constraint under a single currency regime, a sustained loss of competitiveness is still a bad economic shock to a country, especially when there aren't many policy options to remedy the situation.
Capital flows reverse
While the financial crisis was largely an external shock, it wreaked havoc in the financial markets and the capital flows from the core to the periphery came to a halt, then reversed. Mostly a result of bank credit drying up, but the revelations about Greek public finances, the implosions in the Irish and Spanish housing markets, and subsequent banking crisis added greatly to the reverse.
Boom turned into bust, capital ran for the exit, and just as the creation of the euro was responsible for the creation of the peripheral boom in the first place, it's also responsible for its persistence.
This particular bust in the peripheral countries has left them with a nasty catch-22 situation:
- Revive growth with reflationary policies but worsen the competitiveness problems
- Improve competitiveness with deflationary policies, but worsen growth
To a large extent, being in the single currency system forced the choice upon these countries, as they could no longer reflate through monetary means or exchange rate setting, two policy instruments that have been forfeited by joining the euro.
Reflation through fiscal means was difficult for particular reasons (Greece's doctoring of their public books) but also ran into the constraints of the euro in the form of the stability and growth pact (now the fiscal compact) limiting deficits to 3% of GDP and public debts to 60% of GDP, forcing these countries into a deflationary austerity run.
The peripheral countries 'solved' their catch-22 by being forced into deflationary policies, largely by the constraints of the euro system itself. Is this an optimal policy choice? Even if one doesn't agree with our analysis here, we think that the record of the past five years speaks for itself:
- Most of the periphery has been mired in recession for most of the period
- Whilst current accounts have improved considerably, this is mostly the result of a drop in imports, itself the product of the economic slump
- Perhaps most damaging, whilst there has been some improvement in public finances, public debt ratios have kept on rising.
Once again, we think that the euro system itself is largely responsible for this sorry state of affairs.
In the present make-up, the eurozone functions very much like the gold standard did in the 1930s, that is, there is a heavy deflationary bias operating. Countries cannot devalue or embark on monetary stimulus:
- Adjustment (through deflationary policies) is the exclusive domain of the periphery, there is no offsetting reflationary effort from the core countries.
- In fact, most of the core countries have also embarked on deflationary policies, producing no offsetting demand for the loss of domestic demand in the periphery (rather, reinforcing that loss and activating the paradox of saving). Nor is the eurozone core producing a higher inflation rate, which would make it easier for the periphery to recoup some of the lost competitiveness, making this process extraordinarily hard and tortuous, or forcing the periphery into outright deflation.
The outcome of this is that most of the periphery is trapped in a deflationary spiral. They can't devalue. They can't embark on monetary stimulus, they are forced to embark on deflationary policies to recoup lost competitiveness and improve public finances.
If you were wondering why they have been mired into an extraordinary long slump, wonder no more, this is why. But this isn't even all.
The result of the deflationary bias is very low or negative growth and very low or negative inflation. This absence of any meaningful nominal growth actually produces a 'denominator effect,' in which, by lack of increase in the denominator, the public debt/GDP ratio keeps on rising.
This is why, despite years of heroic austerity efforts in countries like Spain, Greece, Portugal, Italy, Ireland, debt/GDP ratios have simply kept on rising, even if deficit has been narrowing.
So the two supposed advantages of the deflationary policies, recouping lost competitiveness and improving public finances have been made extraordinarily hard and slow. Any setback, like even a mild US recession, could well throw this process off its already extremely slow track.
The only institution who could produce some reflation is the ECB. Instead, it has been mired into dangerous inaction, even if it has staved off an immediate collapse of the euro by finally promising to do "whatever it takes," that is, do as every other central bank and function as lender of last resort for sovereign debt.
This ECB action (after years of recriminations and hesitations) has prevented an imminent collapse and produced declining bond yields in the periphery without which their public finances would be on an even less sustainable path.
However, the ECB has, at least so far, refused to embark on policies that have helped recoveries in the US, the UK, and Japan, that is, it has refused to embark on quantitative easing (QE). We expect this resistance to melt away pretty soon, considering the economic circumstances.
Speaking of these economic circumstances, much of the eurozone is mired in stagnation. Many know of the lengthy slumps in the periphery, the high unemployment and the staggering youth unemployment rates. However, it's less well known that this is not necessarily the reserve of the periphery:
The country's Observatoire Economique said the outlook was even more troubling than it looked. "France has seen a complete stagnation for the last 10 years, an unprecedented situation since the end of the Second World War," it said. The body said fiscal cuts of 5pc of GDP from 2010 to 2013 had been premature and self-defeating. [The Telegraph]
Bruno de Haas, a former official at the Dutch central bank and author of Why The Euro Will Break Us, said membership of EMU had a disastrous effect on the country's credit structure and was now blocking recovery. "The sooner the Netherlands returns to the guilder, the better," he said. Dutch property prices have fallen by 20pc, leaving a quarter of mortgages in negative equity. As the slump drags on, it makes it even harder for Dutch households to cope with loans near 250pc of disposable income. [The Telegraph]
The zone is plagued by the self-reinforcing effects of collective austerity, tight credit and a strong euro. This isn't a pretty picture:
In summary, why the euro is dysfunctional
- It forces a one-size-fits nobody monetary conditions that were too loose in the pre-crisis years, producing booms and asset bubbles and higher inflation in the periphery.
- It leaves countries without measures to address an asymmetrical shock (like a loss of competitiveness versus other member countries).
- It thereby forces a deflationary bias on the system as a whole, which has a tendency of being self-reinforcing.
We already mentioned that this is very much like the gold standard worked in the 1930s, and you have to realize that the sooner countries left the gold standard, the quicker they recovered.
We have little doubt that if countries like Greece or Portugal would have left the euro five years ago and devalued, they would have recovered by now. Argentina recovered within a year after the 2001 crisis when it forfeited on debt and its parity with the dollar.
Unfortunately, leaving the euro is fraught with legal and practical problems and risk, a different proposition than leaving a gold standard or a currency peg.
While the present situation can continue for a considerable amount of time, it is not without significant risk, the most important of which are:
- Public finances reaching a point of no return
- Banks going bust
- The public getting fed up, leading to political turmoil.
The slow grinding combination of virtually zero growth and zero inflation has a destructive denominator effect on public debt/GDP ratios, look what's happening to Italy's:
In case you think Italy is unique...
Greece's 2012 'interruption' of the steeply upward trend is simply the result of investors taking big haircuts in a debt restructuring.
If a country can't grow its way out of debt, it can't inflate the debt away, it can't devalue away its lost competitiveness, it's between a rock and a hard place. Do you fully get the rally in peripheral bonds? It only makes sense when it's 100% certain that the ECB will, sooner rather than later, embark on massive bond buying.
Then there are the banks. The latest scare came from Portugal, but do we really think eurozone banks are all sound, with low growth, and big portfolios of sovereign debt. The latter still points to a potential vicious cycle in which banks and public finances tear one another down.
For political observers it's a bit of a mystery why the unprecedented slump hasn't led to a greater political fallout. We know now that governments were toppled in Italy and Greece, by rather non-democratic means. To assume that this relative quiet will last forever is assuming quite a lot.
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