- The present path of policies in the eurozone is not sustainable for economic nor for political reasons.
- A move toward complete monetary union is politically unfeasible and the prospect of countries bolting from the policy constraints is real.
- We believe the ground is more fertile for policy changes not only because of the above, but also because the German economy is no longer immune from the eurozone woes.
- Mario Draghi seems to prepare the ground for a more aggressive monetary policy, European shares could benefit and the euro will fall further.
It's no secret what has caused what can now be called a depression in much of the eurozone. Below is a figure that shows not only the extraordinary length of the eurozone economic crisis, but at the same time that countries who stuck to the gold standard in the 1930s fared the worst.
This isn't a coincidence. The euro produces, just as the gold standard in the 1930s, a strong deflationary bias in which countries in trouble are unable to reflate. We have described the mechanics of it here.
So dire is the situation that something of a revolt is threatening. It is also comparable, at least in some countries, to what happened in the 1930s and much of the eurozone faces a similar stagnation as Japan after the bursting of its epic asset bubbles.
Such a revolt was in sight last week when French economy minister Montebourg revolted against austerity policies and cited the IMF and Paul Krugman in support. While Montebourg's views could have been no surprise to nobody, two things happened:
- The French government fell as a direct result of this
- ECB president Mario Draghi de-emphasized austerity in a significant speech at Jackson Hole
We have wondered for some time why the rather unprecedented slump in the eurozone periphery hasn't led to more political upheaval. For a while, things looked explosive in Greece only, but in the rest of the periphery things were fairly quiet. This despite the dire economic circumstances and little perspective of any immediate or even near-time relief.
We both feared and hoped that things would come to a climax, as it should be clear to all that the European Monetary Union (EMU) is a deeply dysfunctional arrangement that has ravaged whole countries and generations (see here for an explanation). In its present state, things simply can't continue.
But given the EMU constraints, logically it's only the completion of it that could bring some solace. But this would involve a move to a real monetary union with a much larger common budget or automatic redistribution from booming to busting regions and debt mutualization.
This is simply a political non-starter, considering that there is no majority in favor of this in any country and that proposals will have to pass all of them, probably quite a few with referendums. Our preferred solution would be a break-away of the Northern countries, forming a 'neuro' currency, which would immediately appreciate significantly.
But now that Germany has finally fallen victim to the same economic forces, the prospect of a sharp appreciation in its currency isn't making this solution any more likely either. Here is Ambrose-Pritchard from The Telegraph:
German bond yields are pricing in stagnation as far as the eye can see. 10-year Bunds fell below 1pc this morning for the first time in history, and far below levels seen during the deflationary episodes of the Second Reich in the late 19th Century.
And you really have to marvel at the following graph to illustrate that point:
And there is little reason to expect any relief anytime soon, inflation expectations in the eurozone are basically falling to earth:
Fortunately, the same forces reaching Germany will also give Mario Draghi some leeway, and he seems to be ready to pounce on this opportunity with some gusto. We don't recall a previous instance where Draghi so clearly questioned the rationale of pro-cyclical austerity during a slump, and he had a rather astute observation:
Despite very low policy rates, the cost of capital actually rose in stressed countries in this period, meaning monetary and fiscal policy effectively tightened in tandem.
You see, this is the effect of EMU. Investors selling assets in the periphery receive euros, which they can invest at no cost or exchange risk in assets in other eurozone countries, so these euros can very well leave the periphery. This is tightening monetary conditions no matter what the interest rates are.
This is quite different from what happens in a country which has its own currency (say the UK). Investors selling assets get pounds, they either sell them on the forex markets or buy other UK assets. If they sell the pounds, the buyers of these will invest in UK assets, the money never leaves the country.
Combined with the effects of austerity almost everywhere, it's no wonder the periphery is in eternal slump and no wonder this is also affecting core countries but Draghi also shifted somewhat on fiscal policy:
Turning to fiscal policy, since 2010 the euro area has suffered from fiscal policy being less available and effective, especially compared with other large advanced economies. This is not so much a consequence of high initial debt ratios - public debt is in aggregate not higher in the euro area than in the US or Japan. It reflects the fact that the central bank in those countries could act and has acted as a backstop for government funding.
Draghi himself changed the latter in 2012, but it took a further two years to realize:
Thus, it would be helpful for the overall stance of policy if fiscal policy could play a greater role alongside monetary policy, and I believe there is scope for this, while taking into account our specific initial conditions and legal constraints.
And it's necessary because while the immediate danger of a eurocrisis has subsided, deflationary forces are preparing the ground for another one as the combined effect of stagnant economies (at best) and low or even negative inflation produces a denominator effect on debt/GDP levels, ratcheting these inexorably upwards despite sometimes heroic austerity measures.
The prospect of one or more countries simply bolting from the present policy constraints or even leaving EMU altogether is more than a theoretical prospect.
So basically, for economic and political reasons, things need to change, the present path is disastrous and simply not sustainable. We feel that Draghi is realizing this and is preparing the ground for policy changes.
The eurozone is labyrinthine in its decision making but we feel that change is in the air. The more significant change would be at the ECB itself, embarking on similar QE policies that have been pursued in the US, UK, Japan, and in a different form, in Switzerland, here is Draghi again:
Inflation has been on a downward path from around 2.5% in the summer of 2012 to 0.4% most recently. Acknowledging this, the Governing Council would use also unconventional instruments to safeguard the firm anchoring of inflation expectations over the medium- to long -term.
We don't expect this immediately, the ECB has the cover that it first wants to see what kind of traction their latest initiatives will have:
We will launch our first Targeted Long-Term Refinancing Operation in September, which has so far garnered significant interest from banks. And our preparation for outright purchases in asset-backed security (ABS) markets is fast moving forward and we expect that it should contribute to further credit easing.
The market is clearly sensing the change and we're getting a little more optimistic about meaningful policy changes after Draghi's speech. As we argued it would, the euro has declined, and now stocks, after a pretty significant wobble, have turned again. In the absence of geo-political hiccup or a major correction in US stocks, we expect these trends to continue for some time.
So we think shorting the euro (EUR/USD) or an ETF like iPath EUR/USD Exchange Rate ETN (NYSEARCA:ERO) or CurrencyShares Euro Trust ETF (NYSEARCA:FXE) still makes sense and there are opportunities in European shares as well, one can dabble into ETFs like iShares MSCI EMU ETF (NYSEARCA:EZU).
Additional disclosure: We're short EUR/USD