This Is Not An Inflection Point For Europe

Includes: ERO, EU, EUFN, EUFX, FXE
by: Kyle Spencer

SA Contributor Cam Hui wrote an excellent article yesterday about whether reduced wages and Chinese investment constituted "an inflection point" for Europe.

I believe the answer is no.

The assumption that the situation in southern Europe will stabilize once competitiveness in the southern European job market is restored is pervasive. The British don't question it, the Germans don't question it, the IMF doesn't question it, The Economist doesn't question it. But will internal devaluation really save southern Europe?

Below is Richard Koo's chart illustrating at what point internal devaluation (read: deflation) will reduce the wages of the southern European countries to a point where they intersect with Germany's. The implication is that once that happens, competitiveness will be restored and the European crisis will effectively burn itself out.

When Wages Hit The Floor

Reducing wages to restore competitiveness would solve a lot of southern Europe's problems -- on paper, at least. It's a different story altogether if you're unfortunate enough to live in Spain, Greece, Ireland, or Portugal while wages are plummeting through the floor.

For all the bravado of Prime Ministers Mariano Rajoy and Antonis Samaras, it is difficult to imagine how the PIIGS governments will achieve such a prolonged, foreign-mandated reduction in wages. Have the electorate in southern Europe given any indication that it rewards incumbents who prolonged their misery? Quite the contrary: the voters of southern Europe have sacked every head of state who agreed to the Troika's austerity demands without ceremony.

In order to reach the intersection point in Mr. Koo's chart, politicians in four countries are going to have to sell their citizens on four to eight years of economic pain.

How would that work, exactly?

Four to eight years is not like having a rotten tooth on a national scale, where all that's required is a pinch of courage, a pull, a bottle of codeine and a doctor's note. Four to eight years of deflation is the socioeconomic equivalent of Stage 4 cancer.

Worse, when you factor in the past four miserable years in southern Europe, an additional four-to-eight year time horizon implies not one lost generation, but the possibility of two. Twelve years of continuous economic turmoil is just two years shy of the duration of the disastrous Weimar Republic, and hasn't been felt in southern Europe since the dismal years following Napoleon's defeat at Waterloo.

Nationalism Lives

Another problem with the benefits of reduced labor costs is that the economic re-alignment which follows is not an instantaneous process. The notion that these benefits will accrue more or less automatically is the unspoken reason behind Germany's unrelenting austerity time-table; that, and the fact that austerity is being demanded of Spaniards, Greeks, Irish and Portuguese, rather than Germans. (The German austerity drive after the fall of the Berlin Wall was necessary for reunification of East and West Germany. It was for Germans, by Germans.)

Regardless of what the European technocrats confidently assure one another in Brussels, nationalism is still the dominant paradigm in Europe.

The idea that a Greek or Italian politician will show the voters a chart like the one above and say, "Look! Another 4-8 years, and we're home free!" is precisely the problem with the Troika's approach: It assumes that the people of Europe will see both economic necessity and their own "best interests" and follow the Troika program.

Unfortunately, the human brain isn't configured that way.

Mario Monti was accepted with a sigh of relief by world markets and the Italian people. It's lasted less than a year.

No Silver Bullet

Simply matching Germany's unit labor costs isn't enough by itself to make international businesses relocate. This is due to the investments those companies will have already made within the more competitive nations which cannot be moved or liquidated quickly, such as manufacturing infrastructure and corporate real estate. There are intangible assets, such as personal relationships, reciprocity and goodwill that mitigate against relocation. There are multi-year contracts between international businesses and local affiliates. There are tax breaks between businesses and local governments. There are supply chains that have been meticulously established. There are language barriers and kids in schools. There are wives, husbands, golf memberships and the family dog to be considered.

There's the social instability that accompanies prolonged periods of inflation. The streets of Athens look like a scene out of John Carpenter's "Escape From New York." Drug dealers sell openly in the streets. Unemployment across Europe is creating a black hole where the vibrant, skilled citizens just waiting for foreign investment are supposed to be.


"Internal devaluation" and ECB bond buying are the flavor-of-the-month among investors anxious for a European turnaround. Internal devaluation in Spain won't erode the real value of debt incurred from the property bubble. It won't erode the corrupting influence of nepotism, clientism and organized crime in Italy. It won't increase Portugal's 28% high school graduation rate, or bestow natural resources upon Greece. The hymns to Europe emanating from Brussels will not turn the Germans into Spaniards, or the Portuguese into Frenchmen. It won't make the Irish praise Angela's Merkel's name or sing "viva la Europe!"

Nothing has changed in Europe but the spin.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.