Seeking Alpha
Small-cap, macro
Profile| Send Message| ()  

Some argue that looking beyond the rubble of the eurozone crisis, a much fitter, leaner continent is emerging. Indeed, there is quite a bit to be said for this thesis.

Budgets are trimmed virtually everywhere, mostly in the eurozone periphery. Structural reforms increase the workings of markets and competition. The periphery is regaining some lost competitiveness as well.

There is indeed a sort of mini-supply side revolution going on in the eurozone, according to the IMF. And according to the table below, it's most intense in the places that need it most, that is, in the eurozone periphery.

(click to enlarge)

Many fret that unleashing market forces, while having long-term benefits, will exert a short-term cost, especially when produced in an already very depressed economy. However, the IMF has studied that and is sufficiently reassuring:

while their benefits usually take time to fully materialise, structural reforms seldom involve significant losses and often deliver gains already in the short run.

However, this doesn't hold for all reforms:

At the same time, though, some of them, such as unemployment benefit and job protection reforms, have smaller or even negative effects in depressed economies.

In any case, however difficult it is to see through the present problems, one could argue that the foundations are being laid for a eurozone that is significantly more market friendly, dynamic and competitive.

Internal devaluation
Progress is also being made on restoring intra-eurozone balance, with peripheral countries restoring some of the lost competitiveness through the rather painful process otherwise known as 'internal devaluation.'

Upon joining the eurozone, peripheral countries received a boost in monetary credibility and they could no longer devalue. This reduced risk set of an inflow of capital that created economic booms (of various proportions and compositions) in the periphery, the side effect of that was a faster growth in unit labor cost and inflation relative to the core of the eurozone.

This boom was allowed to proceed by the ECB setting rates too low for the periphery in its one-size-fits-nobody monetary policy. But the decade of accumulated inflation differentials (and altered trade patterns) resulted in rather substantial losses of competitiveness in the periphery.

However, by the rather brutal means of 'internal devaluation,' this loss of competitiveness is now being redressed, at least in part. This is a slow and grinding process, according to FTAlphaville:

Greek prices rose roughly 30% since 1999 relative to Germany (20% compared to the euro area ex-Germany). Spain's prices rose by 20% and 10% respectively. To regain competitiveness at a rate of 5% over three years would require a decade of internal devaluation in Greece.

And here are Guillaume Gaulier et al on Voxeu.org:

Since Eurozone countries cannot devalue their currency, policymakers should instead try to restore competitiveness through internal devaluation, i.e. by reducing adjusted wage costs. One estimate for Greece, for example, is that adjusted wage costs need to be reduced by 31%, effectively reaching the level of Turkey (Sinn, 2012).

The mechanisms are brutal. Private sector wage 'moderation' simply works via terribly depressed economies creating mass unemployment. However, there are significant indications that the main problem wasn't excessive wage growth in the export sector. This is important, as it's not widely understood what exactly the problem was in the periphery. Again here are Guillaume Gaulier et al:

In the Southern EZ countries current account deficits reflected an excessive increase in imports. In the run-up to the crisis, exporters from these countries could perform well on the international markets despite the rise in their countries' adjusted wage costs, because the bulk of the rise in wage costs occurred in the non-traded sector.

So what is mostly needed is to cut wages in the public sector. This is actually happening in countries like Ireland, Greece, and Portugal, see the graph below:

Thus, since public sector wages are more easily controlled by politicians and significant cuts have already been made in quite a number of countries, there are reasons to be optimistic about the progress being made in the process of 'internal devaluation.'

However..
So, if structural reforms are being accelerated and internal devaluation is proceeding well, there are reasons to be optimistic about the eurozone, right?

Well, not quite. The wage cuts, spending cuts and tax hikes being made in most of the periphery aren't being offset by any form of stimulus. No devaluation, no offsetting monetary impulse, nothing. In fact, money is leaving the periphery. Depositors are taking their money to banks elsewhere (Germany, Luxembourg) on a rather large scale.

In Spain, in July of this year alone, depositors withdrew a record 75 billion euros from their banks. One has to realize that being member of a currency union makes this deposit flight way easier. Also, realize what happens when peripheral assets (like government bonds) are sold. The seller receives euros, with which he can buy assets in 17 countries without incurring any currency risk, so the money is likely to leave the periphery.

Contrast that to what happens to a same asset sale in a country that isn't a member of a currency union, say the UK. Sellers will receive the currency of the country (pounds) and they're likely to sell that as well, causing the pound to depreciate until it meets buyers. The buyers of the pounds are likely to buy UK assets or put the money in UK banks, so the money never really leaves the country and the transaction produces a currency depreciation helping exports.

Instead, through deposit flight and asset sales, a member of a currency union does not see any depreciation, but will experience a capital outflow and a resulting decrease in the money supply that depresses economic activity. This is indeed what has been happening in the eurozone periphery:

(click to enlarge)

All this exerts a terrible deflationary pressure on the periphery. The question now is whether the progress with the structural reforms and internal devaluation outweigh these deflationary forces.

Memory lane
The IMF has done a wonderful job reminding us about a similar experience, post-WWI Britain. From The Economist:

Britain emerged from the first world war with debt at 140% of GDP and prices more than double their pre-war level, but it was determined to pay off its debt and return the pound to its pre-war value against gold. This required excruciatingly tight fiscal and monetary policy. The primary budget balance (which excludes interest) rose to a surplus of 7% of GDP. The Bank of England raised interest rates to 7%, and deflation meant that real interest rates were even higher. The results were awful: output was lower in 1928 than in 1918. And the debt ratio actually rose, to 170% of GDP in 1930 and 190% in 1933, as high real rates and declining output wiped out the benefits of a primary surplus.

Note that clinging on to the Gold Standard by savage austerity unleashed exactly the same deflationary forces as what's happening today in the eurozone periphery. The only difference is that Britain had independent monetary policy, but it used this to keep the currency fixed to gold, jacking up interest rates.

While no eurozone peripheral country can jack up interest rates like that, the capital outflow and resulting monetary contraction exert a similar deflationary impact. Note also:

Economic output in 1938 was barely higher than in 1918. And that was not the fault of the great depression - in 1928 output was actually lower than in 1918.

(click to enlarge)

That's quite a wasted decade (and a half). Note also how, despite all the austerity, debt/GDP actually kept on increasing, creating a rather nasty vicious cycle. Sound familiar?

Its economy will contract by 6.5% this year, worse than a previous estimate of 4.8% in March suggested to its bailout lenders, it said in a draft budget submitted to parliament. Greece also said its economy will shrink for a sixth year in 2013.

Or Portugal:

The Portuguese people have put up with one draconian package after another - with longer working hours, 7pc pay cuts, tax rises, an erosion of pensions, etc - all amounting to a net fiscal squeeze of 10.4 of GDP so far in cyclically-adjusted terms. (It will ultimately be 15pc)..... Citigroup expects the economy to contract by 3.8pc this year, a further 5.7pc next year, and yet again by 1.3pc in 2014.

Or Spain:

Rajoy has passed austerity measures worth around 65 billion euros to the end of 2014 in an effort to shrink one of the euro zone's highest budget shortfalls from 8.9 percent of GDP in 2011 to below 3 percent.

Does this help? Well..

Citigroup expects the economy to contract by 3.2pc next year and 0.8pc in 2014, pushing public debt to 100pc of GDP.
Chief economist Willem Buiter said the mix of austerity and reform will not restore Spain to "fiscal sustainability", even if EU loans keep Spain going for another couple of years. He expects "debt restructuring" in the end.

Indeed:

Treasury Minister Cristobal Montoro said debt would likely reach 85.3% of the country's annual economic output this year, increasing to 90.5% in 2013. His comments come after more cost-cutting plans were unveiled last week.

Meanwhile, Italy:

IMF Survey: Italy's fiscal consolidation for 2012-14 will be around 5 percent of GDP.

By now, the effects should be rather predictable:

Italy slashed its economic growth forecasts on Thursday saying it was now expecting contractions of 2.4pc for 2012 and 0.2pc for 2013.

And:

The IMF said in its Fiscal Monitor report that Italy's deficit would fall this year to 2.4 percent of output, well above Rome's 1.6 percent target, and would decline to 1.5 percent in 2013, when Italy is aiming to balance its budget.

Some people, like Niall Ferguson seemed to believe that austerity is expansionary. By now, that belief has been thoroughly disproved by the facts. The remaining question is whether austerity will actually improve debt/GDP levels. Luckily, at least the IMF seems to have some grasp on the underlying mechanisms:

The Fund's forecast that Rome will significantly overshoot its balanced budget target next year will put pressure on Monti to adopt additional corrective measures, though the IMF itself has urged against this due to the weak economy.

If you do what you always do you have a habit of getting what you always got. Unfortunately, the IMF isn't in the driving seat, and this understanding of the vicious debt-deflationary spiral has yet to grasp the minds of the Germans and the ECB.

European shares
While we earlier entertained the thought that the structural reforms now unleashed in the eurozone could lay some of the foundations for something approaching a future European economic renaissance, the British experience post-WWI really put these hopes in the fridge, for now.

European shares in general have seen one of the strongest rallies in the summer.

(click to enlarge)

Against the backdrop of this strong rally and the continuing cycle in which economic growth and public finances in the periphery continually lag expectations, we think that this is about it. The only trigger for a new leg in this rally we can imagine is Spain asking for an official bailout, unlocking ESM and ECB money and conditionality.

Such an event would actually buttress the vicious austerity-growth cycle, as it means Spain really doesn't have any options left.

Source: Should You Buy European Shares?