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Europe Heads Down The Deflationary Road

There is a major ongoing debate in the eurozone about what to do about the "virtuous" countries, such as Spain and Italy, that have lost access to the bond market due to high risk spreads (as opposed to fiscal profligacy).

One side of the debate has argued that the eurozone is a currency union, not a mutual assistance society, and that these countries should regain the market's trust on their own via greater austerity. The other side argues that it is the duty of all members to do what is necessary to "defend the euro" and that, if these countries pursue the path of virtue, the eurozone should provide temporary assistance in their time of need.

In the last few weeks, both the ECB and Germany have joined the latter (more charitable) group and have stated that the eurozone should offer help to innocent countries that have lost market access, such as Spain and Italy.

Both Draghi and Merkel (but not the Bundesbank) have agreed to the idea that if these countries apply to the Troika for assistance, both the EFSF/ESM and the ECB will purchase their bonds in an effort to drive down "excessive" risk premia. This has suggested to the capital markets that a medium-term solution is in the cards, and all may be well.

I don't think so. The new consensus has two flaws: (1) it assumes that bond purchases at the margin can change market sentiment; and (2) that once these countries get over the current hump, they will regain the market's trust and re-enter the bond market at reasonable spreads.

I have already discussed the unwillingness (inability?) on the part of Spain and Italy to apply to the Troika and submit to IMF conditionality and supervision. Let's assume they can somehow get over that aversion and submit, agreeing to greater austerity in exchange for assistance (which they both must have PDQ).

What are the prospects that, having submitted to the Troika's demands (no easy task in a democracy), and after implementing the required austerity, that these countries will be in good enough shape to re-enter the bond market on their own over the medium-term? I would say zero.

This is because the Troika's solution is austerity/deflation in lieu of devaluation, which has been precluded by monetary union.

Eighty years after Irving Fisher proposed the debt-deflation theory*, it should be unnecessary to point out that austerity and deflation cause a downward spiral in nominal economic activity, while magnifying the real value of debt.

It is possible to maintain growth while undergoing an "internal devaluation" in an economy with highly flexible nominal wages such as Hong Kong, but the list of such economies stops at Hong Kong.

The modern economy has inflexible nominal wages. In order to force nominal wages to become flexible requires a depression. Just think about Spain or Italy: what will it take for their public and private sector unions to accept a material decline in nominal wages? This did occur in the US during the Hoover years, but it required starvation as an incentive and the occasional use of the army. Hoover was not re-elected, and FDR promptly reversed the deflation.

Western European countries cannot become competitive due to declining nominal wages because they are democracies and the electorate won't permit it (see: Greece). The voters will revolt before they accept a cut in nominal wages. These are quasi-socialist economies with powerful national unions negotiating industry-wide contracts. These unions control the major left-wing political parties. They have never and will never agree to a national decline in wage-rates, no matter what the level of unemployment. (They are victims of the "money illusion": they can happily accept devaluation, but not deflation.)

Consequently, deflation with sticky wages will lead to massive unemployment, declining output, declining government revenue, reduced national debt capacity and greater over-indebtedness. These countries simply cannot regain their creditworthiness without a significant level of inflation and nominal growth, neither of which is being offered by anyone.

The Draghi-Merkel caucus is only offering these countries more debt on top of more austerity. As their debt burden grows, their economies will shrink, requiring more debt. Is there anyone in Europe who has taken Economics 101? Has any important eurozone (or IMF) official read Friedman, Krugman, Eichengreen or Bernanke? It's astounding to me that inflation is not even part of the eurozone debate. When inflation is even mentioned, it is done so as an anathema, like the plague: "We may be starving, but at least we don't have inflation."

So, to return to my question: will the Troika's medicine succeed in bringing Spain and Italy back to the bond market on their own: No. So nothing will be fixed by the new eurozone consensus.

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*Fisher's debt-deflation theory (a bit simplified):
National over-indebtedness will lead to a loss of further credit availability through the alarm of creditors. Then we may deduce the following chain of consequences in nine links:

    • Debt liquidation leads to distress asset sales;
    • The contraction of the money supply as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling leads to:
    • A fall in the level of prices, in other words, an increase in the purchasing-power of the currency. Assuming that this fall of prices is not interfered with by reflation, there must be:
    • A still greater fall in the net worths of business, precipitating bankruptcies
    • A like fall in profits, which leads companies which are running at a loss to:
    • A reduction in output, in trade and in employment of labor. These losses, bankruptcies and unemployment, lead to:
    • pessimism and loss of confidence
    • Hoarding and slowing down still more the velocity of circulation thus further reducing nominal activity.

The above eight changes cause:
9. A decline in nominal interest rates and a rise in the real rates of interest.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.