The eurozone has been plagued by internal contradictions producing the longest slump in recorded history. This slump was greatly prolonged by the deflationary bias in the eurozone.
The lack of exchange rate adjustment led to the accumulation of large current account surpluses in some areas (we'll call them the 'core') and large deficits in others (the 'periphery', mainly Southern Europe).
All the adjustment to correct those imbalances in the system was forced on the deficit countries, they had to embark on a painful process called 'internal devaluation', recouping their lost competitiveness through deflationary policies.
Apart from the fact that this wrecked their debt dynamics, it's also rather difficult to win back lost competitiveness against a core country like Germany when inflation is virtually absent in Germany itself.
One of the main problems with the eurozone is that the surplus countries weren't subject to any adjustment, while the deficit countries had to embark on deflationary policies, there was no compensating reflation in the core countries, producing a deflationary bias of the whole system.
Without the euro, countries like Italy, Spain, Portugal and Greece would have simply devalued, and this would have made German (Dutch, Austrian, etc.) goods and services more expensive in these countries, hence part of the adjustment would have been born by the core countries. Not so under the euro.
However, there is the possibility that the core countries reflate out of their own free will. Germany could embark on a great fiscal stimulus program, and this would lessen the adjustment burden of the peripheral countries in several ways:
- Increased demand for their goods and services, as Germany would become a bigger export market for their products.
- Higher German inflation would make it easier for the periphery to recoup lost competitiveness.
So why hasn't Germany done this? Basically because of fiscal rectitude, Germany wants to run sound public finances, and sound public finances they have.
In fact, Germany has run up the largest public surplus since reunification, a whopping 19.4 billion euro surplus in 2015.
The forecast of the public debt/GDP ratio also shows a healthy decline.
So there doesn't seem to be a prohibitive need from a public finance perspective to keep a tight lid on money. But there is more to this, consider the following graph of Germany's current account surplus:
That is a whopping 8.8% current account surplus and national income accounting demonstrates that this means Germany saves 8.8% of it's GDP more than it invests. Consider also the graph for the 10 year German bund:
While interest was already puny, the rate has gone negative after the Brexit result, as bond yields everywhere have fallen to new lows.
Combining a savings surplus of 8.8% of GDP with a budget surplus and negative interest rates and you have a magic elixir to do wonderful things you never dreamed of.
Germany could invest in housing, transport, infrastructure, science, education, research and development, it could be a mini-China, constructing whole cities if it wanted to.
All this whilst issuing debt that collect a rent in the form of a negative interest rates, that is, investors pay the Government for the privilege to lend it money.
Of course, we understand that if this happened on a sufficiently large scale, the rates on the 10 year bonds could move positive, but not by much. There is enormous appetite for save haven investment, with yields everywhere crashing below zero.
So basically Germany has a once in a lifetime chance to really upgrade its infrastructure and reinforce their supply side. This could boost their economy for decades.
And it would also remove part of the eurozone imbalances, especially if the German efforts is followed by other core countries which are in a similar situation (most notably the Netherlands).
These core countries could have their cake and eat it. Fortify both the supply and demand side in their economies for free and sharing the burden of adjustment within the eurozone.
This would improve not only the economic conditions within the core countries, it would do so in the periphery as well, and by doing that it would significantly diminish the risk of a devastating eurozone crisis which would make us all worse off.
What's more, much of the pathology in the world economy is caused by a global savings glut. Countries like Germany and The Netherlands, with their whopping current account surpluses (8.8% and 9.1% respectively) are major contributions to this problem.
On a world scale, savings exceed investment, leading to record low bond yields a lack of inflation and excess production capacity that reduces the incentives to invest, which reduces future economic growth by affecting the quality and quantity of capital.
So Germany could go some way in healing the world economy, and doing all that by building German roads, bridges, airports, high-speed train lines, housing, schools, universities etc. in Germany itself. This really does beat all that central bank money that largely stays within the financial system. It's likely to be an order of magnitude more effective.
A once in a lifetime opportunity indeed. What are they waiting for? If Germany and a few other countries act with conviction than some of the rot that is plaguing the world economy in general and the eurozone in particular could be stopped in its tracks.
Combating the deflationary rot is now left exclusively to the central banks of the world, but many (including us) doubt whether their increasingly desperate actions have much effect, or even whether the positive effects outweigh the negative ones.
Simple macroeconomic theory suggests that under these circumstances of excess capacity and zero interest rates, fiscal policy becomes much more effective while monetary policy loses much of its potency.
We can let the rot continue and leave it to increasingly ineffective central banks, and pretend shares are going to be rescued by the American economic motor.
But we think sooner or later that American motor will be infected with the same forces and start to sputter, and it's not hard to see how.
A rising dollar will import the deflation in the rest of the world to the US economy and US corporate earnings, and stock valuations will not be sustained at these levels.
But that is actually the minor, slow burning threat to stocks. The bigger risk is the escalation of the deflationary forces in the world economy.
Two stand out in particular. A substantial Chinese devaluation would panic the financial markets. We have seen this a year ago, when even a mild devaluation caught the markets by surprise and produced a violent sell-off.
The other risks is the eurozone itself. Not only does Brexit put downward pressure on growth, which is already anemic, it also ups the political risks.
Most immediately in Italy, where banks are weighed down by 360 billion euro in bad debt and a bailout with public money is against EU rules.
Public debt stands at 135% of GDP and isn't budging in the upturn, a downturn in nominal GDP will ratchet it up further.
The Five Star political movement which started as a protest movement against the euro is now leading in some opinion polls. They rightly argue that Italy cannot do much to solve its problems within the euro.
Yes, Italy is rife with inefficiencies and over-regulation, but these are supply issues while their main problem is one of demand, or lack of it, and these cannot really be solved within the constraints of the euro.
Renzi, the present Italian Prime Minister will resign if he loses a constitutional vote in October, the ensuing elections could be a big test for the euro.
In a world which has a deflationary bias with monetary policy mostly exhausted, it's up to fiscal policy of the countries best positioned to act.
The cost of this, given the extraordinary low interest rates, are very low and the pay-off can be substantial.
While the US stands out, it cannot escape the deflationary virus running in much of the world economy. This will manifest itself either as a slow importing of the same bug through a rising dollar, or a more immediate and severe hit by an open crisis elsewhere in the world economy.
Equities are valued basically as if these risks are immaterial. Good luck to that.
Disclosure: I/we 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.