Will the global recession end the Euro?
Ambrose Evans-Pritchard of the Telegraph in London is one of the more interesting reporters on the business scene. In today’s Telegraph, he chronicles the depth and breadth of the global slowdown now taking form.
However, the crux of his article revolves around Spain and the sharp downturn they have experienced. While his article suggests Spain’s slowdown will test the Eurozone’s cohesion, I believe the Euro will pass this test. The global recession will not end the Euro.
The economies of Germany, France and Italy all contracted in the first quarter and may now be in full recession, shattering assumptions that Europe would prove able to shrug off the effects of the credit crunch.
The picture is darkening so fast in Spain that Prime Minister Jose Luis Zapatero cancelled holidays and called his cabinet back to Madrid yesterday for the first emergency session of its kind since the Franco dictatorship. The crisis meeting agreed to a €20bn (£16bn) blitz on public works, tax cuts, and a mortgage rescue to halt the downward spiral.
Growth has turned negative in Ireland, Denmark, Latvia, and Estonia, while grinding to a halt in Sweden and The Netherlands. Iceland contracted by a staggering 3.7pc. The grim data from Eurostat follows a recession warning in Britain, and shock news that the Japanese economy had shrunk 0.6pc in the second quarter.
Almost the entire bloc of rich Organisation for Economic Co-operation and Development (OECD) countries – still two thirds of the world economy – are now in the grip of a major downturn. The oil shock over the early summer appears to have had a dramatic effect on the heavy industries of Japan and Germany.
The eurozone as a whole shrank by 0.2pc, the first contraction since the launch of the single currency a decade ago. Germany led the slide with a fall of 0.5pc. France and Italy fell 0.3pc. The delayed effects of the strong euro, tight credit, and slowing exports have now kicked in with a vengeance.
“This is an alarm warning for the economy,” said the Confederation of German Industry (BDI).
My comment: In effect, the entire developed world has hit the skids due to the fourth oil shock since the end of Bretton-Woods. However, all of the data coming forward has been from the second quarter, a period in which the ECB raised Eurozone interest rates to fight inflation. Evans-Pritchard takes issue with that action.
The European Central Bank and its president Jean-Claude Trichet appear to have misjudged the severity of the downturn, and may have made a serious error by raising interest rates a quarter point to 4.25pc last month.
By then it was already clear that property markets were slumping across much of the region. “What is shocking is the speed of the collapse in Germany,” said Albert Edwards, global strategist at Société Générale. “I think there has been a lot of hubris at the ECB. They took a derisory attitude towards the US, saying the Federal Reserve was too aggressive in cutting rates. Now they are reaping the bitter reward of their policy,” he said.
The ultra-hawkish Bundesbank’s Axel Weber gave no hint yesterday that the ECB is softening, suggesting that the bank sees a deliberate crunch as the only means to pre-empt a 1970s-style wage-price spiral. “The confidence expressed by some observers that weaker economic growth will lead to a damping of inflation pressures is in my opinion premature,” he said.
This is a highly controversial point. Although fuel and food prices have pushed headline inflation to a post-EMU high of 4.1pc, core inflation has fallen from 1.9pc to 1.8pc over the last year. Real wages have suffered a brutal squeeze. Julian Callow, Europe economist at Barclays Capital, said the ECB erred by pre-announcing a rate rise in June.
“They boxed themselves in, and it became hard to retreat. It is clear from the August Bulletin that they have now really woken up to the downturn,” he said. “Recessions in Europe are very nasty events: they tend to be a lot deeper and more protracted than in the US, which is better able to cope with the ups and downs of the business cycle,” he said.
My comment: I urged the ECB to raise rates in my post The ECB is right and the Fed is wrong in order to combat inflation. After all, the easy money of the Fed had stoked some of the commodity price rise in the first place. However, evidence appears to suggest that the heavy lifting of inflation reduction will be done through demand destruction as the global economy slips into recession.
Would I say the ECB erred in hiking rates? I am not there yet (could this be cognitive dissonance at work?) because it was crucial for the ECB to manage inflation expectations, which had been rising in the Eurozone.
Nevertheless, I must admit their move is looking considerably less positive. So, the jury is still out.
Going forward, the Eurozone is constrained by the stability and growth pact hammered out at the behest of German deficit hawks like former German Finance Minister Theo Waigel in order to stop the PIGS (Portugal, Italy, Greece and Spain) from feeding at the trough.
Mr Callow said the EU’s budget deficit limit of 3pc of GDP makes it impossible for many countries to cushion the hard-landing with a spending boost. France and Italy are already near the ceiling. Indeed, Italy is having to tighten policy into the downturn.
Bernard Connolly, global strategist at Banque AIG, said the eurozone faces possible disintegration unless there is a fiscal bail-out from Germany that matches – in sheer scale – Berlin’s Versailles reparations payments after the First World War. “The bursting of the EMU credit bubble seems imminent, and will reveal current account imbalances among euro area countries as extremely dangerous. The medium-term feasibility of the euro area in its current form must be open to very considerable doubt,” he said.
Spain needs a devaluation of 30pc and Greece needs 40pc to restore balance to their economies after suffering a major loss of unit labour competitiveness. The current account deficit is 10pc of GDP in Spain, and 14pc in Greece.
Mr Connolly said the combination of collapsing demand in southern Europe and a slide in the external value of the euro now means that the EMU bloc may now start to export the effects of its troubles to the rest of the world, making it harder to bring the credit crisis to an end.
My comment: Unlike, the commentators in the prior paragraph, I don’t see Eurozone disintegration as very likely. The political pressure to remain in the Euro is too great. Moreover, the costs of leaving the Euro would be prohibitive.
The most likely scenario is some sort of relaxation of the stability and growth pact along with political pressure on the ECB to provide monetary easing — pressure we have already heard from France’s Sarkozy.
Eurostat said Spain managed to eke out growth of 0.1pc in the second quarter but this is a lagging indicator. The switch from boom to bust is now turning violent. There are mounting fears that the country could tip into a severe crisis over the next year.
“A momentous economic slowdown is now under way. We believe the deterioration in Spain is just in the beginning stages,” said a report by Morgan Stanley. It said there was a serious risk of a blow-up comparable to the ERM crisis in the early 1990s. This tim
e there is no easy exit. Spain cannot devalue within EMU, or resort to emergency monetary stimulus.
The Bank of Spain revealed yesterday that Spanish lenders have now borrowed €49.4bn from the ECB, confirming reports that smaller banks with heavy exposure to the property market are now relying on EU taxpayer funding to survive. It is unclear whether long-term support of this kind is strictly legal under EU rules.
Some banks appear to be issuing fresh bonds for the sole purpose of obtaining money from the lending window in Frankfurt. Spain’s finance minister Pedro Solbes says it was clearly “unsustainable” for the country to build 800,000 homes last year in the final crescendo of the boom, but said there was nothing the government could do to stop it.
“The economic situation is worse than we all predicted. We thought it would happen slowly but instead it has hit fast,” he said. Construction reached 18pc of GDP in 2007, much of it funded from foreign capital sources that have now dried up. The sector is in freefall. Unemployment has jumped by 457,000 over the last year. Industrial output plunged 9pc in June.
My comment: The case laid out above for Spain is particularly grim. It represents an Armageddon scenario where Spain has fallen into recession as its economy has been hit by a massive housing and construction sector contraction. Moreover, given the large current account deficit the recession is likely to be deep and protracted. And then there is the question of Spanish banks and likely writedowns from property losses.
All of this speaks to Evans-Pritchard’s main theme of strains in European cohesion as Spain suffers a sharp and deep recession with no monetary stimulus to offset it. The first outgrowth of this has been a divergence of Eurozone interest rates. Spreads of Spanish sovereign debt have been widening over German Bunds. But, I don’t see this going any further than that.
Whilst Europe may be going through a difficult period, and a severe recession for Spain is a foregone conclusion, the political and economic costs of breaking up the Eurozone are too large to bear. For now, the Euro remains safe.
Spain in crisis as Europe crumbles, Telegraph, Ambrose Evans-Pritchard, 15 Aug 2008