Today’s commentary
The scenario I laid out for Europe for 2014 in three posts on the global economy last week is one of muddling through. However, whereas in the US, there are upside risks, in Europe the risks are mostly to the downside, politically and economically. A few thoughts on the situation follow.
In my view, the risks are not just political, but also economic. Right now there are few positive catalysts that are easily recognizable except for the bottoming process I believe is ongoing. On the other hand there are a number of potential exogenous shocks that could throw the European economy off course.
Here is the macro argument:
- Europe is constrained by the euro, which means that sovereign governments, as currency users, must act pro-cyclically and cut deficits during a deep downturn at the same time all other economic agents are doing so. This makes the European situation more volatile economically, increasing the likelihood of downside scenarios and crisis. The present crisis is emblematic of this risk.
- At the same time, the central bank is constrained by the euro because it is forbidden to facilitate government spending i.e. buy government bonds with the aim of preventing the market-dictated solvency issues of a typical currency user from coming to the fore. Thus, as we have seen during the European sovereign debt crisis, this makes European sovereign debt vulnerable to market sentiment, speculative attack and further reinforces the need for governments to act pro-cyclically.
- Counterbalancing this are European-level funds that can be used to dampen the effects of economic downturns. For example, the EU has recently allocated funds to counteract youth unemployment, which is at a record high in the eurozone, with nearly one-quarter in this demographic cohort out of work. These funds are very limited, however.
- At the same time, even within the periphery, GDP growth has been uneven. Countries like Finland and the Netherlands are actually in recession. France is on the edge. Only countries like Germany and Austria, where unemployment is low and where there has been growth fairly consistently, is there the opportunity to act counter-cyclically to offset the pro-cyclicality elsewhere.
- But, one year later, I still believe Germany concerned about its own public finances (link here). The Germans don’t like having 80% government debt to GDP and want to get that number lower. This limits their ability to act counter-cyclically on the fiscal side. Germany has instead boosted domestic demand by easing wage restraint.
- Moreover, thinking in Germany is that easing up now would send the wrong signal to the periphery. The Schröder deficit breach is still rued. Even ECB head Mario Draghi has said that Germany stands as an example for the rest, echoing sentiments widely heard in German policy circles.
- My conclusion then is that the heavy lifting of the eurozone adjustment process will come all on the periphery side.
When I say that the adjustment will come all on the periphery side, I mean that in addition to the public sector austerity, the private sector must shift to a lower consumption, lower wage, lower price level in order to adjust their current account to a neutral or positive level and stop the pressure that the balance of payments creates in terms of external funding needs. This is what is now known as “internal devaluation” because there is no real devaluation currency adjustment, instead the devaluation comes via relative price and wage levels.
But, of course, the internal devaluation tactic is by its nature deflationary. The adjustments in current account puts upward pressure on the euro, fully offsetting the ever looser monetary policy stance of the ECB. The eurozone’s trade surplus widened to 17.2 billion euros in October. That’s the third largest on record. This translates into a stronger euro and the upward pressure on the euro makes periphery adjustment even harder.
With that background, it is understandable that we are seeing a very weak recovery in Europe, something akin to the 1930s.
The situation in Italy is one risk here. We could be seeing the makings of a protest movement that collapses the present Italian governing coalition. In today’s links post I have a number of links analyzing the political situation there. But a reader from Italy gave me a very good testimonial just the other day. The reader wrote me about the protests:
The people who participate are from different backgrounds; many are communist, this true – but not all. I have clients who are well off who say they would join. They don’t because they have small children, or they have a business, these are risky situations.
Stratfor writes that they protest against austerity. They are not against austerity in itself; they are against the fact that austerity is only for lower middle class. There is no austerity for public administration employees, and especially not for politicians, who continue to spend millions on fringe benefits, favors, and luxury items to buy off votes. There are load of scandals where government officials have spent money on hotels because they can write it off as business costs when really they are vacations. Since truck drivers in Italy have energy costs higher than any other euro country they can’t compete, and Letta keep raising taxes on those who work.
They voted the other day to cancel state financing of parties; taxpayers can give contributions if they want on their tax return and deduct, but it goes into force in 2017. That doesn’t make any sense. And also there are so many loopholes, that these parties will get money anyway. Parties need financing, but there is no proportion, some parties get billions and then they spend the money on hookers. I’m not kidding.
So, think of these protests as a combination Occupy Wall Street – Tea Party movement that run right across the political spectrum. The tenor here is anti-corruption, anti-status quo, not left or right.
Italy is the most important country in the so-called periphery. In fact, I would suggest it is really more of a core country except in terms of economic performance. The euro zone is about Germany, France AND Italy. Without, Italy, the eurozone collapses. And so what happens in Italy is important. Could Italy fall back into recession? Yes. Could the government fall? Yes. Could interest rates rise as risk-off toward Italy develops? Yes.
And the Industrial production figures in Europe released late last week were decidedly poor. The Telegraph calls them the “worst industrial output figures since [the] height of eurozone crisis show economy is struggling to regain momentum”. Production in France declined. Production in Germany declined. And while the latest PMI shows a better situation, France lagged, with numbers suggesting another dip in this quarter’s GDP.
My point here is that it is not clear that Italy, France or Europe have left recession or that the political risk has receded. The European sovereign debt crisis is not over. We are muddling through. But any reasonably large exogenous shock will tip us back into recession and crisis.
Muddling through in Europe
Today’s commentary
The scenario I laid out for Europe for 2014 in three posts on the global economy last week is one of muddling through. However, whereas in the US, there are upside risks, in Europe the risks are mostly to the downside, politically and economically. A few thoughts on the situation follow.
In my view, the risks are not just political, but also economic. Right now there are few positive catalysts that are easily recognizable except for the bottoming process I believe is ongoing. On the other hand there are a number of potential exogenous shocks that could throw the European economy off course.
Here is the macro argument:
When I say that the adjustment will come all on the periphery side, I mean that in addition to the public sector austerity, the private sector must shift to a lower consumption, lower wage, lower price level in order to adjust their current account to a neutral or positive level and stop the pressure that the balance of payments creates in terms of external funding needs. This is what is now known as “internal devaluation” because there is no real devaluation currency adjustment, instead the devaluation comes via relative price and wage levels.
But, of course, the internal devaluation tactic is by its nature deflationary. The adjustments in current account puts upward pressure on the euro, fully offsetting the ever looser monetary policy stance of the ECB. The eurozone’s trade surplus widened to 17.2 billion euros in October. That’s the third largest on record. This translates into a stronger euro and the upward pressure on the euro makes periphery adjustment even harder.
With that background, it is understandable that we are seeing a very weak recovery in Europe, something akin to the 1930s.
The situation in Italy is one risk here. We could be seeing the makings of a protest movement that collapses the present Italian governing coalition. In today’s links post I have a number of links analyzing the political situation there. But a reader from Italy gave me a very good testimonial just the other day. The reader wrote me about the protests:
So, think of these protests as a combination Occupy Wall Street – Tea Party movement that run right across the political spectrum. The tenor here is anti-corruption, anti-status quo, not left or right.
Italy is the most important country in the so-called periphery. In fact, I would suggest it is really more of a core country except in terms of economic performance. The euro zone is about Germany, France AND Italy. Without, Italy, the eurozone collapses. And so what happens in Italy is important. Could Italy fall back into recession? Yes. Could the government fall? Yes. Could interest rates rise as risk-off toward Italy develops? Yes.
And the Industrial production figures in Europe released late last week were decidedly poor. The Telegraph calls them the “worst industrial output figures since [the] height of eurozone crisis show economy is struggling to regain momentum”. Production in France declined. Production in Germany declined. And while the latest PMI shows a better situation, France lagged, with numbers suggesting another dip in this quarter’s GDP.
My point here is that it is not clear that Italy, France or Europe have left recession or that the political risk has receded. The European sovereign debt crisis is not over. We are muddling through. But any reasonably large exogenous shock will tip us back into recession and crisis.