Friday, November 25, 2011

The Coming Euro Depreciation

Simon Johnson agrees with the first step towards a solution of the euro problem that I suggested in my book, “L’euro: comment s’en débarrasser”. Namely, a substantial euro depreciation that would stimulate growth in the eurozone.

In his post for Project Syndicate on November 23, “Does Europe Have a Korean Option?” he writes:

“The obvious escape route leads through economic growth, which would reduce the debt-to-GDP ratio that make interest payments look reasonable. But the standard ways to stimulate the European economy are not available: fiscal policy is constrained by already-high debt levels; and the European Central Bank, fearing inflation, has kept a tight rein on monetary policy.
None of the other ideas on the European table, including various kinds of “structural reform,” will provide fast growth in the short term.

  A genuine devaluation, on the other hand, would work wonders for the real economy. The moribund Italian economy would spring to life if the euro fell by 30%, adjusted for inflation.”

Some observers wonder how the euro could be depreciated, given that it is a floating currency, the price of which is market determined. But Johnson explains the obvious:

“If the ECB agreed to loosen monetary policy or provide enough “liquidity” to support various bailouts, investors would fear inflation, weakening the euro. On the other hand, if the ECB preferred to let major countries, such as Italy, default on their debts, this would likely weaken the euro even further, as investors feared a contagion of defaults.
While depreciation would never be eurozone officials’ stated policy, it currently looks like all roads lead in that direction.”

There are major obstacles in the way of a conversion of the ECB to a loosening of its monetary policy: first the statutes of the institution that assign it only one aim, price stability. But also the German aversion to inflation, due not so much to a memory of the 1923 hyperinflation, but more to the re-export model of the German economy that rely on a strong currency and non increasing wages.

An increase of inflation would fuel wage increases in Germany and a depreciating euro would inflate the cost of buying intermediate industrial components from Central Europe and elsewhere, thus jeopardizing the competitiveness of German exports. 

As a result it seems to me much more likely that the German government will stick with its “brinkmanship” policy leading to Greek and probably Italian governments defaults. Indeed, austerity programs (the shrinking of government spending), while necessary in the medium term, bring the southern economies closer to default.

As explained in The Economist article “Is this really the end?” (November 26), here:

“Add the ever greater fiscal austerity being imposed across Europe and a collapse in business and consumer confidence, and there is little doubt that the euro zone will see a deep recession in 2012 – with a fall in output of perhaps as much as 2%. That will lead to a vicious feedback loop in which recession widens budget deficits, swells government debts and feeds popular opposition to austerity and reform. Fear of the consequences will then drive investors even faster towards the exits.”

And it will lead to a major depreciation of the euro. It has started already with today’s temporary low point of 1,33 to the dollar, and one can only hope that it continues all the way to something like a 1 to 1 parity or even less.

This would alleviate the current pressure leading to a break up of the euro. But it is the only way out of the crisis and it would make the exit of individual countries from the eurozone much easier, avoiding the high cost of total collapse.     

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