Indeed the ECB surprise rate cut reflects (at long last) a growing concern over the inflated price of
the Euro and the risk of deflation in the Eurozone that it creates.
Deflation is a problem because lower prices mean lower incomes and
ultimately profits, so businesses cut spending on everything from new capital
investment to wages and jobs, while consumers cut on their spending too and try
to deleverage. Everyone is poorer and the cuts in corporate and household
spending can bring further price cuts and usher the EU economy in a
deflationary spiral whereas growth is already paltry and falling. The EU
inflation rate is currently at 0.7% a year, well below the official 2.0% target
and the EU official growth rate forecast for the year has recently been revised
downwards from 1.2% to 1.1%.
With lower incomes debtors have a harder time repaying fixed debt
payments (interests). The ratio of interest payments to current national income
increases, increasing also the risks of default of debtors while EU banks hold
hundreds of billions of southern governments bonds. And in theses countries too
the debt/Gdp ratio keeps rising despite optimistic official declarations to the
contrary.
In itself, the recent strength of the Euro price versus the Dollar (and
thus the Yuan) determines a weakening blow to the Eurozone economy because it
hampers exports to the rest of the world and boosts imports from the rest of
the world, depressing the production of the Eurozone firms exporting to the
rest of the world and of the Eurozone firms that compete with the imports from
the rest of the world.
This explains why a growing and vocal share of the opinion in the
Eurozone condemns “globalization”. Open markets (free trade) mixed with a
massively overvalued currency can destroy an economy. Confronted with rigid
wages, decreased incomes, and rising taxes rates (in recession governments need
to increase transfers and social spending to stay in power while their tax
receipts contract) exporters file for bankruptcy as well as firms faced with an
increased competition from imports.
There is no way out of such a
dangerous situation without a major return of the Euro price to an equilibrium
level with the Dollar and the Yuan, meaning approximately a 1 to 1 parity with
the Dollar. The smallish adjustment that followed Mr. Draghi’s mini-cut of
interest rates (from 0.5 to 0.25%) is dramatically inadequate to the task. A
major correction is, however, “what it takes to save the Euro”, or, more to the
point, to ”save the Eurozone economies”, even though even a major external
adjustment of the Euro price would not in itself be enough to correct the
competitive unbalances between individual countries within the Eurozone.
Further corrections of exchanges rates between Italy, Spain, France and Germany
would be necessary, on top of a major depreciation of the Euro relative to the
dollar (and the Yuan), for these countries to return to sustained growth. Hence
the necessary return to national currencies. The price of the currency is not
the only determinant of growth of course, but with external prices of national
products and services overvalued by 25% or 30% and imports undervalued by the
same proportion, no return to growth is possible.
Unfortunately there is a wide and growing divergence about monetary policy
within the ECB between representatives of the “north” and of the “south”. It
follows that it is likely that ECB’s policy will not be radically changed
towards expansion at a time when the US Federal Reserve has delayed the ending
of quantitative easing. These
divergences of monetary policies on both sides of the Atlantic prevent any
major correction of the Euro’s excessive pricing in the short run while making
the euro quite popular with international investors. But the risk is growing
that such an unbalance is unsustainable. That’s why the risk ratings of euro
debtors are downgraded and it is a sign of further weakness in the Eurozone
economies, until a new crisis of the euro, echoing that of last year, returns
and compels the eurocrats to adopt some radical new stance.
