Monday, November 11, 2013

“Strong” Euro, Deflationary Risk, and Globalization Bashing

 Euro's excess strength implies an increased risk of deflation in the eurozone and a continued "globalization bashing" in public opinion.

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.