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Sunday, September 11, 2011

It’s the end of the Euro (as we know it)

Several investment banks and think-tanks have stated that the Eurozone is at a “cross-roads”. Either there is more fiscal integration they say (e.g. common coordination of government spending), or the zone will be facing monetary dis-integration (e.g. countries going out of the Euro). Some are even claiming that the “end-game” is nearing, e.g. that we are going to see in which direction this is heading soon.
These are correctly pointing to the fact that monetary integration (with low inflation targets) without fiscal coordination is unsustainable. Nevertheless, the idea of a sufficiently potent European fiscal coordination is utopia (will Greeks allow the German’s to dictate their public pension schemes and tax-levels? It’s like returning to being ruled by the Roman Empire overnight…). 

The likely end-game is that countries like Portugal, Spain and Greece will continue suffering until they chose to abandon the Euro. And when they leave, they will briefly suffer substantially more, before things eventually will get better.

A brief recap of history

To fully understand what is happening, one needs to recap a little bit of history. The entire concept of the Euro and the European Union is built on that of economic convergence. With no restrictions on the flow of labour, capital, goods and services between countries, labour costs, capital returns and prices will converge to a common average. In other words, if labour is cheaper in Greece, then the return on real capital invested in Greece (such as a car assembly plant) is higher. 

The higher prospective capital returns will continue attracting more capital, fueling demand for local labour (increasing local wages) until capital returns and labour costs are more or less the same everywhere. Similarly, if wages are higher outside of Greece, Greek workers will go working abroad, reducing domestic labour supply and adding to the labour supply where the cost of labour is the highest. The free flow of labour and capital in the Eurozone should lead to greater prosperity and economic growth for all, as labour and capital will flow to where it is most efficiently utilized.

Before 2007, when the most recent economic contraction was initiated (by some investment analysts barely out of their diapers referred to as “The Great Recession“), there were in fact many signs that convergence had taken place. Borrowing costs went down substantially in the PIIGS countries (Portugal, Ireland, Italy, Greece and Spain), the cost of labour increased markedly, and the cost of a shopping basket (adjusted for differences in VAT) became more or less the same in Spain as in Ireland. Spain experienced higher GDP growth than most of Europe, and in Ireland the growth was so high the country was dubbed “the Celtic Tiger“. The Euro appeared to be a success; overall GDP growth in the Eurozone was showing levels not experienced in decades.  

So, from this magnificent state of economic euphoria, what went wrong?

As borrowing costs decreased, borrowing increased. Real interest rates in Spain, Ireland and Greece were de-facto strongly negative, so investors and consumers were incentivized to borrow as much as they could and place funds in assets whose prices are a direct function of domestic inflation, such as real estate. This was also fueled by significant European Union development grants (e.g. payments from richer to poorer member states to pay mostly for infrastructure investments, such as roads), a form of fiscal stimuli given completely without regard to where the economies were in the business cycle, further adding to economic imbalances

Constantly increasing real wages (and declining unemployment) lead to optimism about the future, GDP “trend growth” estimates where revised upward to account for the economic boost that had been experienced by convergence, prompting governments to believe there would be more tax income in the future that could be used for current spending and investment.

Though the underlying changes in the economic conditions were supported by the fundamentally sound principles of economic convergence (and the noble ambition of European economic equality and development), the growth momentum created lead to the economies experiencing the same dynamics that have created every economic bubble known to mankind, from the Dutch Tulipmania in the 1640s to the dot-com bubble in the early 2000s, to the real estate bubble that popped in Dubai in 2009; an irrational public belief that the trends experienced in prices and incomes over a limited recent historic time-frame are likely to continue far into the future.

In fact, among the Eurozone countries with the lowest initial real-wages (e.g. those that were the furthest away from other countries in terms of economic conditions and thus experienced the strongest momentum in the convergence process) expectations of prices and growth rates took on a dynamic of its own, decoupling from the initial economic fundamentals which had triggered the trend. For example in Spain, lower financing costs initially lead to increased demand for real estate, which lead to price increases, which lead to more investment, employing more people in the construction sector, decreasing unemployment, increasing GDP growth momentum and income levels, leading to more demand for real estate and further expectations on price increases, etc.

These dynamics has taken us to where we are today; the economies of Portugal, Ireland, Italy, Greece and Spain are deep in debt, and they are unsuccessful in attracting the capital necessary to generate growth, as real wages are higher than what is economically justifiable by the productivity of labour (the consequence of running high past inflation, and also a consequence of the Czech Republic, Poland, Hungary, Slovakia, Bulgaria, Romania having joined the European Union). 

Worse yet, a considerable chunk of the debt is held by governments, much subscribed to recent fiscal over-spending aimed at stimulating the economies back to a misguided perception of what is the true “trend growth” of the economy. The government fiscal spending has actually made things worse, as the bulk of funds have been deployed unproductively (such as government grants given to consumers to make new car purchases, prepping up the balance sheets of failed banks, preventing necessary restructuring).

The most likely end-game

As the fundamental problem of the economies is that they currently have labour costs that are too high, growth will not return until labour cost have come down sufficiently to provide competitive capital returns again (e.g. the same economic mechanism which had initiated the growth is now hindering it). 

This can happen in two ways:
  1. Through labour market mechanisms (e.g. price adjustments through shifts in the supply and demand of labour)
  2. By a de-valuation of the currency vs other currencies

Decreasing the cost of labour through labour market mechanisms essentially means that the economies will run with high unemployment, and that the unemployed will be required to compete for the jobs on offer by requiring less pay. As the labour force on average eventually will earn less, their ability to pay for housing and other capital goods will decrease, essentially implying that the entire economy will undergo a process of deflation. 

Falling real-estate prices will then continue to threaten the value of collateral for loans held on banks’ balance sheets and restrict their ability to keep lending. This will hamper new investment in the industry and service sector, restricting demand for labour (initially creating even more unemployment).

Furthermore, the high taxes these governments need to collect to pay back the high public debt implies lower capital returns, which means that labour cost must come down even more in order to compensate. Considering that these economies additionally have good unemployment benefits, public pension schemes, inefficient government bureaucracy, high level of corruption, a high share of labour in the public sector, strong unions and high minimum wages, wages will take a very very long time to adjust

The deflationary spiral that will follow will resemble that of the Great Depression of the 1930s, when the gold standard restricted the possibility of reducing real wages trough quantitative easing (e.g. by printing money so that prices increase more than nominal wages). What has been dubbed as “the Great Recession” is very far from showing its full impact; the imbalances (public and private indebtedness) seen today are far worse than those of the 1930s.

The current modus operandi of decreasing the cost of labour through market mechanisms will eventually lead to so much social unrest that any government following this policy sooner or later will be replaced. It is a recipe for social and economic disaster; the deflationary spiral that will follow will add tremendous systematic risk to the entire European banking system, not to mention the political risk that will be created by the social unrest that will accompany such a policy.

The inevitable will eventually happen; these economies will exit the Euro, de-facto devaluing their currencies. This will imply the governments defaulting on their debt, making it impossible for them to borrow more, nevertheless it has the benefit of immediate restoring domestic wages to competitive levels, as prices of imported goods will increase so much that it becomes economical to produce many of these domestically again. 

This will attract capital and external demand for domestically produced products and services (for example, agriculture in Greece is about 4% of GDP, whilst tourism directly accounts for about 15% (2009), both will increase substantially as Greece becomes more attractive as tourist destination and improves its terms of trade). And growth will be restored, although from a much lower base (as measured in Euros).

So what does this mean for the Euro?

It means that the “bad news” for the Eurozone are to continue and that the “end-game” is no-where near. Weaker economies still have some way to go before realizing that exiting the currency is the only way forward. Early indicators to watch out for is public opinion towards the Euro in the troubled countries, financing problems triggered by flight of deposits from PIIGS domiciled banks, as well as irregular changes of government. It may take 12-36 months to unfold in its completeness; it will continue to be strongly resisted by Germany, who is benefiting from a low Euro in its exports, and whose banks will be heavily penalized by a PIIGS default.

However, unless fiscal integration becomes more than just an idea, the structural problems created by a common currency will likely not stop just with the PIIGS countries. For illustrations sake, let’s say the PIIGS countries all exit the Euro and the Euro essentially consists of France and Germany. It is reasonable to expect the Euro to appreciate against other currencies in such a scenario, as it will only consist of remaining stronger economies. 

Though Germany may find a stronger Euro compatible with its national inflation targets, France may not, and suddenly the remaining Eurozone is facing the same issues, even just with two economies remaining (e.g. the real exchange rate is suitable for Germany but not for France, and France may exit to avoid deflation. Already now France is pushing for a more inflationary ECB monetary policy, whilst Germany – whose population consists of net savers- is resisting).

Once the “shake-up” has been complete, the Euro will be synonymous with the Deutschmark. It will continue strengthening against other currencies until the German current account is balanced. Meanwhile, funds will continue to flow to Gold, Swiss Francs, Norwegian Kroner and other currencies with strong underlying fundamentals, as the US will be running high inflation, potentially having more resemblance to Zimbabwe than the global reserve currency it used to be (more on this to follow later, in a separate article).

The last straw of hope

The last straw of hope for the Euro is through the aggressive printing of new money by the ECB and the creation of inflation. Inflation may create differences in real wages between countries without having them to go through dangerous deflationary spirals, however such a policy would require that stronger economies (such as Germany) are willing to run with higher inflation than weaker ones for longer periods of time to consciously deteriorate their own terms of trade

As this in practice would mean a transfer of wealth from net savers (e.g. Germans) to net debtors (e.g. Greeks), it is highly questionable what level of support such a policy might have among the general public in the stronger economies. The social and economic cost of a “soft” default, which this implies, would in any case be preferable to the cost of a “hard” default from Greece and a full exit from the Euro, arguably also for the German public (if they understood the full consequences, however national pride and PIIGS bashing seems to be getting in the way of judgement). 

This will in any case require a radical change in ECB policy, which needs to happen fast, where monetary policy at all times will be adjusted to accommodate for the weakest membership states and where the ECB inflation target is adjusted significantly upwards (a firm requirement to ensure stability in the Eurozone in the absence of fiscal integration, as it gives countries greater flexibility in adjusting their terms of trade). If this change in policy manifests itself (it is most likely far too late for that now anyway, as the deflationary spiral is gaining momentum in all of the PIIGS), the next bubble to be created will be in German real estate.

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