The Bennett Newsletter
World markets this year have marched to the drum beat of stimulus from the US, UK and emerging market growth, punctuated by panic about Europe. The US, UK and Japan have zero interest rates, and are saying, in effect, ”if you want yield, take risks”; while the European situation’s periodic crises provides enough risk to plunge markets into severe contraction.
This oscillation makes life hard for investors. Should one be bullish and back shares? Or, should one give greater weight to Europe? My viewpoint presently is that the Euro will remain a persistent problem but will not prevent a mild appreciation in markets until next May-June when QE2 comes to an end. By that time there will be a flood of liquidity making markets quite resilient.
The medium term’s outlook is less positive. The stimulus will have worn off and there will be very volatile markets as Europe’s problems intensify as the PIIGS try to roll over their debts. So what is the Euro’s future? My pick is “drift”, Germany cynically keeps it on life-support; an opinion that puts me on a limb.
The scenarios
Bond markets have scorned the €85 bn Irish bailout. Yields have risen not just for Ireland, but also Portugal, Spain and even Belgium. Can unity remain? Can the PIIGS endure the austerity necessary to make the system work?
Europe’s business press postulates a choice between two alternatives previously considered “unimaginable”: fiscal union or break-up. I will add another possibility: the “drift” option. This may occur because no consensus will emerge on break-up or fiscal union. Moreover, I contend that Germany favours it, would benefit from it, and will torpedo alternatives.
Fiscal union.
Union would involve a profound debate on how the costs are to be apportioned. This will be a struggle between and within counties.
Charles Kindleberger’s “The Financial History of Western Europe” shows that the level of the currency was contentious in Europe in the 1920’s and ‘30’s. The issue was should the working class bear the cost through deflation and unemployment so that rentiers and importers could enjoy a high currency? Keynes pithily observed in 1922 that the choice between inflation and deflation “comes down to the agonising struggle among interest groups.” A fiscal union would radicalise politics and tear the continent apart.
Breaking up the Euro would be very painful. http://www.economist.com/node/17629661. What would occur if country “X” were to withdraw, devalue and perhaps default? This would put the burden upon creditors, especially banks which have advanced loans or bought bonds.
But Country X might have a conservative government which follows standard economic advice to force down labour costs. Consumption taxes would further hurt workers. Welfare may be cut, curtailing pensions, health and education benefits to workers and middle class. If Country X has a left-centre regime, it might set the currency low and import inflation: this hurts the middle-class and savers. Income taxes may rise hurting business and the middle class.
If Ireland or Greece left the euro the costs will be huge. It takes years to prepare for reintroducing a national currency and any hint of such a major event leads to massive capital flight. The regime would have to clamp down on bank withdrawals and control capital flows. This would crush commerce.
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Do nothing
Europe’s leaders have been timid in response to the liquidity crises. They acted slowly and reluctantly to bailout Ireland and Greece. The ECB has been frowned upon for buying weakening bonds. There seems to be little understanding that Greece and others really cannot service their debt and that the creditors must suffer. The Economist says “some pain must be inflicted on bondholders”. Germany hates the idea of aiding the indigent PIIGS.
Germany has reacted indignantly against issuing an E-bond and also creating a joint EU-IMF emergency fund. Angela Merkel claims “competition on interest rates is an incentive to respect stability criteria”. This translates loosely into:” we want to keep our rates low, and not carry you”
That means many more emergency liquidity loans. The crises do not result in lasting solutions, but each crisis takes its toll on the fighting fund and weakens the system
Germany
Germany has no appetite for fiscal union or even extending guarantees to the euro-members weaker partners. It loved the Deutschmark but had to accept the euro as the price of unification with East Germany. Its savings were diverted by banks to the profligate PIIGS.
The Financial Crisis has benefitted Germany. It has retained its savings and has attracted more capital which it has invested. It is booming as the world’s greatest exporter. It is confident and tells other countries that the only model that works is low inflation, frugality and hard work. It knows that the euro, weakened by crises and doubt about the future, has assisted its exports. If the Euro was sound, it would appreciate as its rivals, like the dollar and yen, lack robust fundamentals.
A low Euro is in Germany’s interest. It might contribute grudgingly to bailouts but its share will be low. It was happy to allow the non-euro entities like the IMF and the UK to lead in saving Ireland.
Meanwhile it will explain that the PIIGS brought destruction upon their own heads by using German credit and capital to spend wildly before the crisis and abandon all discipline. They created the bubbles and acted unsustainably. Their budgets broke all the rules.
Germany sees some justice in the profligates now being punished by high interest rates, and implies it might help when and if the PIIGS get their budget deficits under control. It has also said foolish creditors must take a haircut. It is content that the market is imposing a new disciple upon errant euro-members. They are learning painful lessons that Germany learned in the Weimar Republic years.
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