When Harold Macmillan was when asked what was most likely to blow governments off course, he replied “events, dear boy, events”. Both politics and economics, by their very nature are unpredictable. Unlike the physical sciences, cause and effect can be both mean reverting and reflexive. The cross over point is not always obvious and events are unpredictable.
I’ve not written anything over the past two weeks, not because nothing has happened, but because there has been little insight to pass on. At the end of last year, it looked like we were seeing the demise of the eurozone, but the ECB’s LTRO seems to have postponed the denouement.
While the LTRO does not solve the solvency crisis of banks and sovereigns, it has bought some time. How much is still open to question. A Greek default in March could open the floodgates. Equally, there has been ample time to arranged contingencies.
Containing any spill over into Portugal will be a severe test to eurozone policy makers, but they can’t say they haven’t been warned. The LTRO should contain the short-term liquidity strains in the eurozone bank sector. With so much liquidity being placed at the ECB, despite a negative spread, most banks will have secured themselves against all but a severe run. For those brave enough, the carry trade on sovereign bonds provides an opportunity to rebuild some capital.
We seem to have returned to a “wait and see” period in markets. Asset prices have yet again been buoyed by monetary pump priming by central banks, but the real economy can’t use (or doesn’t want to) use the credit provided, so it goes into asset markets. While there is the latent threat of inflation, it does appear that the global economy, especially the West, is in a true liquidity trap.
At these times, it is best to return to what we do know rather than speculate about events, that by their very nature, are unpredictable in timing and magnitude. What we do know is that there are two fixed points in the global economy that are causing severe distortions.
The first is the renminbi peg. This has caused the problems for both the Chinese and US economies. Put simply, it has caused over consumption, low savings, and investment in the US and the opposite in China. The trade and capital imbalances are an out-working of this. Arguably, it has also caused higher unemployment in the US.
There are some positive signs that other economic mechanisms, mainly high inflation in China, are bringing about a rebalancing. The real effective exchange rate of the renminbi is appreciating through the substantially higher rate of inflation in China. This seems to be having the effect of rebalancing trade. The trade surplus, although volatile, is declining.
China would be more sensible to allow the exchange rate to appreciate to offset these inflationary pressures rather than allow high inflation. By maintaining its crawling peg, monetary conditions are red hot and are producing severe distortions within the economy. My guess is that the Chinese are afraid to allow too much appreciation because the corporate sector operates on thin profit margins. A bust in the corporate sector allied to the over extended position of the banks to the real estate sector would wreak havoc in the banks.
However, it is impossible to know when the chickens will come home to roost in China. The problems of an overheated real estate market, hidden debts in the municipalities, over investment, financial repression, low share of GDP taken by wages and corruption are well known and rehearsed. National statistics are so unreliable that a bust could be occurring long before it’s recognised by outsiders. Nevertheless, the rebalancing that appears to be happening between the US and China makes me a bit more relaxed, although still wary.
The other fixed point is the eurozone. The competitive divergence and the accompanying trade and capital imbalances are now a frequent topic for debate in the quality press. Anyone and everyone by now should know the underlying cause of the crisis. What is lacking is recognition by the political elite. Germany is trotting out the same austerity prescription, seemingly not understanding that the only way the the south can repay its debts to the north is for the trade surplus of the north to become a trade deficit.
In a fixed currency regime, this can only be achieved by the north (i.e. Germany) indulging in a massive domestic demand stimulus, a credit boom and tolerating significantly higher rate of inflation than the overall eurozone. It will also have to come to terms with a trade deficit. The matching offsetting capital flows can then be used to pay down the debts owed by the south.
For every trade surplus, there must be a trade deficit. For every creditor, there must be a debtor. This is not economic theory, it is economic fact. German politicians either don’t understand or don’t want to understand. Until the disease is correctly diagnosed, there can be no cure. Sadly, that is where we are in the euro crisis.
How will it play out? No-one knows for sure. It could easily drag on for another two years, but I suspect the crunch will come sooner. Should a Greek default cause a unstoppable cascade to Portugal spreading to Ireland, Spain and Italy, then the game will be over. However, this seems too obvious.
The French elections could be another catalyst. Hollande will be very different to Sarkozy. Germany will be less likely to tolerate a Hollande view of Europe. The fiscal pact has already run into some legal sand traps. It will be dead if the Socialists win in France. The next German federal elections in 2013 will start to enter the political calculus as this year develops.
In my view, Italy is the elephant in the room. It has a completely technocratic government with no democratic mandate. As the unpopularity of the previous regime fades over time and the austerity measures bite, Italians are likely to question the legitimacy of the government. Civil unrest is a distinct possibility. Berlusconi is biding his time and waiting for a chance of revenge. Because Italy runs a primary budget surplus, it could exit it the euro and function in a way that Greece cannot.
I do wonder whether, when push comes to shove, Germany will really go for full fiscal union. Regaining the Deutschemark will look an increasingly attractive option. The banking system will need to be recapitalised, but it will anyway whatever happens. Better to do that with a strong currency. German exports will suffer, but perhaps not as badly as anticipated as German industry tends to be high value added and somewhat price insensitive. German consumers would get a huge boost in relative purchasing power, which would be politically popular. Personally, I believe a German exit is the least disruptive option.
If the eurozone breaks up, many pundits have forecast the end of the world. I take the opposite view. Dislocation will be severe but the changes in currency and competitive parities would unleash a strong rebalancing mechanism which could be the foundation for a decade of growth. At the moment the eurozone is a depression and deflation monster. Get rid of it and we could be surprised at the strength of a recovery in Europe.