The EU Summit and ECB meeting which transpired last week are likely to be the final supporting actions by Eurozone officials this year. The tack forward for Europe has been clarified; move ahead with the long and arduous process of fiscal unification, supported by a reactive ECB. The path ensures two outcomes; that there will be flare ups along the way which will negatively impact sovereign debt/currency markets, and that Europe’s economies will continue to slow as the mending process is drawn out. The way forward will be the German way forward, and the rest of Europe will need to accept it in the near term.
Germany has the strongest and most robust economy in the Eurozone. German unemployment is low and the euro has already depreciated to levels which will support German export growth. For many years in a row, Germany has run a current account surplus based on German specialization in the manufacturing area and the benefits of a pegged currency, which is much lower than the Deutschemark would be as a standalone currency unit. The Germany economy would be in a much different place if the euro currency peg (pegged to the prospects of 17 nations and not just Germany) wasn’t in place. Two relevant comparisons can be made with Switzerland and Japan. Both nations have no issues with inflation, have taken dramatic measures to weaken their currencies and have business environments which are being pressured by lack of cost based competiveness. Toyota came out late last week and stated that a strong yen is “destroying Japanese industry”. Switzerland has initiated a cap on the exchange rate relative to the euro and is willing to print Swiss francs in unlimited size in order to halt currency appreciation.
The German economy is healthy for many reasons beyond the adoption of the euro. Germany is a proud country that works together, prides itself on efficiency, and has an education system and labor market that promotes specialization and technical skills. Nonetheless, the cost of production in Germany has been held down for many years which have created export advantages relative to other European nations and a stronger German labor market. The pros and cons of Eurozone membership counter-balanced over the past decade. Germany received a lower than otherwise exchange rate and Italy and Spain received a higher exchange rate but lower than otherwise sovereign borrowing costs. Presumably, the adoption of the euro reduced trade barriers and costs for all participants so net-net all members were better off in the pre-financial crisis days.
Today, the market is no longer willing to homogenize Eurozone credit risks and borrowing costs are much higher for Italy, Spain and the rest of the Eurozone periphery. The southern European economies experience the constricting effects of a stronger than otherwise currency in tandem with debt costs shooting higher because adjustment mechanisms have disappeared. Without meaningful currency depreciation, which would reduce costs of production and stimulate business activity, southern Europe is forced to accept deflationary forces and the need to reduce income and wages to improve competiveness and lift business activity. Adjustments which require lower wages are blunt and will be firmly opposed by unions and politicians. The US was in a similar situation after the financial crisis and cut interest rates, ran a fiscal deficit, let the dollar depreciate, and ultimately implemented quantitative easing.
The German trade surplus has been in place for a number of years while trade deficits have been consistently run in Italy, Spain, and Portugal. Part of the explanation of trade deficits has to do with comparative advantages and technological strengths. But another part of the explanation is cost. The two large economies in the world which have run consistent and steady trade surpluses for many years are Germany and China. Both of these counties have a semi-pegged currency which has traded below the value it would be absent the peg being in place. Export geared economies like Germany and China need the rest of the world to run trade deficits in order to sustain the dynamic. Currency pegs have exacerbated the imbalances and shifted job creation to the nations where costs are pegged down. As employment problems in developed economies around the world continue, one tempting solution is a resumption of trade barriers and high tariffs. This would be an unfortunate outcome because GDP growth would slow around the globe. A better solution is one where trade is free, but individual countries have a market based adjustment mechanism which also works freely.
Italy and Spain aren’t able to propagate the super simulative conditions which are appropriate for their respective economies because each country is beholden to the ECB and euro currency. Germany and the ECB have made it clear that they will not bend in their inflation fighting focus, which is very appropriate for Germany and the northern European economies, but is inhumanely restrictive for southern Europe. The Mexican Standoff between southern and northern Europe has found a near term resolution with Germany and the ECB dictating the path to recovery. The path forward will be very painful for countries with high unemployment where the adjustment mechanism is out of their hands.
For now, the market is anticipating that all the austerity and adjustments move ahead over the next couple of years but major political risks loom along the way. Whenever the approach of creating a tighter fiscal union gets questioned, confidence will have a propensity to vaporize quickly. The best case outcome is volatility in European confidence, a meaningful recession for a number of Eurozone countries and an eventual solution leading to collective growth a few years out. A more bearish case will be that the pain is too great to endure for some counties with high unemployment and no adjustment mechanism and a Eurozone breakup ultimately takes place.