Where are we now in Europe?
Europe continues its fudge and bodge, it continues to ignore the core problem which is that the Monetary Union just cannot work under the current framework.
The Core Problem
Under a system of freely floating exchange rates (the dollar and sterling are free floating, the Renminbi is not) the market on a continuous basis bases prices in a combination of factors. These are: the level of domestic interest rates, the inflation rate, the Government’s budget position, the balance of payments, in particular the current balance (this is the net of visible and invisible flows), and the way in which this is being offset through the capital account (in particular by Government borrowing from outside the economy).
If the market decides that in combination, the country is in an unsustainable position, they sell the currency. There is a devaluation. This with time lags results in an adjustment via more profitable exports, more expensive imports, higher interest rates, and for a time, lower growth. It takes about three years for the rebalancing to work. But it does work. We in the UK have been doing this on and off for the last 45 years.
The Eurozone problem is that this adjustment mechanism doesn’t exist between Euro member countries.
In any currency union the balances of the public sector, the private sector and the external sector must sum to zero.
From the beginning of the Euro, the following countries ran surpluses on their external account (i.e. with other countries):
- and only just, France
They were selling more than they were buying.
The following countries ran deficits on their external account.
They were buying more than they were selling.
The balance of payments for any country must balance each month. This is a feature of double entry book keeping. The surplus countries exported capital (money) to the deficit countries. These flows were organised by the private sector with bank lending, through M&A, and the middle classes buying property abroad. The flows were large and deemed low risk because there was no exchange rate risk.
When the credit crisis hit in Oct 2008, these private sector flows ceased. Individuals in the deficit countries stopped spending and began to reduce their debt as their wealth collapsed. As individuals and companies moved from deficit to surplus, their Governments moved deeper into deficit (it happened in the UK too!). So debt moved from the private to the public sector.
No longer is the private sector in the surplus countries willing to finance the debt of the deficit countries. Instead it is a combination of the European Central Bank (ECB), the International Monetary Fund (IMF), and the European Support Fund (ESF).
Germany is a third of the Eurozone. It therefore is the dominant underwriter of the ECB. Germany is adamant that the ECB should not buy sovereign debt, apart from to supply short term liquidity.
The latest EU agreement is that the size of Government deficits will be limited, and policed by Brussels. The limit is current borrowing to be no more than 3% of GDP, unless there are exceptional circumstances! This does not address the current problem.
Deficit countries within the Eurozone must reduce their external deficit, i.e. they must sell more and buy less from outside. Because they are so uncompetitive, their only way forward is a deep recession, i.e. buying less because their wages are falling. Germany doesn’t seem to realise that its exports to the deficit countries will collapse. So ITS surplus will fall due to lost sales.
What can be done?
The ECB should be allowed to buy sovereign debt. This will give the markets confidence and ensure private sector flows return. It will reduce the cost of funding for the Club Med countries. It will not be inflationary. It will also prevent a meltdown of the European Banking system and give UK Banks a boost (because the credit default swaps payments will not be triggered).
The alternative is chaos and a horrendous feedback loop which would run as follows. Italy would only be able to borrow at 8-10%, Standard and Poors would then downgrade their debt because tax income is insufficient to cover payments at such a level. It would apply to the IMF for credit. The IMF would impose very tough conditions. Even more of the Italian Economy would go unofficial further depressing tax receipts. The same for Spain.
Will the ECB Act?
Yes but not before Europe as a whole is in recession. The change will come at the end of this year when Germany has experienced zero growth due to a sharp reduction in exports to the Eurozone.
What does it mean for UK Business?
The exchange rate risk is increasing, particularly Sterling-Euro. Ideally business would match income and expenditure by currency type, thus neutralising the impact of currency movements. For many this is impossible. They have only two options, buy forward (expensive) or make sure the margin is sufficient to cover the swing in rates. The average for 2012 I guess to be 1.18, but it could go as high as 1.26 and down to 1.08. There are many who would suggest 1.30 plus, but this is highly unlikely because the finances of the UK are fragile and we have a difficult year ahead. S&P are downgrading sovereign debt in the Eurozone primarily because, unlike in the USA and the UK there is no lender of last resort i.e. a central bank willing to purchase significant amounts of Government debt from private sector investors. This action creates liquidity and confidence so that at auction Government can get the credit they need at a price which is manageable.
The French seem to think that their recent downgrade is due to some Anglo-American plot, rather than the simple fact that quantitative easing is an essential monetary tool which the ECB is forbidden to use and therefore financing the French deficit is more difficult.
How Deep Will the European Recession be?
It is my opinion that it will be deeper than many expect for the following reason: since October last year European banks have been shedding assets at the rate of 35Bn Euros a month. They have sold these assets on. This doesn’t reduce the supply of credit or money, but they are doing the easy bit first as they try desperately to meet the July 2012 deadline for their core capital to be at least 9% of their balance sheet. From now on they will be reducing their net loan book, and withdrawing credit from central and Eastern Europe. In the last two weeks (January 16th) they stopped lending to each other. The wholesale money market is key to the proper functioning of the credit system. The UK market seized up in October 2008, the impact on growth was quick and substantial. The same is happening today in the Eurozone. On January 16th 2012 Eurozone banks had parked 501 billion Euros at the ECB. This is money which should be oiling the wheels of commerce. The chart on the next page illustrates my view.
My guess is the Eurozone will shrink by 1.5% by the end of 2012, and with no change in ECB policy, by 2.0% in 2013. We have to hope that this will cause Germany to rethink its current stance on lender of last resort for the ECB, but once credit crunch begins the feedback loop is powerful in a downward spiral.
The Impact on the UK
The EU is the largest importer and exporter on the planet. 50% of UK exports go to the region. Of our top ten markets, 8 are in the EU. This trade is worth 3.5 million jobs, and around £2300 per household. So a 2% contraction in the Eurozone, translates into a 4% nominal drop (assume a 2% inflation rate in Europe) which is in round figures £100 per household income contraction. This is on top of the increase in income taxes which Gordon Brown announced three years ago would apply in 2012.