Ambrose Evans-Pritchard on the Eurozone

I have taken the liberty of publishing the following article of Ambrose Evans-Pritchard: My grovelling apology to Herr Schäuble: So there we have it. The [European] problem is solved. How can I not have seen it? How can any of us on this blog thread have missed it? I apologise for mentioning that unemployment is 27.8pc in Greece, 26.3pc in Spain, 17.3pc in Cyprus, and 16.5pc in Portugal, or for pointing that it would be far worse had it not been for a mass exodus of EMU refugees. Nor was is proper to mention that Greek youth unemployment in 62.9pc. These are trivial details. I apologise for pointing out that the EU-IMF Troika originally said the Greek economy would contract by 2.6pc in 2010 and then recover briskly, when in fact it contracted by roughly 23pc from peak-to-trough, and will shrink another 5pc this year according to the think-tank IOBE. This slippage is well within the normal margin of error. I apologise for mentioning that the debt trajectories of Spain, Greece, Italy, and Ireland have accelerated upwards under the austerity plans, and therefore that the policy has been self-defeating. It was quite uncalled for to point out that Italy’s debt ratio has jumped to 130pc of GDP, or to so suggest that debt cannot keep rising on a contracting nominal GDP bas, and I will wash my mouth soap if I ever utter the words “denominator effect” again. It is shabby to use such cheap language. I apologise for mentioning IMF studies showing that the fiscal multiplier is three times higher than first thought by EU officials in EMU crisis states, and therefore that the contractionary effects of belt-tightening are far greater than first calculated. As for using that pious and pretentious Greek word “hysteresis” to suggest that mass unemployment and the collapse of investment in southern Europe has lowered the economic growth trajectory of these countries for years to come, outweighing any of the alleged gains from the EU-imposed reforms: this is just trying to blind good folk with posh talk. I apologise for suggesting that German reforms under Schröder have been vastly overblown, and that German competitiveness gains have been chiefly the result of a beggar-thy-neighbour wage squeeze at the cost of EMU trade partners. Nor should I have said that a small open economy like Sweden in the 1990s may well be able to tighten its way back to vitality in a the middle of a global boom, but if half Europe does so in unison in a slump, it will inflict carnage. It was unconscionable of me to say that Germany has locked in a semi-permanent trade advantage over Club Med, or for saying that the trying to close this gap by imposing deflation on the South is impossible because this will play havoc with debt dynamics. How could any of in the eurosceptic camp have stooped to the historical pornography of the 1930s, suggesting for one moment that EMU replicates the worst errors of the interwar Gold Standard, or that the German-led creditor bloc is doing to Spain exactly what the US-led creditor bloc did to Germany from 1928-1933? Just sheer smut. I apologise personally to Mr Schäuble for calling him a dangerous mediocrity: arrogant, shallow, narrow-minded, provincial, and unscientific in equal degree. This was shockingly rude. It brings shame to Fleet Street. I should not have questioned his wisdom in thinking it is possible to harmlessly enforce contractionary policies on the South of a single currency zone without offsetting expansion in the North. Events have shown that he has the finest mind in Europe, and a superb grasp of European politics. Moreover, people have seen the light even in Greece, where he is now adored. I apologise for screaming for two years that the EMU would blow apart unless Germany allowed the ECB to step up to its responsibilities as a lender of last resort for sovereign states, as it finally did at one minute to midnight in July 2012. It was the Fiscal Compact that saved EMU, and the Six Pack, and the Two Pack, and all those rule books from Berlin. It was carping for me to suggest that recent charts showing a dramatic narrowing of unit labour costs in Spain et al are largely bogus, the mirror of mass unemployment that causes an automatic rise in apparent productivity; and nor should I have quibbled about the low trade gearing of Spain, Italy, Portugal, and Greece, or suggested that exports are too small a share of GDP to lift these countries out of the morass quickly. This is just pointy-headed, clever-clever, anorak stuff, and frankly laughable. So no, Mr Schäuble has pulled it off. The German Constitutional Court is in the pocket of the German finance ministry and will thankfully run a coach and horses through the Grundgesetz when it rules next month, or soon after. The court will not stop the ECB keeping Italy and Spain afloat. The law has been stitched up, so no problems there. The eurozone is recovering. It is immune to the sharp rise in the exchange rate of the euro over the last six months. It is immune to a 70 basis point rise in borrowing costs imported from Fed tapering. It is immune to the emerging market crisis. It doesn’t matter that the M3 money supply has rolled over again, slowing to stagnation levels, or that EMU credit contracted at an accelerating rate of 1.6pc in July. None of this matters. I feel like an utter fool. Having read Mr Schäuble's succinct and well-crafted thoughts, I just want to curl in a ball and weep. Es tut mir leid.

Every so often, one thinks that something has changed, and it is time to alter one’s portfolios to reflect this. And what has changed is that the surge in emerging economy growth both in absolute terms and relative to that in developed economies has now come to an end. Two factors are important – emerging economies relative labour advantage has been eroded through rising wage costs and following on from that, export led growth will be much more difficult. Secondly, capital is still flowing from emerging economies to the developed world, partly capital flight and partly portfolio diversification. Thus it is hardly surprising that developed markets are outperforming emerging markets. Sadly, in terms of reorganising portfolios, it is easier to see those sectors that will suffer from this trend as opposed to those that will benefit. These are commodity producers who will not find China such an easy place to sell to, and secondly, companies who have profited from cheap outsourcing from China, such as IKEA. One consequence of this change is that the growth in income inequality within both developed and emerging economies may well have come to an end. The reasons are rising wages in emerging economies and in developed economies, the shift of manufacturing jobs overseas is now being reversed.

The IMF and Greece

The IMF has commented that whilst Greece has made real progress in rebalancing its economy, it has made virtually no progress in improving productivity. The rebalancing has come at the tremendous cost of a fall in output of 25% from its peak in 2007. Greece is seriously lagging in its commitment to privatisation, liberalising regulated professions, and on judicial and labour market reforms. Part of the problem is that the severity of the recession has increased resistance to reform. Greece is caught between a rock and a hard place as reform is easiest to implement in a time of growth but is most needed when the economy is depressed. Whilst the cyclical outlook is improving, it is not at all clear that Greece can move into a period of sustained growth.

Abenomics

The Japanese 1st quarter GDP numbers have created quite a stir amongst those of us who get excited about such things. According to the data, the Japanese economy grew by an anuualised 3.5% in the first three months of the year, suggesting that the eponmyous reflationary policies of the new Prime Minister are working. Unfortunately, as with most new economic policies, it is far too early to tell. The best that can be said is that Japan's new policies are doing somewhat better than the austerity policies of the Eurozone whose economy contracted by 0.2% in the same quarter. Japan's economy intrigues. Its problem is that it is not growing in nominal (or money) terms and indeed nominal GDP is 9% lower now than it was in 1997, whereas its real level (or volume) has risen by 9%. In other words, prices have fallen by more than 15% in the last 15 years (.91/1.09 -1). This, compounded by a falling population, means that it is impossible to service one's debts, and although the non-financial corporate sector has deleveraged, much of this has been transferred to the government sector whose net liabilities has risen from 34% to 144% of GDP over the period. In volume terms, what has sustained the economy has been consumption, both private and public, and to a lesser extent net exports. Investment on the other hand has fallen by over 20% and the ratio of investment to GDP has fallen from 30% to 20%, somewhat closer to the OECD average. At 30% in the early 90s, this ratio was clearly excessive and in some ways its decline is to be welcome although it has added to the deflationary pressures in Japan. In value terms, the fall in investment spending matches the fall in GDP. It is also clear that whilst the export volume growth has been strong, its value has not, meaning that companies have had to cut prices substantially to sell goods abroad. The other statistic of note about Japan has been the transformation in its trade accounts. It is now running a trade deficit of almost 2% of GDP compared to a surplus of 2% eight years ago and its current account is only just in surplus as a result of a surplus in foreign income. Japan has always been viewed as being an excess saver but this is no longer true as ageing consumers run down their savings and the government spends considerably more than its income to keep the economy afloat. The government has announced an inflation target of 2% and that it will double the monetary base as a way of achieving that target. The yen has fallen from under 80Y to the dollar to over a 100Y to the dollar. Some have called this the beginning of a "cureency war" and others are predicting a rapid growth in exports at the expense of other depressed economies. What is more likely is that companies will increase export prices in response to the rising cost of imports, most notably commodities, and leave export volumes as they are. What we are really looking for is a sustained rise in consumption in both nominal and real terms and these 1st quarter figures give cause for hope in this regard. Unfortunately what is missing from the figures is any evidence of an end to deflation and here one is going to have to wait for some time for proof that Abenomics has worked.

PMI data for April

There was not much in the data to get excited about, and it is possible that global economic activity actually fell in April. The recovery remains weak, despite a rise in activity around the turn of the year. The reason for the weakness has to be the ongoing saga in Europe, where activity has been contracting for twelve months. It is little wonder that the enthusiasm for austerity is not quite as great as it was, and demonstrates just how misplaced this enthusiasm has always been. Elsewhere, activity is still increasing but not as rapidly as a few months ago, and it is quite clear that stimulus policies will remain in place for some considerable time.

BRICs

The acroynym BRICs was the great theme for the bulls of emerging markets, comprising the four largest emerging economies in the world, each with their own growth dynamic. Unfortunately the bull case for these four economies is now looking distinctly stale. China. China has overinvested in manufacturing capacity with the result that returns on assets is probably negative. This is reminiscent of Asia (Thailand/Indonesia) prior to Asian crisis of 1997. It is likely that the level of bad debt within the banking sector is extremely high although there are no precise figures on this. The authorities are well aware of the problem but they are loathe to tackle the problem head on and they rely on other stimulatory measures to boost the economy. These are not working with the result that economic data out of China will disappoint over the next few months. India. India is running a large current account deficit and is running into reform fatigue. There are some initiatives to boost infrastructure spending which is sorely needed, but again economic growth will probably disappoint over the next few months. Russia. The problem with Russia is political as Putin's position continues to weaken. Putin's problem is that he retains his Soviet instincts of throwing his opponents in prison on trumped up charges, whenever they have the temerity to oppose him. He cannot grasp the notion that for every opponent in jail, there will be 5 more to replace them. In the meantime, the economy is plagued by insecure property rights and capital flight. Brazil. Brazil has been tolerably well run in the last decade and much better than in previous decades and also compared to Argentina and Venezuela. Unfortunately, it needs to be even better run. Its trend rate of growth has been lifted from the 3% to 4% level to 4% to 5%. This is not good enough with teh result that the economy is running into inflation problems even at relatively low levels of growth. That is the bad news. The good news is that there are other large emerging economies in this world to invest in and each one should be viewd on its own merits. There is no easy way of making money in this world and a blanket enthusiasm for emerging markets and the BRICs in particular was not one of them.

The Bank of Japan

When economic historians look back at the Great Recession of 2007/09, the greatest criticism they will make is that policy makers put too much reliance on monetary policy and not enough on fiscal policy. They will argue that the fears over the rise of public debt to GDP were overdone and too much emphasis was put on the numerator, public debt, and not enough on the denominator, nominal GDP. It is much easier to control the ratio if the denominator is rising than when it is falling. This point has been completely missed by the authorities in Europe, particularly in Germany. They have decided to completely ignore the lessons of the 1930s when too many countries tried to adhere to the gold standard and failed miserably. Today’s ‘gold standard’ is of course EMU and the fiscal austerity imposed by Germany on the periphery economies is having the same disastrous results. If there is any doubt about this, simply compare European unemployment and retail sales to those of the US. European unemployment is now 12% and rising whereas that in the US is 7.7% and falling. European retail sales have fallen by 1.5% over the last 12 months whereas those in America have risen by 4.5%. One country that has changed course in recent months has been Japan, where Prime Minister Abe has insisted that the Bank of Japan adopt an inflation target of 2% and do everything possible to ensure it is reached. In addition, there has been a sea change within the Bank of Japan with a new Governor and a Board prepared to support him. Gone is the traditional timidity where the attitude has been ‘we have done all we can’ to be replaced by ‘let’s go for it’. To this end, the Bank of Japan has announced that it will double Japan’s monetary base and formally adopt the 2% inflation target. QE will now be the centre of what the BoJ does. This is a significant shift, not just for Japan but also for Asia and even possibly globally. If only policy makers in Europe would take notice! If one wants to temper one’s enthusiasm for Japan, it would be the need for the change in monetary policy to be accompanied by structural reform. PM Abe has talked about this need but in the obscure world of Japanese politics, do not hold your breath.

Cyprus

Cyprus has its deal with the EU to resolve its banking crisis but the question is at what price? There is the usual bad bank/good bank resolution stuff and it is bad news for uninsured depositors. No-one will shed much of a tear for the Russian depositors but not much mention is made of Cypriot businesses with over €100,000 deposits. Insured depositors are safe (for the time being). Cyprus will now see a substantial shrinkage in its banking sector and in turn in the economy, which will make it difficult to meet the debt to GDP targets. The other thing that is not clear is whether the EU now has a template for dealing with banking crises in member countries or whether it is still moving on a case by case basis. One could be cynical and say that the EU is enjoying what it is doing to the Cypriot banking sector, which is effectively killing it off and making several Russian oligarchs pay. Malta and Luxembourg should beware; the big guns could be out for them as well. But when it comes to Germany’s own weak banks, it is the softly, softly approach. There are double standards in all of this. This ‘agreement’ and all the associated issues over deposits increases the chance of bank runs in other periphery countries. In the long run, this may be no bad thing as it will highlight the perennial problem of moral hazard and the risks within banking and so lead to a shrinkage in deposits to GDP. In the short run of course, it is the last thing we need. The final point, which applies to all of the periphery, is that a hard-nosed approach by Germany and the ECB is perhaps understandable but for such an approach to work, Germany itself need to make a concession which is that she must become the spender of last resort. This she has conspicuously failed to do.

The latest global All-industry PMI data for February point to an economy inching forward. It is am improvement but not a terribly exciting one. The US is doing somewhat better, Japan is doing less badly than before and within Europe, Germany is improving but the periphery remains in a bad way. Italy remains a real concern. The OECD lead indicators are telling us that the developed world is doing a bit better than the developing world.