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Eurozone falling chickens choice internal or external devaluation


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The political and economic backround in Europe is awful and no good choice is left to solve the huge imbalances between countries: external or internal devalutation.

Whatever the route followed it will translate into a fall in standard of living of Europeans. The path followed by European politicians for the past 4 years has led to a dead end and they will soon have to decide which of two tough routes to follow..

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Eurozone falling chickens choice internal or external devaluation

  1. 1. Eurozone falling chikens’ choice: internal or external devaluation?1. An awful political backgroundSince the financial crisis started in 2007, 8 elections in Europe have drivenincumbent parties out of business. Whether justified or not, it shows how theEuropean population is disgruntled by a generation of politicians whose lack of courageled to the current over-indebtedness mess (N.B. voters share the responsibility by votingfor the same politicians they despite now).For a couple of years I have written that Greece could not be saved and I strongly believethat European politicians did not give a damn about Greece to solve the crisis, andwere solely interested in insulating their banks from a Greek default: tosucceed, (1) time needed to be garnered (hence the succession of costly bailouts) and (2)the ECB involved by buying sovereign debt from banks and extending unlimitedliquidities; banks used these liquidities to buy more European sovereign debt (the 3 yearsEUR 1 trillion LTRO is meant (1) to provide some breezing space for deficit proneSouthern European countries –France included- and (2) give a free return to banks tostrengthen their balance sheet in the turn of 2-4% i.e. EUR 20-40 bn a year, a disgrace– asa side comment, none of the executives of European banks benefiting from the ECB largessshould get any bonus since the profitability of banks has nothing to do with managerialacumen, and should in fact, for many of them, be bankrupt; as I have advocating for somany years banks’ executives and theirs boards should have been fired: what shareholdersare waiting for?).Greece will again go the poll in June and I do not see why results would favor a corruptand incompetent political arena which has ruled Greece for 30 years, and all poll aregiving the extreme left SIRYZA party a large lead. Despite disguised threats to the Greekelectorate (80% want to remain within the EZ but with no austerity but an open checkbook from the Germans – they are living in Cuckoo land) from policy makers about apossible exit from the EZ (if your vote is wrong i.e. you do not abide by our integrationistrules, then it will be a disaster for you and no more money from us), the PASOK and theso-called liberals will be out of business for good, hopefully. The trick is to propose at thesame time a referendum about the exit of Greece from the EZ which would end up in arather strange situation where the majority would vote for an anti-austerity parliamentand at the same time vote again the exit from the euro whilst bailouts are linked toausterity; the discussions about adding growth to austerity are fine but will not address theroots of the problem: lack of competitiveness. 1
  2. 2. the failure of economic convergence within the EZ, we are witnessing Greece’sstandard of living fast converging not with Northern Europe but with its Europeanneighbors, Romania and Bulgaria!For the time being, Greece got its EUR 4.2 bn rescue payment from Europe last week (addEUR 1.6 bn if the IMF disburses its part of the deal) that will cover its liquidity needs forJune and probably until late July since Greece has hardly any repayment due in July.Parliamentary elections in France, also taking place in June, will see the current Sarkozystparty (UMP) lose a considerable number of seats pending unofficial local agreements withthe FN, Mrs. Le Pen populist party. The socialist party will win the elections, thequestion being by which margin: if their victory is large enough, after gaining controlof the Senate in September 2011 for the first time under the Vth Republic, they could hold2/3 of the congress (Senate + Parliament gathering) to modify the constitution as theywish.Germany’s Chancellor Angela Merkel registered a strong defeat in North Rhine-Westphalia state election in May, the most populated region. However the increased leadfor the SPD (the center left) does not mean that this will end the austerity imposed ontoSouthern Europe since it is the SPD that enshrined budget balance in the Constitution:Germans will not agree to finance ad vitam aeternam Southern Europe for the sake of“peace and the European construction”, which is the dogmatic and untrue eurocraticmotto.2. An awful economic backgroundEconomic forecasts for 2012 and 2013 are between bad and disastrous forClub Med countries (the IMF is less confident than the EC, and private forecasters areeven more pessimistic), and downward revisions will crawl along the year and next.As the table below exemplifies, GDP will turn negative this year and more deeplyso in 2013, with hardly any EU country escaping, the EZ being more affected, andwithin the EZ, Southern Europe the mostIn the case of France, the new President, François Hollande, based his economic programon official, and as usual over-optimistic, growth forecasts of 0.7% in 2012, 1.75% in 2013and 2% until 2016, whilst the country will be in negative territory in 2012 and 2013 atleast. Add a Greek default and you get an asset that becomes a straight loss in the turn ofEUR 15 bn from the first bailout already paid plus any recapitalization of the ECB. 2
  3. 3.’s deficit will not be reduced back to the 3% Maastricht criteria in 2016 and its debtwill continue on its upwards trajectory. Expect 2 notch rating downgrade within 12months.Like other Europeans, the standard of living of French citizens will keep upcontracting.The key issue of low competitiveness is structural, and economic, social andtax reforms are not addressed. Policy makers have focused for too long on what theythought, incompetently or dogmatically, were liquidity issues. 3
  4. 4. The choiceThis foolish blindness is leading to one of two tough choices: internal or externaldevaluation to quickly regain competitiveness.Let’s come back to my preferred equation:PIB = Public spending + private spending + commercial balanceThe World has huge imbalances which result from demand led economies(USA example) whose consumption is satisfied by export driven economies(China for example), and these imbalances must be corrected to go back to someeconomic and financial normality.Looking at the equation, and taking into account the state of debt and budget deficits indemand driven economies in the West, they MUST shift their focus to improvingtheir trade balance, and export driven countries MUST stimulate domesticdemand.There are two ways to improve the trade and services balance: either increaseexports or reduce imports or a combination of the two.To increase export one needs to propose goods that others want to buy by focusing onadded value products (there is no way to be competitive for goods very elastic to prices) orunique goods and improve competitiveness. Wage and social costs are the items acountry controls which impact productivity and no Club Med country will escape harshausterity. Energy is also quite important and must be addressed (the USA is thriving inbecoming self sufficient again in the years ahead thank to technology which allows shaleoil and gas recovery – this will all also have a substantial positive impact on the US tradebalance).To reduce imports, goods must become too expensive for consumers or find thesame ones locally at attractive prices. This can be achieved via custom tariff and/orother tricks or via unfavorable exchange rates.Therefore, taking the extreme case of Greece (but it is valid for Spain, Italy, France, etc.),to rebalance the economy and improve the terms of trade, the choice isbetween external or internal devaluation.External devaluation corresponds to the exit from the fixed exchange ratemechanism (the euro) where the Drachma will loose 50-70% of its new parity with the 4
  5. 5. (or DM) leading to much higher imported goods thus lowering consumption andmore importantly lowering imports; this assumes that the goods and services needed willbe substituted with locally produced one, otherwise the country will continueimpoverishing itself. The terms of trade for exports will also dramatically improve,assuming Greece will produce goods other countries want to buy. For the country not tocrumble under debt servicing, this will be accompanied with a debt default(restructuring, straight default, inflating the debt away, you name it). Competitiveexchange rate devaluation has always been and still is an economic policy tool(see the US and China manipulating their currencies at will).Internal devaluation is where countries have chosen austerity withoutcurrency devaluation: the only adjustable variable is real wages and socialbenefits which must be reduced and this must be equivalent to a currencydevaluation. The terms of trade will not improve and trade imbalances will remain. Debtservicing becomes unsustainable by eating a rising portion of taxes collected. This can onlywork with fiscal transfers from other countries if a social collapse is to be avoided, i.e.Germany continuing paying.Whatever the course of action followed, the standard of living of Europeanswill continue to fall for years if not for a decade. However, the internal devaluationonly route, if followed, would end up very nastily.I will never sufficiently outline the need for Europe to focus on innovation(strength of the US which also explains why I am more positive on the US economicprospects than the European one) and demographics, an other factor of economicgrowth: spending money in these areas instead of Greece et al. would havebeen more beneficial to European growth long term.Source:Capital Economics: European Economic Outlook Q2 2012 5