Monday, January 14, 2013

Strengthening Euro May Reignite EU Crisis

Back in September, ECB President Mario Draghi outlined the central bank’s willingness to cap sovereign yields through unlimited open market transactions (OMTs) for countries that requested help and submitted to structural reform (i.e. deficit reduction). Following the announcement, sovereign yields began falling across Europe and the euro began appreciating against numerous other currencies. As sovereign credit markets have eased, no countries have been forced to ask for explicit help from the ECB and the ECB has not needed to purchase sovereign debt in the secondary market. Although credit and currency markets reflect a strengthening European economy, unemployment continues rising to all-new heights and GDP growth remains decidedly negative in many countries. If actual economic improvement is not forthcoming in the next few months, Joerg Bibow may be correct in claiming that Draghi’s Liquidity Bluff Will Be Called

Essentially there are three parts to properly resolving the euro crisis, and one vital precondition. The first is symmetric internal rebalancing, the second is dealing with the area’s debt overhangs, and the third is to turn the flawed euro regime into a viable one by fixing the original flaws. Crucially, crisis resolution will be difficult, if not impossible, without robust GDP growth. For in a shrinking economy not even a balanced budget will prevent the public debt ratio from rising further, while interest rates cannot be low enough when even nominal GDP growth is turning negative.
Mindless fiscal austerity is self-defeating when inflicted on a deleveraging private sector and fiscal multipliers large when neither monetary conditions nor exports can provide much relief. Pursued simultaneously across the continent, European countries are deflating each others’ key export markets, implicitly relying on extra-regional exports to make up for their suicidal pursuits. By forcing adjustment solely upon debtor countries, where debt overhangs are naturally concentrated, their solvency problems are made only worse. Resisting upward wage realignment, Germany is pushing its partners, including France, into debt deflation.

Structural reform is no offsetting growth strategy at all. It worked for Germany, and only with a long delay, because Germany was going it alone while the world economy was strong. Germany needed an external surplus of 7 percent of GDP to finally balance its public budget. Today, the world economy can barely tolerate a repeat of that feat for Euroland as a whole.
As over-indebted private sectors continue to deleverage alongside attempts at fiscal restraint, the EU is effectively relying on its export sector to make up the difference. In a weird twist, Draghi’s actions to stem the sovereign debt crisis have prompted a significant appreciation of the euro. This result all but ends the EU’s hopes of creating an external surplus sufficient to balance fiscal budgets and will increase downward pressure on economic growth. My conclusion remains similar to Bibow’s:
In short, the euro remains firmly on track for breakup. It is only a matter of time until Mr. Draghi’s liquidity bluff will be called.

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