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 chikens’ choice: internal or external devaluation?
1. An awful political background
Since the financial crisis started in 2007, 8 elections in Europe have driven
incumbent parties out of business. Whether justified or not, it shows how the
European population is disgruntled by a generation of politicians whose lack of courage
led to the current over-indebtedness mess (N.B. voters share the responsibility by voting
for the same politicians they despite now).
For a couple of years I have written that Greece could not be saved and I strongly believe
that European politicians did not give a damn about Greece to solve the crisis, and
were solely interested in insulating their banks from a Greek default: to
succeed, (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 unlimited
liquidities; banks used these liquidities to buy more European sovereign debt (the 3 years
EUR 1 trillion LTRO is meant (1) to provide some breezing space for deficit prone
Southern European countries –France included- and (2) give a free return to banks to
strengthen their balance sheet in the turn of 2-4% i.e. EUR 20-40 bn a year, a disgrace– as
a side comment, none of the executives of European banks benefiting from the ECB largess
should get any bonus since the profitability of banks has nothing to do with managerial
acumen, and should in fact, for many of them, be bankrupt; as I have advocating for so
many years banks’ executives and theirs boards should have been fired: what shareholders
are waiting for?).
Greece will again go the poll in June and I do not see why results would favor a corrupt
and incompetent political arena which has ruled Greece for 30 years, and all poll are
giving the extreme left SIRYZA party a large lead. Despite disguised threats to the Greek
electorate (80% want to remain within the EZ but with no austerity but an open check
book from the Germans – they are living in Cuckoo land) from policy makers about a
possible exit from the EZ (if your vote is wrong i.e. you do not abide by our integrationist
rules, then it will be a disaster for you and no more money from us), the PASOK and the
so-called liberals will be out of business for good, hopefully. The trick is to propose at the
same time a referendum about the exit of Greece from the EZ which would end up in a
rather strange situation where the majority would vote for an anti-austerity parliament
and at the same time vote again the exit from the euro whilst bailouts are linked to
austerity; the discussions about adding growth to austerity are fine but will not address the
roots of the problem: lack of competitiveness.
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After the failure of economic convergence within the EZ, we are witnessing Greece’s
standard of living fast converging not with Northern Europe but with its European
neighbors, Romania and Bulgaria!
For the time being, Greece got its EUR 4.2 bn rescue payment from Europe last week (add
EUR 1.6 bn if the IMF disburses its part of the deal) that will cover its liquidity needs for
June 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 Sarkozyst
party (UMP) lose a considerable number of seats pending unofficial local agreements with
the FN, Mrs. Le Pen populist party. The socialist party will win the elections, the
question being by which margin: if their victory is large enough, after gaining control
of the Senate in September 2011 for the first time under the Vth Republic, they could hold
2/3 of the congress (Senate + Parliament gathering) to modify the constitution as they
wish.
Germany’s Chancellor Angela Merkel registered a strong defeat in North Rhine-
Westphalia state election in May, the most populated region. However the increased lead
for the SPD (the center left) does not mean that this will end the austerity imposed onto
Southern 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 eurocratic
motto.
2. An awful economic background
Economic forecasts for 2012 and 2013 are between bad and disastrous for
Club Med countries (the IMF is less confident than the EC, and private forecasters are
even 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 deeply
so in 2013, with hardly any EU country escaping, the EZ being more affected, and
within the EZ, Southern Europe the most
In the case of France, the new President, François Hollande, based his economic program
on official, and as usual over-optimistic, growth forecasts of 0.7% in 2012, 1.75% in 2013
and 2% until 2016, whilst the country will be in negative territory in 2012 and 2013 at
least. Add a Greek default and you get an asset that becomes a straight loss in the turn of
EUR 15 bn from the first bailout already paid plus any recapitalization of the ECB.
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France’s deficit will not be reduced back to the 3% Maastricht criteria in 2016 and its debt
will continue on its upwards trajectory. Expect 2 notch rating downgrade within 12
months.
Like other Europeans, the standard of living of French citizens will keep up
contracting.
The key issue of low competitiveness is structural, and economic, social and
tax reforms are not addressed. Policy makers have focused for too long on what they
thought, incompetently or dogmatically, were liquidity issues.
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3. The choice
This foolish blindness is leading to one of two tough choices: internal or external
devaluation to quickly regain competitiveness.
Let’s come back to my preferred equation:
PIB = Public spending + private spending + commercial balance
The 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 some
economic and financial normality.
Looking at the equation, and taking into account the state of debt and budget deficits in
demand driven economies in the West, they MUST shift their focus to improving
their trade balance, and export driven countries MUST stimulate domestic
demand.
There are two ways to improve the trade and services balance: either increase
exports or reduce imports or a combination of the two.
To increase export one needs to propose goods that others want to buy by focusing on
added value products (there is no way to be competitive for goods very elastic to prices) or
unique goods and improve competitiveness. Wage and social costs are the items a
country controls which impact productivity and no Club Med country will escape harsh
austerity. Energy is also quite important and must be addressed (the USA is thriving in
becoming self sufficient again in the years ahead thank to technology which allows shale
oil and gas recovery – this will all also have a substantial positive impact on the US trade
balance).
To reduce imports, goods must become too expensive for consumers or find the
same ones locally at attractive prices. This can be achieved via custom tariff and/or
other 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 is
between external or internal devaluation.
External devaluation corresponds to the exit from the fixed exchange rate
mechanism (the euro) where the Drachma will loose 50-70% of its new parity with the
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euro (or DM) leading to much higher imported goods thus lowering consumption and
more importantly lowering imports; this assumes that the goods and services needed will
be substituted with locally produced one, otherwise the country will continue
impoverishing 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 to
crumble under debt servicing, this will be accompanied with a debt default
(restructuring, straight default, inflating the debt away, you name it). Competitive
exchange 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 without
currency devaluation: the only adjustable variable is real wages and social
benefits which must be reduced and this must be equivalent to a currency
devaluation. The terms of trade will not improve and trade imbalances will remain. Debt
servicing becomes unsustainable by eating a rising portion of taxes collected. This can only
work 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 Europeans
will continue to fall for years if not for a decade. However, the internal devaluation
only 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 economic
prospects than the European one) and demographics, an other factor of economic
growth: spending money in these areas instead of Greece et al. would have
been more beneficial to European growth long term.
Source:
Capital Economics: European Economic Outlook Q2 2012
http://www.capitaleconomics.com/
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