Just as in the Game of Thrones, the Eurozone drama seems to drag on interminably. It seems to take forever to get to the next installment. I think GRR Martin (the wickedly brilliant creator of the series) should be confined to his Santa Fe villa until he finishes his epic – one of the few lapses in my personal belief that we should be allowed the freedom to control our own time. I read the first of the books in 1996 and the fifth when it came out in 2011, and he will need to finish at least two more. You can do the math, but it is clearly taking longer and longer between books – just as Europe seems to be taking longer and longer between successive peaks of its crisis. Perhaps we should confine the leaders of Europe to a far-northern Scandinavian hotel with hard beds and minimal amenities until they resolve their problems.
In the latest installment of the Eurozone crisis, deflation is back and winter is coming. This week we'll look at what is shaping up to be a very interesting year in Europe. I am going to visit a number of themes and offer links to readers who want to delve more deeply, as to develop each one would take several months' worth of letters. Next year it probably shall.
Winter Is Coming
One of the continuing themes in the Game of Thrones is that a winter of epic proportions looms in the immediate future, and the world is not prepared for it. "Winter is coming" is whispered by worried wise men who urge various leaders to prepare, yet they put off the necessary in the face of the urgent. Signs that a European winter, too, is coming have lately been cropping up.
Key measures of inflation are decelerating across the Eurozone, and the region is as close as it has ever been to a deflationary bust. It's troubling enough that Eurozone headline CPI collapsed from 1.1% in August to 0.7% in September and that core CPI fell from 1.0% to 0.8% over the same period; but measures of Eurozone money supply (M1, M2, & M3) are also decelerating rapidly, suggesting that the deflationary trend will most likely continue without decisive action from the ECB, which has been strangely absent from the current rush by central bankers to print mountains of money. And the ECB could actually make a case for such action!
Even worse, this new round of borderline deflationary data is coming not just from a small number of lost causes like Greece or Cyprus. Ten out of the seventeen Eurozone countries experienced rapidly decelerating inflation rates over the past few months, including Italy and France. Spain officially fell into deflation for the first time since February 2010. In many ways, the situation is even worse than the CPI numbers suggest. Note that Italy, France, and Germany all hover barely above 1% inflation. And their numbers are falling.
There are two major problems associated with an extended period of ultra-low inflation or deflation in the Eurozone. First, peripheral countries will have a much harder time servicing and retiring their debts without the extra boost to nominal GDP that positive inflation provides. Even if you are working on lowering the absolute amount of your debt, it is impossible to improve your debt-to-GDP ratio when GDP is falling and your debts are growing. Moreover, outright deflation works to crush debtors (and debtor nations) by increasing the real weight of the debt and triggering the destructive debt-deflation cycle described in Irving Fisher's Debt Deflation Theory of Great Depressions (1933).
The second major problem is that currency appreciation always accompanies deflation – all else being constant – so that affected economies also become less competitive in terms of exports at the very moment that a positive trade balance is most important.
These are problems that I have written about for years. The effects of a common currency and monetary policy are spread around very unevenly in Europe, creating a boom in certain countries (chiefly Germany) and a sad bust in others. This disparity is the very predictable result of a currency union sans fiscal union. And trying to fix the Eurozone fiscal structure after the fact is akin to fixing the engine of an airplane while flying at 30,000 feet.
The rapidly weakening inflation we are seeing in Europe is a very big deal, because deflation can become a chronic, crushing condition, making it even harder to deal with excessive debt, undercapitalized banks, and runaway fiscal deficits in major countries like Spain, Italy, and France. Over time the masses begin to expect falling rather than rising prices, and these expectations can be very difficult to reverse without credible, decisive, and powerful action from the central bank.
Up to this point, the ECB has been almost completely unwilling to squarely confront the issues at hand. The ECB balance sheet has been inexplicably shrinking for the past year (more on that in a moment). That is why ultra-low inflation readings should not come as a surprise. Not only has the ECB not been easing, it has actually tightened its balance sheet considerably over the past year. To many observers, this trend clearly demonstrates German dominance within the ECB.
"This is just like Japan," says Lars Christensen of Danske Bank. "The central bank thought money was easy when in fact it was much too tight. But effects could be much worse in Europe because unemployment is so much higher." In addition to a central bank seriously behind the curve, structural problems are holding back economies across the periphery, including Spain, Italy, and, yes, even France.
"Like Japan, necessary structural reforms prior to the crisis were delayed and now these will have to be implemented in an environment that is both economically and politically more fragile," said Takeo Hoshi & Anil Kashyap in a recent report for the IMF. Germany looks like an exception precisely because it undertook structural reforms well before the crisis, which is part of the reason that Germany is doing so well and much of the rest of Europe is not.
You can see the disastrous difference between German industrial production and Italian industrial production in this chart from my friends at GaveKal. This chart would look much the same whether it was France, Italy, Greece, Ireland, or any of the peripheral countries contrasted with Germany. Structural reform of labor policies requires massive social disruption in the best of times. I think we can all agree that for southern Europe this is not the best of times.
True, the risk of government funding crises has receded since Mario Draghi's July 2012 commitment to "do whatever it takes" to preserve the Euro; but debtor countries like Greece, Cypress, Spain, Ireland, Portugal, Italy, and France have been forced to bear most of the economic cost. Like Japan, the Eurozone has failed to adequately recapitalize its banking system, and troubled economies have failed to address structural problems through reforms.
Ambrose Evans-Pritchard recently noted, "While the risk of a Eurozone bond crisis has greatly receded since the ECB agreed to act as a lender of last resort in July 2012, this has been replaced by slow economic attrition."
Outright Monetary Transactions (or OMTs) by the ECB are limited by the size of its balance sheet, and the German Constitutional Court may further limit the ECB's capabilities when it rules on OMT in early 2014. No one really seems to be talking about this fact, but the ECB is losing firepower each and every month as its balance sheet contracts. This trend is going to require Germany to change its stance in the face of the next crisis, but the question is, what will Germany demand in return? Germany always seems to have a price for action. While the market was willing to give Draghi the benefit of the doubt in the last crisis without his really having to fire a shot, it is entirely possible that it will question the limits of his ability to find the funds necessary to solve multiple crises at once. And if France is one of those countries that needs aid? Mon Dieu, c'est une catastrophe!
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