Ambrose Evans-Pritchard is outstanding in his expose on Europe's increasingly more evident deflationist cul-de-sac, and the ever more obvious L-shaped "recovery" facing Europe. While it has taken fans of the euro currency a mere two short months to not just diametrically change their exposure vis-a-vis the "long" currency of choice, but to allow speculators to build record euro short positions, the question of how America (and China by virtue of its dollar peg) will deal with euro currency that has no choice but to go lower, becomes an increasingly thorny issue. And to further confound deficit worries, recent overtures by the Fed in the form a discount rate hike make it all too obvious that the bond market will likely soon demand a much more substantial "pound of flesh" to fund America's burgeoning deficit. In this context, the threat of increasing rates, coupled with a euro that could reach $1.25 according to Morgan Stanley, and hit a low of $1.10 according to Albert Edwards, makes the policy prospects before the Federal Reserve so much more daunting.
In the fiat world, deficit/surplus adjustments can only take place in the FX arena, and via domestic Treasury rates in those cases where pegs or monetary unions makes isolating specific countries impossible. Europe's weakness, as is currently well acknowledged by everyone, is that one currency's exchange rate somehow represents a gamut of relatively disjointed countries, each with unique economic profiles, cultural risks, and societal pressures. To be sure, in the gold standard world, things were simpler to say the least. From Evans-Pritchard:
EMU is slowly suffocating boom-bust states trapped in debt deflation, acting in the same perverse and destructive fashion as the Gold Standard in the 1930s.
Gold rules were simple: surplus states loosened, deficit states tightened. This preserved equilibrium. World War One shattered the system. The US was not ready to take the guiding role from Britain.
The dollar was undervalued in the 1920s. America ran vast surpluses, like China today. So did France, which re-pegged too low. Both drained the world's bullion. Yet neither loosened: the Fed because Chicago liquidationists ran amok; the Banque de France because its post-War brush with hyperinflation was still fresh.
Adjustment fell entirely on deficit states such as Britain. They had to tighten into the downturn, feeding debt deflation. Global demand imploded on itself until the entire system collapsed. In the end, the US and France were victims of their obduracy, but that was not clear in 1930, or 1931, except to Keynes.
We have recently learned that Central Bank obfuscation and outright fraud was a prevalent phenomenon precisely in those years when gold flows were supposed to be representative of economic relative strength. While we may wonder just how much deception Montagu Norman's and the New York Fed's current crop of comparable central bankers may be engaging in, it is no secret that in the 1930's central bankers, and gold, were the focal points of economic data manipulation. Which, among other reasons, is precisely the reason for elimination of the gold standard and letting floating currencies take the place of gold flows.
Yet little did the Bretton-Woods participants know that in 50 years Europe would attempt to take America head on, and institute not only a flawed experiment in cultural homogeneity, but one in which monetary independence would be abandoned, leaving fiscal instruments as the only viable way to control economic inefficiencies. The recent disclosures about the PIIGS sorry state has only crystallized how in today's fiat world, fiscal policy can not only be masked to misrepresent the true state of affairs (thank you Goldman Sachs deficit-masking swaps), but is powerless to control creeping simple Ricardian imbalances. The various deficit and surplus realities within distinct Europe regions are now seen as comparable to those between the West/US (deficit) and China (surplus). Indeed, one must have been living in a cave not to be aware of the amount of US bickering over the alleged Chinese currency manipulation, in which Americans demand that China let the renminbi inflate. So what should a much smaller Europe do when its very foundation prevents comparable FX adjustment (the alternative, of course, is simple - abolish the euro, yet doing so would be an admission of defeat for the premise of European integration, and a slap in the face of all those who naively believed that the consolidated European economy can compete with the US). As Evans-Pritchard points out:
This is the story of Euroland. The North is in surplus, the South in deficit. Germany's current account surplus was 6.4pc of GDP in 2008, Holland's 7.5pc. Club Med deficits topped 14pc for Greece, and 10pc for Iberia. The gap has narrowed since but remains structural.
This is an intra-EMU version of China's surplus with the West. But at least China is doing something about it with a fiscal blitz and 30pc growth in the money supply.
Germany has banned budget deficits, implying a fiscal squeeze next year. IG Metall has agreed to a pay freeze, undercutting Spanish and Italian unions yet again. How can Club Med close a 30pc gap in unit labour costs against deflating Germany?
Brussels is enforcing an EU-version of Pierre Laval's deflation decrees in 1935, the policy that tipped France's Third Republic over the edge. It has ordered Greece to cut the deficit by 10pc of GDP in three years or face the whip under Article 126.9. Spain must squeeze 8pc. France next?
Paradoxically, a toothless ECB, long deaf to the very same deflationist threats it now has no choice but to deal with, has done nothing, and continues to do nothing, to address the spiraling deflation it now finds itself in.
The European Central Bank is letting deflation run its course. Business credit is falling at a 2.3pc rate, while M3 money continues to contract. Frankfurt says demand for loans has slackened, so this does not matter. We will find out.
German growth fell to zero in the fourth quarter as state stimulus faded. Italy turned negative again. Spain never left recession. This recovery has `L-shaped' all over it.
The only reason why the European economy has not collapsed just yet is that unlike in the US, Europe has not been faced with the same multi-trillion mortgage overhang on the balance sheets of various semi- and fully-nationalized financial institutions, an overhang which is more representative of overall U.S. societal "wealth" than the stock market, and all other assets combined. Were the US to pursue the same deflationary policy of "inaction" as Europe, most of the bailed out banks would have long seen been shuttered or found themselves in need of yet another bail out, coupled with outright daily debt monetization. For as long as even the impression remains that the Fed can inflate its problems, it allows banks, with GAAP complicity, to mark assets to whatever valuations are desired, in the hope that one day book values and market values will match. It is our belief that this day will not come for many years, and possibly, should the Fed be forced the acknowledge the ever deeper hole the US economy finds itself in (absent premeditated debt monetization, but in light of reality this is still a remote possibility), ever. But until then extend and pretend is the name of the game, which is why we have long postulated that in G-7 meetings early in 2009 it was precisely the plan to delay the moment of reckoning for the euro, and allowing the dollar to depreciate in the meantime, thus taking the full initial deflationary brunt away from the United States. We wonder just what assurances were given back then to European politicians about the form of assistance that in one year, when it will have been all too obvious that Europe should have been devaluing the euro just as much if not more as the dollar, America would be "forced" to provide to Europe. We are confident that the IMF held a special place in guarantees given by Summers and Bernanke to his European colleagues. We are also confident that the announced (and half consummated) sale of a total of 400 tons of gold, and soon possibly much more, by the IMF is anything but a coincidence.
Yet where does that leave Europe for now?
Dr Krugman said EMU had lured Spain into a debt bubble and left the country exposed to an "asymmetric shock" with no defence. "If Spain had had its own currency, that currency might have appreciated during the real estate boom, then depreciated when the boom was over. Since it didn't and doesn't, however, Spain now seems doomed to suffer years of grinding deflation and high unemployment." He wants higher inflation to rescue eurozone deflators from their trap. So does the IMF, implicitly. But who in Europe will or can take that decision?
Albert Edwards from Société Générale said governments should use their powers over the exchange rate under Article 219 to force a change in policy. "The politicians should take matters into their own hands and instruct the ECB to drive the euro lower," he said.
That can happen only once France thinks the dangers of Laval policies outweigh the dangers of defying Bundesbank orthodoxy. Until then EMU will be an instrument of slow deflation torture.
We presented Edwards' most recent outlook a few days ago. The implication here is that not only will European politicians be soon forced to take the fight with central bankers to the next level (as will America eventually), should they wish to retain any chances of avoiding an early political grave, but very soon have no choice but to call in whatever promises and guarantees were given by the United States in those bleak days in early 2009, when the only option was to kill the dollar in the prevention of an all out financial cataclysm. One thing is certain - Greece is just the beginning.