By Michael Burke, B&M Research
The Euroland economy is heading into an upturn. Many observers are inclined to believe that it is Euroland, the economies that have adopted the euro, which will fare best of all over the next period. This sentiment has underpinned the rebound in the euro on the foreign exchanges and has even led to talk of an early increase in ECB interest rates.
In effect, there are two economies operating in the Euroland area, the near-recessionary German and Italian economies, and the solid growth countries such as France and Spain. There are also the rapid growth economies led by Ireland, but these are statistically insignificant in the aggregate Euroland total.
But the fact that Germany and Italy combined comprise around 50% of total Euroland GDP implies that a return to trend growth throughout the whole area requires either a sustained upturn in these two economies, or significant above-trend growth in countries such as France, Spain and others. Since the latter is unlikely without producing stresses in these economies, then we must look to Italy and Germany to make some contribution to an area-wide upturn.
But the deep-rooted difficulties of the German economy are well-known. Structural problems associated with the lack of investment have appeared as resources are swallowed up by the black hole of eastern Germany. As a result, fiscal policy continues to act as a drag on domestic demand. In addition, the Deutsche mark’s overvaluation in its euro entry point means that overseas demand growth must come via a depreciating exchange rate.
But Italy suffers similar problems. Here too, fiscal policy is acting as a drag on growth, and is set to continue is this vein for a prolonged period. Exporters grown used to repeated devaluations have yet to adapt to a fixed currency with European trading rivals. Remember, Italy has permanently locked in a 20% appreciation of the currency compared to its lows of 1240 versus the Deutsche mark in early 1995. In the first five months of this year, foreign orders have fallen by 6.9% from a year ago. Exports have fallen by 7.2% over that same five-month period from a year ago. Total orders have fallen by over 4% this year and industrial production is down 1.5%.
The policy mix is clearly not stimulating growth. The exchange rate is overvalued and fiscal policy remains tight. Even if there is some slippage in the budget deficit, this is largely involuntary and is a result of economic weakness. In the now traditional Euroland response, further austerity measures will be put in place in the middle of an economic downturn!
But the role of monetary policy is also decisive. Lower interest rates appear to be a negative for Italian growth. This is because historically high interest rates and large levels of government short-term debt formerly encouraged private savings into high-yielding T-bills. The convergence that saw Italian yields drop to European norms, and the subsequent cut in rates by the ECB, has had a large negative impact on total household incomes. The one-off capital gain from that fall in yields was little compensation and is now long gone. Perversely, the low level of euro rates will negatively impact household incomes and consumption, for years to come.
These three problems – an overvalued exchange rate, an ever-tightening fiscal policy, and the drop in private investment income – are not insurmountable. But they will require behavioural changes on the part of exporters, business investors and private savers that tend to occur over generations. There is no quick fix.
As a result, Germany and Italy combined will continue to act as a drag on total Euroland growth for years to come, and place severe limits on the likely pace of the upswing in the immediate period ahead.
Euroland as a whole is faced with three key problems:
Â· Excessively high levels of government debt
Â· Excessively high levels of unemployment
Â· Deteriorating competitiveness due to lack of investment
High debt and high unemployment imply that fiscal policy will be tight and monetary policy will be loose to offset them. This loose money/tight fiscal policy mix is the classic recipe for currency weakness.
Furthermore, the fundamental starting-point is a weak one. Over the last decade, US business investment has expanded by over 39%, and even in Japan it has risen by just under 7%. But Euroland’s net new investment has been close to zero. This explains all the relative deterioration in competitiveness, and the excessively high unit labour costs.
Euro Assets on the Sidelines
For corporate and other borrowers, the euro has been Godsend, offering both very low interest rates and currency depreciation on their liabilities. No doubt this has been an important, if temporary factor in euro weakness.
But in the recent bond bear market, European government bonds have fared worse than US Treasuries, despite being at different ends of the business cycle, and in the absence of either inflation pressures or rate hikes in Europe. This spike in long-term interest rates will be just as damaging to the Euroland economy as it will to the US. But at least the US has experienced a prior boom that justifies a bear market in bonds.
The fact that slower growth and no inflation have not insulated European bonds strongly suggests that foreign (chiefly Japanese) investors are the price-setters in euro government bonds and that they do not like them any more than US Treasuries. And, assuming that the bond bear market will not last forever, this places the euro in a relatively weak position when investors return to hunting for yield.