Some Reflections on an Historic Weekend for Europe

May 10, 2010

The EUR 750 billion package of loans and loan guarantees reminds me of the dollar rescue package of November 1978.  Each of these policy responses was anchored around a show of force to the market through a compilation of enormous resources to impose stability.  Each had some other elements.  In November 1978, the Fed also raised its key interest rate by an unprecedented 100 basis points to 9.5%, and euro area officials are also promising now to meet their budget deficit-reduction targets and to accelerate their process of fiscal consolidation.

The November 1978 plan only buoyed the dollar temporarily.  By June 1979, it was sinking again because the initial package of measures addressed symptoms rather than root causes.  In November 1978, a 9.5% interest rate was only marginally above CPI inflation of 8.9%, but with GDP expanding at an 8.5% annualized pace in the final three quarters of that year and resource availability as tight as a drum, inflation moved above 11% by mid-1979.  A whole new approach to the problem was needed and came in October 1979 when the Fed replaced an interest rate-oriented monetary policy with one that would focus on the quantity of money.  The new framework eventually let short-term rates soar to 20%, and a multi-year period of dollar appreciation ensued. 

Something much more substantial is going to be needed to fix the euro sovereign debt crisis on a long-term basisA way must be found to restore the competitiveness of Greece, Spain, Italy, Ireland, and Portugal.  Fiscal austerity alone is not going to do it, and I frankly do not see a plan succeeding in the long-run without a major restructuring of debt in these economies and/or a means to depreciate currencies.  The latter can partly happen if the euro falls substantially against other currencies, but even that doesn’t help the competitiveness of the peripherals vis-a-vis Germany.

Euro area bonds have reacted more convincingly than currency markets.  This makes sense because the plan was directed at bonds, not the euro.  Indeed, the ECB’s belated willingness to buy fixed income securities, even though taken with the caveat that all such interventions will be sterilized creates a possible dynamic that could be inflationary.  Bundesbank President Weber, who’s been rumored to be the leading candidate to follow Trichet as ECB President, warned about this danger today.  The euro was as weak as $1.2518 last Thursday, closed at $1.2732 before the weekend, advanced sharply early today to $1.3094 when news of the historic agreement broke, but is presently back at $1.2790, having relinquished slightly more than half its gain from Thursday and 84% of today’s earlier run-up.

I suspect the inflationary fallout from the EU and ECB announcements is over-rated.  That’s the lesson from Japan’s experience.  People should not assume future inflation unless one sees sustained and excessive monetary and credit growth.  Those developments in fact were present for much of the euro’s life, and excessive inflation did not result even then.  The region’s CPI has risen around 2% per annum, marginally above target.  Now, M3 and credit growth are showing on-year declines.  Unless such accelerates, the danger will be one of deflation, not inflation.

The North Rhine Westphalia election results are worrisome, and I’m not referring to the greater difficulty Chancellor Merkel may encounter achieving fiscal consolidation and other economic reforms.  I see in these results a continuing pattern of democracies around the world that have misfired from a functionality standpoint.  Now one observes a greater voter predisposition to try out politics that is less conventional and further from the center between Left and Right.  It’s happening in the United States, most dramatically with the ascendance of the Tea Party movement.  It probably would have happened in Britain if that country did not have a first-past-the-post system of electing parliamentarians.  In North-Rhine Westphalia, the Christian Democratic Union’s voter share plunged to 34.6% from 44.8% four years ago, but the main opposition, the Social Democratic Party had a 2.6 percentage point (ppt) decline to 34.5%.  The national government’s junior partner, the Free Democrats, benefited from these losses only very slightly, with a 0.5 ppt increase to 6.7%.  The big winners were the Greens, up 5.9 ppts to 12.1%, the former East German Communists and other sympathizers now reformulated in the Left Party (up 4.7 ppts to 5.6%), and all other fringe parties, whose share collectively rose by 1.7 ppts.

Voter disaffection with mainstream parties is not surprising.  Democracy isn’t delivering the goods very effectively.  Asia’s brand of a more authoritarian strain of democracy yields faster economic growth.  So does China’s managed capitalism with political dictatorship.  Democracy hasn’t worked well in Africa or the Middle East, demonstrating that it is not the best system for everybody.  If centrist democracy loses its hold, what will the world look like in ten years?  I’d think it will be more dangerous from a geopolitical standpoint.

All of which returns these musings to their starting point, Europe’s common currency.  Every crisis including this past week when the future of the euro seemed perilous, political leaders have said no to the notion of dissolving the bands that hold them.  The impetus for their resolve has repeatedly sprung from foreign policy considerations, not the union’s economic merit.  A single monetary policy and currency in the heart of Europe was built in spite of major reservations that a region with multiple fiscal policies and different languages was not an optimal one to share the same currency.  Leaders have felt that war in Europe would not occur between nations sharing a currency as well as a mobile labor force and highly fluid financial and physical capital and traded goods and services.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.

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