Issue 76

Inflated Threats: The Eurozone Crisis and the Challenges Going Forward

By Wolfgang Münchau
Associate Editor, Financial Times

This is a transcription of the keynote Macro-economic speech delivered by Wolfgang Münchau at the 2014 LBMA Conference in Lima, on 10 November 2014.

The LBMA conference for the industry is an excellent opportunity to reflect on some of the major issues affecting the Precious Metals market. The Eurozone crisis matters in your industry, because the way the scenarios develop will impact market prices. It will have a huge ramification as well for the global economy.

This is not the first crisis. When I grew up in Europe in the 1970s, there was a joke about the EU and how dysfunctional it was. A European nightmare in which the British were in charge of the cooking, the French were the engineers, the Swiss the lovers, the Germans the policemen and the Italians responsible for making the trains run on time.

We have come a long way since then and my modern version of this European nightmare is a Europe where Germany saves, even though it has the capacity to invest and to use fiscal measures to make adjustments to the economy. It is a Europe where France and Italy use fiscal capacity they don’t have. Europe has a single currency, but its governments refuse to do all the things necessary to make that single currency work.

The problems in the monetary union are generally put down to fiscal irresponsibility, but a lot of adjustments happen in the economy when you forge many countries– it is now 18 – into a single currency.

These are not just fiscal, there are also private sector flows. With the labour markets being unco-ordinated, all functions of the economic policies are essentially national, under national political control, especially the structures of markets. Despite the single market rules, which provide some minimum standards for product markets, all the other factors have been left to national control.

During that period, Germany started an improvement in the real exchange rate, which is the key thing that happened. This wasn’t that big of an issue in the first five years of the last decade, but with labour market and welfare reforms, the wage demands are moderated against the rest of Europe. It made Germany more competitive in one respect, which meant large export surpluses and its counterpart large saving surpluses. Last year, Germany’s current account surplus was 8%, which is high. It will be similar this year. You can explain some of it through the fact that Germany is an ageing society, which will be a demographic shock. Germany should probably run a current account surplus but nothing of that size. It cannot explain an imbalance as big as 8% of GDP.

“Europe has a single currency, but its governments refuse to do all the things necessary to make that single currency work.”

The photo shows Mario Draghi and the German Finance Minister, Wolfgang Schäuble.

When you have these massive differences in the current account balances between member states in a monetary union, you don’t get a balance of payments crisis, which is what you would normally get if the counterpart were deficits in other countries. You would get a credit crisis. So, the excessive wage moderation in Germany was purely selfish, perfectly legitimate and a politically legitimate policy. You want to be competitive and have full employment; you can’t really blame anyone for that. This is the same in every other Eurozone country; they acted rationally, it was not irrational behaviour.

We then got a financial crisis, not a balance of payments crisis but credit crisis. We have a private and public sector credit crisis. The latter was probably avoidable in some instances – certainly in Greece – but in the private sector crisis it was not. The German surpluses had to go somewhere. They were invested, usually at negative returns on investment. And private sectors in other Eurozone countries spent too much. That wasn’t the result of some behavioural error; it was the result of a system that has imbalances.

Afterwards, Germany agreed to bankroll the system. That wasn’t clear in the beginning because Germany was in a favourable position, it is a rule-based system. The no bail-out principle was enshrined in the treaty. Partially giving up on that was a big deal. They came to an agreement of having a bail-out treaty, the European Stability Mechanism (ESM), which was set up by a treaty among the participating members and became the blueprint. We bail you out, but you have to fulfil some criteria. We’re sending in the IMF, the ECB and the European Commission to oversee that you’re doing all the necessary adjustments. But it became also the kernel for why things have gone wrong subsequently. If you’re in a situation like that, the ideal adjustment for Germany is to accept higher inflation. This is now looking at it not from a German perspective but from a global perspective. And that’s what the Americans, the IMF and everyone else is saying: the ideal adjustment is for Germany to accept higher inflation, say 3% or 4%, and for the other Eurozone members to have slightly lower inflation so that we’re kind of reversing the process of the last decade and trying to achieve some normality. This is not happening. The opposite is happening because Germany is not inflating. Germany is very much in the mid-range in the Eurozone with regard to inflation rates, which are very similar to the core of the Eurozone. Therefore, the other member states are adjusting. The south is adjusting through deflation, and we see negative inflation rates in southern Europe and Germany having inflation rates of around 1%, which is below the ECB’s inflation target of 2%

Even the strongest economy is still inflating at only half the target rate, which is the reason why we are so concerned about inflation.

As such, the Central Bank would normally act to address the imbalance. It could pretty much solve the problem; however, it cannot do so when inflation is at the zero lower band. That’s a global scenario. We’re all at the zero lower band so this kind of thing couldn’t have happened at a worse time, when monetary policy is unusually constrained. And there are additional constraints placed on the European Central Bank – all sorts of laws that others don’t have. It is not the central bank of a country but of a monetary union. There are lots of things the ECB is not allowed to do that other central banks find easier to do.

What do we do now? It’s been talking about QE for the last 12 months and say it is ready to implement it. In reality, we know it doesn’t have it in place. Things first have to get worse for it.

Pablo Iglesias

This is probably the reason.

I was recently in Berlin talking to Schäuble and he made it clear to me that this is the red line.

Everyone you talk to in Germany tells you that QE is the red line. We’ve been willing to go along with the bail-out mechanism, but this is a real red line. We’ll see what happens when it is breached, which I believe is going to happen. The Germans are holding out on the system. The reason we don’t have QE is because of Germany.

Draghi wanted to bring Germany on board with all his policies; he outvoted Germany on interest rate cuts and on his famous official outright monetary transactions (OMT), the programme introduced two years ago that stabilised the financial system and ended the acute phase of the financial crisis, his backstop guarantee. The Germans were opposed to it, so was the Bundesbank, but not the government. On QE, it’s going to be difficult. Draghi didn’t want to force the issue earlier, at a time when he would have alienated Germany to an extent that there would have been an irrevocable breach of trust.

In January, there will be a court case on the OMT programme. My expectation is that the European Court of Justice will give the green light. That will encourage the ECB, given that the legal arguments are clear, so I expect that in the first quarter of 2015 we’re going to see a QE programme. I’m not very enthusiastic about it, although I am in favour. However, the QE programme will probably be 500 billion euros, which is small. The Eurozone is almost the same size as the US in terms of annual economic output, but the US QE programme was three or four times as large as the EU programme will be.

Of course, in Europe, when we decide something controversial, we don’t go 100% nor 0%. Draghi will say we have QE and the Germans will claim we don’t have it. When the announcement is made, you will spend quite some time interpreting what you’ve actually heard.

How will it work? 500 billion euros isn’t going to make a big shift. There is a valid argument against QE relative to the US and the UK. The European economy is much more bank-based, so a lot of the financial instruments whose interest rates you will manipulate through the programme matter less to the Eurozone economy than they would have mattered to the US. The main channel for the Eurozone will be the exchange rates, but don’t get too excited about that either. The reason is that people always focus on the dollar-euro rate, which has gone down significantly. But the nominal exchange rate effect, which is the one that matters, hasn’t moved as much. This is because the yen has depreciated against the euro, the other European currencies are fairly stable, as is the pound, but the Swiss franc is certainly not – it is not revaluing against the euro. Many of the currencies are fixed. Italy gained a boost when installing the exchange rate mechanism in the 1990s, but there needs to be a 30% devaluation in the currency for Italy to get the same kind of effect through a euro devaluation. As an example, the euro would need to devalue by 60%, but it’s not going to happen. It would be like a 60 to 70 cent devaluation in the dollar; this is just too big, the reason being that the US is a large economy.

The Eurozone is in many respects similar to the United States. The exchange rates are not completely irrelevant, but it’s not as important as it would be for a small island economy. And since the Eurozone consists of 18 mostly small countries, everybody talks about the exchange rate as though it was the exchange rate of 18 small open economies, when it is the rate of a large, closed economy. The latter is very different in its behaviour from that of small countries.

If you wanted to make QE work, you would probably have to do more – not just buy more but also use other channels than the exchange rate. My favourite channel would be an expectation of the future. We could shift inflation expectations by changing the inflation target. One thing you could do, and that would still be in line with the treaties and with our 2% inflation objective, is a price level target. Not an annual inflation rate but a long-term price stability objective, which would mean that even if inflation rises, if that were to happen in the next ten years, we wouldn’t stop this programme immediately. People always fear that when inflation arrives, the ECB will be the first central bank to break, which will impact on the programme, knowing that they don’t give you a target, they don’t give you a guarantee about how long or how much they will buy and for how long. This will impact confidence. The way to boost it would be to introduce some kind of target change. Now that’s not going to happen. I understand they discussed it on the governing council, and, for the moment, it has been rejected. The question is: what will happen if QE is put in place but doesn’t work?

The photo is a man from Spain, Pablo Iglesias. Why this is dangerous for Europe is that it’s already a ‘secular stagnation’ we’re falling into. This recovery we were supposed to have seen isn’t happening. This fact is more dangerous than the financial crisis when the central bank stepped in and ended it. What we’re now seeing is the financial crisis translated into an economic crisis because of the way we have reacted to it and all the constraints we have imposed on ourselves. This economic crisis is not just a malaise; we’re not like Japan with zero growth rates and a country that’s still functional. We will have a lot of insurrection and political discontent, especially in the countries that are affected.

Spain is a good example of a country that had two very strong parties – the centre-left party and the centre-right party, which has dominated the political spectrum since the democratic revolution of the 1970s. There have been no other serious political players in Spain except for this party until Podemos. Its foundation was not that long ago and it is now leading in all polls.

Mr Rajoy

The above is a photo of Mr Rajoy a talented sociology professor, who is probably of the new breed of leaders to be taken most seriously. We’re going to see political issues arising that we haven’t seen before. Will Mr Rajoy be the Spanish prime minister at next year’s election? It looked a pretty certain prospect even six months ago but is now much less clear. People are talking about a grand coalition, which is bad news because that’s the best recipe to encourage opposition. Rajoy will then be the opposition leader and that will change the politics of that.

Alexis Tsipras may become the next prime minister of Greece. He is leading in the polls and the government is not looking good. I don’t take him as seriously as Podemos because I think he will ultimately do what his predecessor did. He has a different rhetoric, his party is clearly different, but he’s very much part of the policy consensus. He’s not nearly as radical as he appeared to be two years ago, so I would expect him to present a different style; however, I’m not sure whether the substance will be all that different.

Casaleggio (left) and Beppo Grillo (right)

The above photo shows two Italians, Casaleggio and Beppo Grillo. Beppo Grillo is the party leader of the Five Star Movement in Italy. Casaleggio is the intellectual and financial power behind the party. They believe that Italy should leave the Eurozone. This was the party with the most votes in the last election, but because in Italy you have parties forming pre-electoral coalitions, it isn’t even the main opposition party in the parliament. The main opposition party wants to exit from the euro. That’s different from the consensus 10 years ago when both the government and the opposition consistently supported the euro.

Marine Le Pen said that if she becomes president of France, the first act in office will be to instruct the Treasury to leave the euro. I don’t think she will become president of France at the next election because these political changes take a long time to come to fruition. There are many things that could happen between now and the next election; for example, Hollande might not run and therefore she might not face him but someone from the conservative party. There may be political developments and intrigue, but it’s already telling us that the National Front is leading in the polls, which is completely new. While I don’t expect her and Grillo to become the next generation of leaders, Podemos and Tsipras, Iglesias and Tsipras are more likely challengers.

This would change politics, just as oppositions change politics. When the opposition is against the euro, you’re going to be more careful. The same is happening in Germany with the anti-euro party. The effect will not be that the party gets into power – it won’t – but it constrains the government’s ability to say ‘no’ in public and ‘yes’ in private, to be pragmatic. We’ve heard Germany saying no to QE, no to fiscal expansion and so on.

This chart above shows ‘secular stagnation’. It plots the annual inflation rate and the interest rates on the left, which asks the question: how high does the interest rate have to be, the Eonia rate being a short-term rate, for inflation to be at a certain level? The upper circle is the old Eurozone world and various years. The dots represent the years before the crisis. Inflation was generally between 1% and 2%, between 1% and 3%, usually it’s sort of centring, averaging on 2% in the upper circle, and the interest rate was around 4%, between 2% and 5% but sort of averaging 3% to 4%. That was the pre-crisis world. In economics, you have this equilibrium, meaning things get out of sync but all sorts of market forces bring it back into balance again. This is precisely what happened. We have moved towards a different and lower equilibrium. The reason is the zero bound interest rate.

What does it all mean? I don’t want to propose a hugely stagnating Eurozone; there are various scenarios possible: Eurozone stagnates, Japan stagnates, China is slowing down, you can get pessimistic and think gloom and doom forever. Or we have a deflationary scenario but are going to do much about it – unlike the Japanese – and our financial system works very differently from that of Japan in the 1990s. We could have a scenario where deflation, or ‘lowflation’ as the IMF calls it, is followed by inflation. Or we could have five years of lowflation and then so much cash in the system that it eventually leads to growth, which then might become inflationary.

We could have a decoupling scenario where the Eurozone does what Japan did, but the rest of the world isn’t following, it is not affected and finds its own way. That depends on how well the rest of the world can absorb the current account surpluses of Europe, which it is running now, and whether it has the capacity to absorb them and overcome the global shock that comes with it.

These are the three scenarios that stem from it. I believe it would slow down the world for a certain period of time but not forever. It is a classic economic shock to the world; however, the global economy is going to be fine with that. I’m not that optimistic about the Eurozone itself. But that is another story…

Wolfgang Münchau, Associate Editor Financial Times

Wolfgang Münchau, 49, is associate editor and European economic columnist of the Financial Times. Together with his wife, the economist Susanne Mundschenk, he runs eurointelligence.com, an internet service that provides daily comment and analysis of the euro area, targeted at investors, academics and policymakers.

He was one of the founding members of Financial Times Deutschland, the German-language business daily, where he served as deputy editor from 1999 until 2001, and as editor-in-chief from 2001 until 2003. FTDeutschland is now a firmly established player in the German media market with a daily circulation of more than 100,000 copies sold.

Previous appointments include correspondent posts for the Financial Times and the Times of London in Washington, Brussels and Frankfurt. He was awarded the Wincott Young Financial Journalist of the Year award in 1989. He holds the degrees of Dipl-Betriebswirt (Reutlingen), Dipl-Mathematiker (Hagen), and MA in International Journalism (City University, London).

He has published three German-language books. His book Vorbeben, on the financial crisis, has received the prestigious GetAbstract business book award in 2008, and is now published by McGraw Hill in the US.