Sunday, 13 June 2010

Square Circles

The Malta Independent on Sunday - 13 06 2010

The US economy seems well entrenched in a gradual recovery from the banking induced recession. The recovery is now being reflected even in the US jobs market, which is normally a lagging indicator of economic growth. Employers initially meet increased production demand with overtime and part-timers until they are convinced the demand is sustainable enough to risk hiring new full time personnel. The recovery is not moving with the same momentum as the fall experienced in 2008, but things work like that. A downturn through sudden loss of confidence is like a fall in a lift shaft, whereas recovery is in gradual, small escalator steps.

Asia, excluding Japan, was never seriously affected by the recession. On the contrary, many Asian countries, China in particular, have problems in calming down asset price inflation while protecting the momentum of economic growth in near two digits terms. Even the UK seems to have hit bottom and retail sales are getting better while unemployment is not getting worse. The new government seems confident enough in the strength of the recovery to embark on a fiscal tightening programme to reverse the economic stimulus of its predecessor without risking a relapse into recession. This confidence is also being reflected in the strengthening of its currency, which this year so far has gained more than six per cent versus the euro.

The obvious question is why the euro economies are still suffering so much and not moving along with the rest in rooting a successful recovery story. I propose that this is a combination of three reasons. Firstly, the euro is suffering from its artificial strength during 2008/2009 when it averaged around USD1.45 and GBP 0.88. This was a double blow for the euro economy. Not only did it suffer reduced demand for its exports as a result of the general recession, but it also lost competitiveness against competitors who instigated or allowed a depreciation of their currency. As things work with a time lag, the euro area is now suffering this loss of competitiveness while competitors are enjoying their gains. Obviously, this situation will self-correct next year as the euro area will enjoy recovery of competitiveness through the current weakness of the euro while competitors will suffer from the current hardening of the USD, GBP and JPY.

Secondly, the euro economy is suffering from continued weakness in its banking system. Banks in the US and UK took very robust measures to bring out all the losses in their books and to take on new capital to rebuild their own depleted resources. Euro area banks by comparison have been much slower in cleaning up their books and to acknowledge their losses and consequently their efforts to take on new capital. As a result, euro area banks remain fragile, pummelled as they potentially would be by further losses they would incur if they were to mark to market their vast portfolio of sovereign euro bonds. Inter-bank financial markets in euro are still gummed up and consequently there is scant diffusion credit through the financial channels for SMEs to have access to the necessary finances to survive, prosper and create employment.

Thirdly, the euro area is suffering from inadequate support from the ECB which the US and UK economies received from their respective central banks in what is technically referred to as monetary easing. Both the US Federal Reserve and the Bank of England supported their respective economies beyond reducing official interest rates to one per cent or less. They actually started buying bonds in the market, effectively inflating the quantity of money to make up for its reduced velocity of circulation. The ECB tried all ways to avoid having to buy bonds. It wanted to avoid the question of whose bonds to buy given that the euro area has 16 different Treasuries issuing sovereign bonds whereas the US and UK central banks have only one Treasury to deal with. Furthermore, the credo of strict monetarism still inhibits the ghostly halls of the ECB through the Bundesbank traditional belief that any increase in the quantity of money ultimately leads to inflation.

When the Greece, Portugal and Spain crisis reached breaking up as the bond markets were practically shutting down for these sovereigns, the ECB had to swallow its pride and embark on a crisis driven bond purchase programme in an unusual display of division of opinion between the ECB governing body and the Governor of Germany’s Central Bank, who remained opposed to the very principle of the ECB embarking on any bond purchase programme. To appease Axel Weber, the president of the Deutsche BundesBank and widely tipped to take over the ECB reins after Trichet’s tenure elapses next year, the ECB committed itself to neutralising the increase in money supply through bond purchases by rolling back other credit lines to ensure that the overall quantity of money remains unchanged.

While the first reason is basically self-adjusting, the second and third causes remain serious and will not self-adjust. On the contrary, as euro area governments will be constrained to roll back their fiscal laxity in order to protect their credibility on the bond markets, failure to compensate fiscal austerity with monetary leniency will seriously risk tipping the euro economy into a double dip recession. A double dip recession would make fiscal austerity doubly harsher, render euro area banking system even more fragile and raise the spectre of sovereign default as spending cuts through austerity are more than neutralised by a drop in tax revenues as a result of reduced economic activity.

The ECB has the near impossible task of putting together a common monetary and interest rate policy for 16 member states in very diverse economic condition. On top the ECB now practically has the sole responsibility for keeping the euro area out of a double dip recession without losing its credibility as the guardian of a sound currency that pretends to be an important contender to the US dollar for international reserve status.

Anybody selling square circles?

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