Eurozone stagnation is a greater threat than debt

October 19, 2014 2:33 pm

Eurozone stagnation is a greater threat than debt

Wolfgang Munchau / Financial Times / http://www.ft.com/intl/cms/s/0/326b0cec-5560-11e4-89e8-00144feab7de.html?siteedition=intl#ixzz3GclFkjT9

Monetary policy can boost markets in the shortrun, but this cannot be sustained indefinitely

It would be wrong to think last week’s global market gyrations signal a return of the eurozone debt crisis. Sovereign bond spreads in the eurozone did not move by much, except in Greece.

What happened last week is something rather different. Financial markets have woken up to the possibility of a eurozone-wide economic depression with very low inflation over the next 10 to 20 years. This is what the fall in various measures of inflation expectations tells us. Investors are not worried about the solvency of a member state. That was clearly different two years ago.

But the present scenario is no less disturbing. The implications for those who live in such an economic snake pit are already visible: high unemployment; rising poverty; real and nominal wage stagnation; a debt burden that will not come down in real terms; a decline in public sector services, and in public investment. A shocking example is the decrepit state of German military hardware. Of the Luftwaffe’s 254 fighter planes, 150 cannot fly.

The eurozone’s stagnation will affect the rest of the world to different degrees. The UK might manage to escape the same fate, but the eurozone economy is big enough to pull Britain down with it. Hardest hit will be the parts of central and eastern Europe that do not use the euro. They are caught between an imploding Russia and a stagnating Europe. It is hard to see how the oil price can recover in an environment of permanently low growth. And it is even harder to see how Russia can live with a permanently depressed oil price.

Secular stagnation – the idea that a chronic shortfall of investment might produce a long period of weak demand – also has disturbing implications for financial investors. The recent high levels of equity prices were premised on the best possible of all scenarios: that productivity growth rates would revert to historical averages, and that the level of gross domestic product would eventually catch up with the pre-crisis economic growth trajectory. Investors have now begun to realise that neither is going to happen. GDP is still only close to the levels of 2007; growth is slow.

The share of GDP accounted for by profits cannot go much higher, either. So, if productivity growth remains low, it is hard to see how equity investments can yield large real returns. Monetary policy can boost markets in the short-run, but this cannot be sustained indefinitely. In such an environment, the yields on risk free securities will be low.

With secular stagnation comes a permanent fall in inflation to levels below the 2 per cent target. The real value of public and private-sector debt will not therefore come down as fast as it should. This in turn will make it harder for governments, companies and individuals to reduce their debt. In such an environment, expect default rates to be high. German sovereign bonds become the only asset in the eurozone that investors regard as more or less risk-free.

One would have thought that such a scenario would produce counteracting forces, for example a weaker exchange rate. Unfortunately, that is not necessarily true. The eurozone is running a current account surplus of close to 3 per cent of GDP this year. One would normally expect the currency of an economy with a persistent current account surplus to be strong. In any case, the exchange rate matters a lot more for smaller and medium-sized economies than for large ones such as the US and the eurozone because the share of trade in GDP tends to be smaller for large economies than for small ones.

The eurozone is a large semi-closed economy, trading most of its goods and service internally, in euros. Whatever is going to save the eurozone, it cannot be the exchange rate, unless the euro depreciates to an extreme extent.

Secular stagnation is thus a lot more dramatic than a debt crisis. With such a threat hanging over us, one would have thought every rational policy maker would want to avoid such a calamity. That would indeed be the case if the crisis occurred in a normal country. For a monetary union where policy is not co-ordinated and where policy makers take a national perspective, the risk of secular stagnation looms large. Even the European Central Bank, the only actor with a eurozone-wide remit, faces legal constraints. This may explain its reluctance to go for quantitative easing. Even as an advocate of QE, I cannot deny we are treading in a legally grey area.

Eurozone policy makers face three choices. First, they can transform the eurozone into a political union, and do whatever it takes: a eurobond, a small fiscal union, transfer mechanisms and a banking union worthy of its name. Second, they can accept secular stagnation. The final choice is a break-up of the eurozone. The second and third choices are not mutually exclusive. As the political union is firmly off the table, this leaves us with a choice between depression and failure – or both in succession.

munchau@eurointelligence.com