There was much excitement last week among the “worst is over” crowd as Germany and France reported GDP growth of 0.3%. But, while it is clearly nice to see the occasional postive number knocking around the global economy, I’m finding it hard to shed much pessimism.
First, the worst may not actually be over. There is talk of a second wave of credit crunch heading for Germany as unemployment and insolvencies rise and the banks – just like those everywhere else – pull back from lending in an effort to rebuild their balance sheets. At the same time, much of the rise in GDP (which is pretty meagre anyway) can be put down to temporary factors – inventory rebuilding elsewhere and the subsidy-fuelled car-buying boom.
All in all, much of the recovery in Germany and France smacks rather of what some economists are beginning to call the “statistical recovery”: one in which lots of macro numbers look positive – not because sustained economic growth is under way but because the ones that came before them were so awful.
But more importantly, Germany and France don’t stand alone anymore. The rest of the Eurozone is still in an utterly dismal state with GDP across its 16 nations 4.9% below its pre-recession level and 0.1% down on the last quarter. Spanish GDP fell 1% in the last quarter and is now down 4.1% from a year ago, while the likes of Ireland and Iceland are not likely to emerge from their miserable mix of debt crisis recession and unemployment any time soon.
If you are holding euros – or too much in the way of euro investments – this is what should be getting you worried. Why? Because it means that the great European currency experiment is under increasing strain.
There is a general view in the markets that because the ECB has as its priority the creation of price stability (the prevention of inflation) it won’t go down the same stimulus routes as the US and the UK. It won’t move interest rates to zero and leave them there indefinitely or print money in the hope of softening the effects of recession because it won’t tolerate the inflation that would follow, particularly given the apparent growth in its two most important economies. That in turn, or so the story goes, means the euro will stay strong relative to the pound and the dollar.
It’s a nice idea, but, says Russell Napier of brokerage CLSA, it won’t wash.
Why? Because the failing economies in the region won’t be able to cope with the deflation needed to make them competitive again in such an environment. As financiers Jim Mellon and Al Chalabi pointed out in their 2007 book, The Top Ten Investments for the Next Ten Years, when countries in trouble have no control over their own interest rates, exchange rates or monetary policy, the only way they can work to regain any degree of competitiveness is to manufacture deflation – that is to cut wages as fast as possible.
And that doesn’t stay politically acceptable for long. Indeed, says Napier, while most governments can survive the slow destruction of a nation’s wealth via inflation (we notice this less) “it is unlikely that any democratic government would survive . . . rapid deterioration in the wealth of its populace” by deflation. The question then is how the ECB will “respond to this increasingly desperate political and economic dynamic.”
The answer, says Napier, is that it will be forced into a U-turn. That finding itself in conflict with most of its 16 governments, it will abandon its “bulwark against inflation stance,” accept that the euro is more likely to survive if it is not strong and so start working to weaken it, hence making all its members more competitive and generating inflation. Expect to see a much looser monetary policy and a much higher tolerance of inflation. And with that in mind also expect a much weaker euro, against the pound and the dollar.
In April this year I came over all bullish on the pound. That turned out to be a good call – it has strengthened significantly since, making everyone’s summer holidays just a little less painful than they would otherwise have been. However, odds are there is further to go – against the euro at least.
I bumped into Jim Mellon at the Edinburgh Festival this week. Two years ago he was worried that recession would put an “intolerable strain on the monetary union.” What does he think now? That it has put an “intolerable strain on the monetary union” and that the euro is “very, very overvalued.”
As an aside, that might be an excellent time to sell that French holiday home you never get around to visiting. The buyers are back – my mother, having had her French farm on the market for three years with no interest has suddenly had a slew of offers and sold to a Russian family – and the currency is on your side. Neither of those things is likely to last much longer.
• This article was first published in the Financial Times