"Progress" in Europe? - Analyst Blog

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Most of the important action last week was in Europe. There was yet another emergency summit. I have given up counting how many of them there have been over the last few months, but pretty soon they are going to have to start expressing them in scientific notation. I am sure this one was not the last. However, there was some significant "progress" in this one.

Of the 27 nations in the European Union, including all 17 that use the Euro common currency, what was agreed upon is the framework of an "intergovernmental agreement." The lone holdout was the UK, which has always had an ambivalent opinion about the whole European project. An "intergovernmental agreement" is a step below an actual treaty, but that means that it will be easier to get passed in each of the nations.

In many of the countries, public opinion is running strongly against changes to the treaties (Lisbon and Maastricht) at the core of the European Union. Thus, going the "intergovernmental agreement" route is a way around that pesky "democracy" thing.

The details of the agreement are still to be worked out, but in essence, every country will be held to a budget deficit of no more than 3% of GDP, and if they exceed that threshold, sanctions will be imposed. The taxing and spending policies of the individual governments would be subject to review by the Central European Government in Brussels.

However, if you take away from a government the right to set its own taxing and spending policies, effectively you have a "student council government": you can have all the trappings of democracy -- free and fair elections for class president -- but the government is entirely impotent. While geographically located in Belgium, in effect it would mean supervision from Berlin. In effect, a kinder, gentler Anschluss.

The loss of democracy is not going to sit well with the countries of "Club Med," most of whom still have lots of people with memories of living under fascism (fewer in Italy where Mussolini was deposed in 1945, but Spain, Portugal and Greece were fascist until the mid-1970's).

Trade Imbalances the Core Problem

The problem is that prior to the 2008 meltdown, it was not budget deficits that were the problem. In fact, two of the countries that are near the top of the "troubled countries" list -- Spain and Ireland -- were actually running budget surpluses in 2007. The core problem is the inter-European trade imbalances. The strong countries, like Germany and the Netherlands, run big trade surpluses with the weaker countries like Italy and Greece. To resolve those, the weaker countries have to be much more competitive relative to the stronger countries.

In other words, the relative cost of doing businesses in those countries has to come down dramatically. If each country had its own currency, the solution would be simple: the exchange rate between, say, the Lira and the Deutschemark would fall. That would make BMWs more expensive in Rome, and Fiats cheaper in Munich. But as long as all the countries are on the Euro, there can be no currency devaluation.

One way out would be for all of the countries in Europe to become export powerhouses to the rest of the world, but I don't know what country would want to start running significantly higher trade deficits. Worldwide, trade surpluses and deficits must sum to zero. Certainly I would not want to see the U.S. play that role. Or within Europe, Germany could lower its trade surplus to allow Greece and Portugal to run inter European trade surpluses. Germany has shown no inclination at all of allowing this to happen.

Thus to restore the balance, the weaker countries will have to go through a process of internal devaluation. In other words, they will have to keep unemployment so high for so long that the people there will accept extremely low wages to bring down the overall cost of doing business. In the process the economy's shrink, and thus the ratio of debt to GDP rises.

The Austerity Dilemma

The austerity that is being pushed on the weaker countries is part of this process. Yes, this process has a shot at keeping the Euro intact, but it offers nothing but blood, sweat and tears for the people of the troubled "Club Med" countries. By going with an "intergovernmental agreement," the leaders avoid having to go to a popular referendum to ratify the changes.

Imagine, for example, you are a Spaniard and unemployment in your country is already running over 20%. Now your government comes to you and says, "We have to keep the French and German banks happy, so we are going to lower your wages, cut your pension, raise your taxes and make it very expensive to send your kids to college. Oh and by the way, you also lose most of your national sovereignty. In return, you will not have to go back to changing your Pesetas into French Francs every time you cross the border." Would you say yes or no?

Not having to change currencies is a very real benefit, but it comes at a very high cost. I suspect that most Spaniards would say "show me the Pesetas." The problem is that as soon as a country announced that it was going to leave the Euro, there would be a massive run on their banks. Everyone would rush to transfer their money out of a Spanish bank where the account would be turned into Pesetas, and into, say, a German bank, that would keep the money in Euros.

The Dilemma Otherwise

Looking back, it seems pretty clear to me that the creation of the Euro common currency was a huge mistake, especially doing so without a common fiscal policy in place. However, any attempt to unscramble that egg would be extremely difficult and would cause massive economic dislocations. How big would the dislocations be? Well the Dutch investment bank ING took a stab at it, and here is what they came up with:

I'm not sure of all the assumptions that went into this, and it probably required a fair amount of guesswork, but I suspect the numbers are of the right order of magnitude. Just to put those numbers in perspective, the peak year-over-year decline in real GDP in the U.S. from the Great Recession was 5.0%. So in the case of a total break up, Spain would be looking at a downturn twice as bad, and would be starting that downturn when unemployment is already over 20%.

The ECB hinted, however, that it would be willing to ease up if the governments put in place something like this agreement to keep fiscal policy in check. That would greatly help the situation.

Actually what Europe needs now is inflation. That would help lubricate the adjustments needed. Costs in Greece and Italy, etc. have to fall, relative to costs in places like Germany and the Netherlands.

The overall level of economic pain required to do this would be much less if, say, Germany were to run inflation of 5% while "Club Med" was running inflation of 1% than if Germany has inflation of 1% and "Club Med" has to run deflation 3%. Germany, for its own historic reasons, refuses to consider allowing the ECB to let up and run higher inflation, and the ECB dances to the German tune.

Zacks Investment Research

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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