Thursday, May 20, 2010

Euro Depression

There has been significant focus on the problems of European debt. There has been much less focus on the perennial European problem of continued mass unemployment. The current recession may have had less impact on European unemployment than US (where Unemployment has shot up). But, this is due to the long term structural unemployment endemic in the EU which existed before recession.

This is partly due to the fact, the European labour market is more regulated. This may make it more difficult for firms to hire workers in the first place, but, it means they are insulated in a recession. Unemployment is therefore less cyclical.

However, whilst much attention has been focused on need to reduce deficits, I worry too little has been placed on ensuring economic recovery and lower unemployment.

Italy is being praised for its tough fiscal stance. It is aiming for a primary budget surplus of 1% of GDP in 2011 and 2.5% in 2012 (link) to start tackling its national debt which is well over 100% of GDP. It is a similar story across the EU, as countries like Spain, Greece, Germany and Ireland make drastic cuts in public spending to try and reduce deficits and calm markets.

In addition, many countries need to try and tackle their fundamental uncompetitiveness. There is a need to bring wage costs under control. Latvia and Estonia have been 'praised' for their efforts to bring wages under control and reduce their deficit. But, it has been at a great cost. Latvia has experienced a deep recession with output falling by 19.2% at worst stage in 2009. This led to unemployment of 22%. (Latvia situation by Krugman) The fear is that this kind of recession could spread to Spain and others.

The problem is that this European wide fiscal entrenchment is likely to have an adverse impact on domestic demand and economic growth.

It is true, the European economy shows signs of recovery - +0.3% in first quarter of 2010. But, this growth is fragile.

Ironically, the fall in the Euro will help provide a boost to EU exports. But, a fall in the Euro may not be enough to maintain recovery.

Euro inflation is hovering around 1.5%. Despite cost push factors like rising oil prices, inflation is fundamentally low. I haven't seen forecasts for European inflation, but, I can only foresee lower inflation rates over the next 12 months.

With many factors depressing growth - falling house prices, spending cuts, wage cuts, tax increases, fall in confidence. What is left to help maintain growth?

Essentially, we have monetary policy. But, the ECB, under pressure from Germany still worries about inflation. We all know the problems Germany had from hyperinflation in the 1920s. But, we can't let the problems of Weimar Germany in the 1920s dictate policy in the very different era of the 2010s. The experience of Japan, US, and the UK is that quantitative easing doesn't cause inflation in the middle of a liquidity trap and deflationary pressures. See: Money Supply and Inflation.

Quantitative Easing is more difficult in the Euro because of issues such as which countries debt to buy. But, there is a strong case for the ECB to pursue Quantitative easing given the problem of debt deflation and mass unemployment. The Euro area, especially in the south, needs some economic stimulus. If we maintain stuck in negative or stagnant growth the prospects for debt reduction will only get worse.

The problem is that the anti-inflationary stance is so deeply embedded in the ECB, I fear they may be too cautious and only resort to quantitative easing when it is too late.

The ECB have a difficult balancing act. There is a need to reassure markets about reducing debt to GDP ratio. But, (as I've said a few times) reducing debt to GDP ratio isn't as simple as cutting spending drastically - the deflationary fiscal effect can make the measure counter productive, unless it is accompanied with a corresponding monetary easing - An easing the ECB show no signs of following.


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