Welcome to the Currency War, Part 11: Europe's Imploding Recovery
For a while there it looked like Europe was beginning to dig itself out of the pit into which it had fallen after the 2008 banking crisis:
The Markit survey of overall business activity in August rose to its highest level since June 2011. And the individual indexes for eurozone manufacturing and services also jumped to their highest levels at least two years.
The figures were stronger than expected and helped send European stock markets higher in morning trading. Germany's DAX and France's CAC 40 both managed gains of more than 1%.
Economists said the PMI data provided evidence that the region's recovery was beginning to find a firmer footing. "So far, the third quarter is shaping up to be the best that the euro area has seen in terms of business growth since the spring of 2011," said Markit chief economist Chris Williamson.
BNP Paribas said the composite PMI reading of 51.7 was consistent with third quarter GDP growth of around 0.3%. Separately, Germany's manufacturing output index hit a 26-month high in August. The sector recorded its fastest growth in new business since May 2011. The upturn is being driven by rising domestic and export demand.
But just a couple of months later the European Central Bank shocked the world by cutting rates to pretty close to zero:
The move took financial markets by surprise - the euro fell sharply in response while European shares rose. Underlining its support for the euro zone, the ECB said it would prime banks with as much liquidity as required until mid-2015. A Reuters poll of economists also saw the ECB offering banks a new round of cheap money within six months.
The 23-man Governing Council had faced intense pressure to act after a shock slump in euro zone inflation to 0.7 percent in October, far below the ECB target of just under 2 percent. The ECB cut its main refinancing rate by 25 basis points to 0.25 percent. It held the rate it pays on bank deposits at zero and cut its emergency borrowing rate to 0.75 percent from 1.00 percent.
Draghi stressed the ECB still had room to act if needed. "We have a whole range of instruments to activate before reaching the lower bound ... in principle we could even cut further the interest rate," he told a news conference.
"We may experience a prolonged period of low inflation to be followed by gradual upward movements towards an inflation rate of below but close to 2 percent later on."
Draghi said there was general agreement on the need to act but differences over when to act, with a "considerable majority" on the Governing Council seeing sufficient evidence of protracted low inflation to cut at Thursday's meeting.
Italian Prime Minister Enrico Letta said the cut showed "the ECB cares about growth and competitiveness in Europe" and that it would allow a "rebalancing" of the euro-dollar rate. The finance ministers of France and Ireland echoed that sentiment.
A Reuters poll pointed to the expectation of a major fresh ECB liquidity operation to keep banks flush with funds to lend to businesses. A majority - 35 of 59 - of economists polled said the ECB would conduct more long-term refinancing operations that offer cheap, unlimited, loans to banks within the next six months, with a median expected maturity of three years.
What happened? In retrospect it's not a mystery. The euro went up in expectation of a stronger economy, and this choked off exports and sent the eurozone back into the deflationary spiral awaiting all economies that borrow way too much money.
What happens next? Dire warnings of chaos if the deflationary spiral isn't stopped...
The latest data show a continued erosion of France's industrial base and export share. It risks shattering the credibility of President François Hollande, who has been talking up recovery for months. A YouGov poll showed his approval ratings have dropped to 15pc, the lowest recorded for a French leader in modern times.
While the risk of a eurozone bond crisis has greatly receded since the European Central Bank agreed to act as a lender of last resort in July 2012, this has been replaced by slow economic attrition. It resembles the mid-1930s slump under the Gold Standard and is fuelling political crises in a string of countries.
Le Figaro said loss of confidence in the French government is turning dangerous, citing a confidential report based on surveys by "prefects" in each of the 101 departments. "All across the country, the prefects described the same picture of a society that is angry, exasperated and on edge. A mix of latent discontent and resignation is being expressed through sudden eruptions of fury, almost spontaneously," said the document. The report warned that people were no longer venting their feelings within normal social structures. Increasing numbers are questioning the "legitimacy" of taxes.
Thierry Lepaon, head of France's Confederation of Labour (CGT), said the situation had become "explosive everywhere" and accused Mr Hollande of betraying French workers. The business lobby Medef has also begun to talk of a "crisis of authority" bordering on revolt as the economy languishes in stagnation.
... followed by the inevitable expansion of debt monetization. From the above article on France:
This may soon be on the cards. Peter Praet, the ECB board member in charge of economics, hinted this week that the bank is mulling Anglo-Saxon style quantitative easing for the first time, ready to take "all measures" necessary to meet its mandate.
"The balance sheet capacity of the central bank can also be used. This includes outright purchases that any central bank can do. The rules do not exclude that you intervene in the markets outright. That's a very clear signal," he told the Wall Street Journal. Ken Wattret from BNP Paribas said the comments mark a "radical change of position" by the ECB.
The question is whether it comes soon enough. Paul Sheard, a Tokyo veteran at Standard & Poor's, said the lesson from Japan's woes in the 1990s is that the authorities must strike very quickly and with maximum force to head off deflation. "You have to pull all the levers at once, and you can't rely on cheap talk. I am afraid Europe may be drifting towards a Japanese situation, but they also face a problem that is orders of magnitude greater than in Japan beause of the architecture of monetary union," he said.
The idea that Europe could recover and start growing always seemed a little far-fetched, what with several of its biggest economies imposing the kind of austerity that's pretty much guaranteed to subtract from near-term growth. And with absolutely no credible attempts being made by countries like France and Italy to scale back all the impediments to wealth creation that had built up over the past few decades of illusory prosperity. These cultures have just hit the wall in terms of size of government and amount of debt in relation to the wealth producing part of the system. It's over for them and they have no idea what to do about it.
But what they will do, obviously, is ramp up the currency war, buying bonds to prop up their banks (which will be first to go if real deflation emerges next year) and force the euro back down. This will succeed, because it's within the realm of a central bank's powers to make those things happen. In effect, the ECB will shift the pressure (i.e., export its deflation) back to the US and Japan via higher dollar and yen exchange rates.
This will make 2014 harder for those countries and lead to huge increases in their debt monetization programs, and so on. The war will continue until the markets figure out that devaluation is official policy of all major governments and that it isn't ending soon, and react by dumping bonds denominated in those currencies.
None of this is exactly a secret; stock markets around the world are anticipating easy money forever. A much more interesting question is why precious metals, normally the prime beneficiaries of officially-sanctioned inflation, aren't going parabolic. There are two possible answers (actually three, but one is too absurd to take seriously):
1) Deflation is the immediate problem, so maybe the gold and silver markets are reacting to what's in front of them rather than what's coming. That's reasonable, and means that as soon as enough new currency has been dumped into the banking system to make inflation the headline problem, an immense amount of terrified capital will pour into the metals and send them through the roof.
2) A lot of the currency that's being created is being directed behind the scenes, first to juice the equity markets and second to depress precious metals. This is consistent with historical evidence, and can continue as long as the ammunition - widely-accepted fiat currencies - remains potent.
3) The financial markets have decided that our problems are fixed and financial assets - highly leveraged, dependent on a smoothly-functioning banking system and very profitable when things are going well - are the best place to be. This might indeed be the belief of the average 30-year-old money manager and retail investors who can't stand it any longer and are jumping into equities, but it's about as appropriate as it was in 2007, and is too sad for the little guy to even contemplate.