Posted by:
Andrew Bell

8 March 2010

The world’s equity markets have, at least for the time being,weathered the test of confidence posed by a tightening of monetary policy in China and concerns about the debt problems of a number of countries, with Greece in particular focus as at risk of default (if markets refused to refinance its debt).

The return of investor confidence has been helped by signals from global governments and central banks that they are nowhere near any significant tightening of policy (diluting concerns about the nascent economic recovery being snuffed out) and by a robust recovery in corporate earnings, helping the market fundamentals catch up with last year’s rally. Even China, which really is tightening, is seen as trying to rein in a boom, not squeeze its economy too hard. Confidence was also helped by pledges from the European Union to stand by Greece, provided it took steps to bring its deficit under control.

The reason for this pledge was not the importance of Greece in isolation, as it represents only a few percent of the Euro currency zone’s output. However, the Euro contains a number of larger economies (such as Italy, Spain and others, collectively abbreviated as “the PIIGS”) for whom membership of the Euro has delivered much lower interest rates than they previously enjoyed – the reward for replacing their own economic credibility with that of Germany’s Bundesbank, which largely wrote the rules for the new currency. As a result of these lower rates, which spurred a credit boom, their economies grew faster than Germany and other core Euro members. Along with this growth came higher inflation and less attention to maintaining productivity in the export-related parts of their economies. Being part of the single currency, they were unable to offset this inflation by currency depreciation and as a result became steadily less competitive.

While the credit boom continued, this trend was masked but since 2007 the credit-sensitive parts of the economy have shrunk (hitting government tax revenues), while the international trade environment has become much more challenging, highlighting the stored up problems of the PIIGS’ loss in competitiveness. Soaring budget deficits and weak trade competitiveness have undermined confidence in their ability to service their debt. If one of them (with Greece seen as having the weakest fundamentals) dropped out of the Euro, the cost of repaying their Euro debt would rise but their competitiveness would improve, putting pressure on the next weakest link and so on.

February’s declaration of support was driven by the need to avoid a domino-like run of European devaluations, putting the relative prosperity of the core economies at risk. However, so far this support has proved to be empty words, with increased pressure on Greece to tighten fiscal policy (not usually a productive policy in a recession) before help is forthcoming. The scale of tightening needed has produced domestic riots. It also seems insufficient for the budget to be tightened when the economy has leaked competitiveness – what is needed is a more competitive currency, either by the Euro itself falling (which has been happening) or by Greece being forced out of it (which would entail the chain reaction that the Euro authorities would like to avoid). The impression given by this reluctant promise of aid is of a lifeguard pledged to stop you from drowning but only once you have used every ounce of energy to stay afloat and really do look like drowning.

Because of the dire consequences for Germany if the weaker Euro members devalued, it seems likely that some form of covert aid will be provided to support Greece and others – paradoxically the more willingly it is offered the less likely it would be called on. At present, market doubts over any “rescue” increase the aversion to buying the Eurozone’s riskier sovereign bonds.

The significance of this for the UK is that it highlights the risk of dissimilar economies sharing a common currency, without having put in place adequate adjustment mechanisms to cope with events that impact some parts more than others. The UK has participated uncomfortably fully in the problems of the credit boom and bust but Sterling’s ability to adjust has buffered the shock and offers a path towards recovery, if the competitive boost from the pound’s fall is retained rather than being frittered away via higher inflation. Having a floating currency does not avoid the need to retain market confidence in our economic policies – indeed arguably it increases it, owing to the greater currency volatility from a floating pound. However, it offers an offset to post-election fiscal retrenchment and will facilitate the necessary shift away from growth previously driven by consumer and government debt accumulation.

The stakes are high in Europe, which either faces a disorderly run of economic crises amongst its weaker member economies or the need for Germany and the other core states to smooth the adjustment for their less conservative partners. The risk is that by acting indecisively Europe will be consigned to a period of relative stagnation, if not as bad as that which has taken hold in Japan since the 1990s. One positive result of this mess is that instability in Europe is likely to keep any tightening from the European Central Bank at bay. There is also some hope that the Bank of Japan may be persuaded to act more aggressively to counter domestic deflation. If both these things occurred, they would materially help in sustaining the uncertain momentum of the economic recovery.

Comments or feedback would be welcome to theblog@witan.co.uk.

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