On Europe, Stock Market Peaks and the Chinese Money Supply
January 22, 2011
Europe matters.Taken as a whole it is the largest economy in the world and a critical player in the running of the global trading system. Problems in Europe over the last few years have periodically had a severe negative impact on financial markets, and therefore it is important to have a perspective on the outlook for Europe and evaluate the possible scenarios. Paul Krugman recently provided a comprehensive and insightful note on this important subject, and is summarised below:
- Europe, like the US, suffered a severe downturn following the global financial crisis but the human costs of the slump seemed far less in Europe than the US.
- However, Europe is in a deep crisis because its proudest achievement, the euro, is in danger as its architects chose to ignore the difficulties that a flawed currency union would bring.
- The process of creating the euro started in 1950 with the creation of the Coal and Steel Community comprising Germany and France, with a political aim to make war unlikely as well as eventually allow free trading of goods.
- The case for a monetary union was to make business easier and thereby provide large economic gains – and in that respect it has been only a partial success by increasing intra-European trade by about 10% - 15% which is much lower than the initial projections.
- However, by entering into a currency union, countries lost their economic flexibility as the adjustment process to deal with a severe recession - lowering wages and prices- is a lot slower and more painful than achieving the same effect through currency devaluation.
- The European monetary union’s structural issues have been highlighted by the crisis: a lack of a fiscal union (to allow the centre to finance the cost of regional downturns) and a lack of labour mobility (to alleviate regional unemployment) due to cultural and language constraints.
- The creation of the euro created a false sense of confidence, thereby laying the seeds for the inevitable crisis – borrowing costs for the peripheral countries came down dramatically (financed by banks from Germany and other countries) creating a real estate boom and artificially higher consumer demand (which actually helped pull out Germany from its economic slump in the late nineties).
- When the real estate bubble burst, its cost on the peripheral economies was significant with sharp falls in employment and fiscal revenues. In addition, the governments were forced to bear the costs of bailing out their financial sectors, thereby creating a loss of investor confidence and much higher financing costs.
- With the peripheral economies having no option but to deflate their way out, leading to a vicious cycle of incomes falling while debt is not, a process which could not be stopped by the traditional method of monetary expansion (as successfully employed by the US and the UK) as they had no control over the currency. This leaves four possible outcomes:
The odds are that the austerity programme will not work – even in avoiding default and devaluation. This should become obvious sooner than later and would cause an irreversible blow to the concept of a European federation. The open question is whether the stronger nations will be willing to bite the bullet to prevent this dire outcome?
- Toughing it out: This is the current favoured route with the peripheral economies pursue austerity by enduring the pain, with funding from stronger nations to buy time until private creditors regain confidence, thereby avoiding default and devaluation. The Baltic nations are held as the role models, whose economies have begun to recover at the expense of suffering depression like declines in output and employment-which they have been willing to bear, being small and poor economies who would benefit tremendously from joining the union.
- Debt restructuring: With Greek and Irish bonds trading at spreads of 9.5% and 6% over German bonds, it implies the markets are expecting partial payment on their debt. While debt restructuring could bring the vicious circle of loss of confidence and rising interest costs to an end, it would not avoid bearing the pain of spending cuts, rising taxes, wage and price cuts (i.e. “internal devaluation”).
- Full Argentina: Argentina was able to recover rapidly after devaluing its currency by 2/3rds and letting its banks default thereby reducing its foreign currency debt burden. Iceland is the only European country following this approach, where a combination of a steep devaluation and allowing its banks to default, allowed its economy to recover rapidly.
- Revived Europeanism: There is a move in some European countries to create “E-bonds”, which would be issued by a European agency for its member states but guaranteed by the EU-effectively transforming the EU into a “transfer union”. However, this has been stopped in its tracks by an adamant Germany which is not willing to bail-out the weaker nations.
Paul Krugman (as usual) provides a masterly framework with which to evaluate the underlying causes of the European problems and to analyse the possible outcomes. I agree that the austerity programme is unlikely to ultimately work – either due to a revolt against these measures in the peripheral countries, a slide back into a severe recession, or a investor confidence crisis precipitated by an unwillingness by German voters to continue funding the weaker countries. This would eventually lead to a debt restructuring, and possibly even an exit from the currency union for some countries. It is therefore a highly uncertain outlook for Europe, which implies staying away from European risky assets and being short the euro during times of temporary strength (such as now).
To follow-up on last week’s long-term chart depicting the growth of the US stock market versus a trend line growth rate, I present below a chart (via Big Picture) which shows a similar story, but in terms of the US stock market capitalization as a percentage of GDP. We have had two declining peaks over the last decade, and looks like we are heading towards another (lower) peak, with the key question being the year – 2011 or a few years from now? (I would vote for 2014).
Finally, I provide below a fascinating chart (via Macromon) which illustrates the striking impact of Chinese money supply growth on GDP, the stock market and real estate over the last decade. The first surge in 2003 had an impact mainly on the GDP, the second surge in 2006 had an impact on the stock market and the GDP, while the third surge in 2009 had an impact on real estate and the GDP (in terms of preventing a decline). I believe the next surge (to take place sometime in 2011/2012 to prevent a possible economic slowdown?) will have a similar impact on the stock market and GDP.
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