Economie européenne

4 janvier 2012

April 2011 – November 2011: the Euro crisis is first and foremost a monetary crisis (part 1)

I wrote this analysis in November 2011. As the Euro crisis reached its high point at the time, I felt the need to put some thoughts in writing to clarify my own thinking. As it has become a rather long text, I will publish it in several parts.

As a simple citizen of the Euro area, I would like to give my take on the present crisis. To summarize, this is not mostly a crisis of sovereign debt or a banking crisis. This is a monetary crisis of a similar nature to the US depression of 1929-1933.

Just imagine that you have been hibernating since the end of March. Forget the twist and turns of the Greek saga, the row of European summits, etc: you have simply not kept up with events. You have just woken up and decide to take a fresh look at the economic situation in Europe.

Monetary contraction

When you went in hibernation, GDP for the whole Euro Area was growing at a reasonable pace of around 2%. Although there were substantial differences in GDP growth between countries, they largely reflected a welcome correction of macro-economic imbalances. Employee compensation was at last growing much more rapidly in Germany (around 5%) than in countries such as Portugal, Spain and Italy (around 2%). Countries with excessive budget deficits were making serious efforts to reduce them, also contributing to reduce macro-economic imbalances. Ireland had already succeeded to move its current account balance into the black, and the Spanish current account deficit was expected to come down in line with the strong reduction of the budget deficit (3% of GDP in 2011). Also positive was that employment was starting to show some signs of life in Spain and Italy, indicating that their competitiveness was recovering.

But what do you see now? The last GDP figures show that growth has come to a halt. In fact, there are evident signs that a recession has already started. Unemployment is rising again even in countries not directly affected by the sovereign crisis, such as France. Most financial assets have lost a good deal of their value. Euro Area stock markets have lost some 20% of their value since April. Government bond markets of most Euro countries have also lost a good deal of their value. The ECB surveys are indicating that banks across the Euro Area are rapidly tightening credit conditions, and that credit demand has weakened.

Such developments could be explained by a strong fall of savings or by a clear increase of credit demand across the economy. But that would translate into strong economic growth, and that is clearly not the case. On the contrary, I believe that economic data in the 3rd and even more so in the 4th quarter will show that the savings rate is increasing, and credit growth decreasing. Furthermore, I expect that the Euro area will see its current account move from a minimal deficit into a surplus. On a macro-economic level thus, the Euro Area is perfectly able to provide for all its financial needs. And of course, unlike some emerging markets, most of the financing in the Euro Area is done in its own currency.

But the clearest indicator of what is going are inflation expectations: they have collapsed since April. In November, the French and German inflation break-evens for the next 5 years fell below 1%. My take is that the financial markets in fact expected the Euro area to move towards outright deflation by the end of 2012.

France - Inflation break-even 5 ans

Open now any economics 101 textbook and try to identify what ailment corresponds to all these symptoms. If it looks like a duck, swims like a duck and quacks like a duck, then it is probably a duck. All the developments above correspond to a massive monetary contraction. The only piece that does not fit easily with the puzzle is that some sovereign bond yields have fallen while others have strongly increased. More on that later.

Strangely, for what I can see, this is not the angle adopted by most economists. I have read many mentions of macro-economic imbalances, competitiveness issues, public debt sustainability, or growth potential. But, although all the symptoms are for everyone to see, not a word about the elephant in the room: a very severe monetary contraction!

Velocity contraction

The natural thing to do when thinking in terms of a monetary contraction is to look at the policy pursued by the central bank. Yes, the ECB did increase the refinancing rate in April and June. But there are no signs that the money supply is shrinking fast. Since April, the balance sheet of the ECB has not shrunk, but grown. If a severe monetary contraction was indeed taking place, then it has probably not been directly caused by the ECB.

A way then to explain the present situation is to fall back on the quantity theory of money. In simplified terms, this theory states that (a change in) real economic output times (a change in) the price level is equal to (a change in) the money supply times (a change in) the velocity of money (Q x P = M x V).

When we observe that economic activity is cooling down, that inflation expectations are falling fast, and that the money supply is expanding slightly, we can only conclude that the velocity of money is dropping like a stone. In normal economic circumstances, the velocity of money is assumed to be broadly stable, and the central bank conducts monetary policy by adjusting the money supply. In my opinion, we have a massive monetary contraction in the Euro Area, but not due to a contraction of the money supply decided by the ECB, but by a fall of the velocity of money due to developments outside the control of the ECB.

The question now is why the velocity of money is falling fast. I think that everyone can see why. Basically, there is a generalized loss of confidence in the continued access to liquidity of many sovereigns of the Euro Area. As a consequence, there is a generalized fear that the banks supported by those sovereigns will get into trouble because of losses on their large sovereign bond holdings. And last but not least, this leads to an ever declining confidence in the continued existence of the Euro Area it self. I will come back on that last point later on.

All these trends are constantly reinforcing each other. Once a sovereign comes under attack, the banks supported by that sovereign start to have trouble accessing liquidity on the wholesale markets because of the potential losses on the large positions in the bonds of their own sovereign. These banks might then be forced to sell some of the bonds of their own sovereign to get the liquidity that they are not getting anymore from the wholesale markets, further aggravating the problem.

Furthermore, the attacks on sovereigns are largely self-fulfilling and have little to do with fundamentals. As Paul De Grauwe has wonderfully demonstrated in its paper ‘The governance of a fragile Eurozone’, sovereign runs in a monetary union can occur in a way similar to bank runs, even if the bank/sovereign is perfectly solvent. If investors have some reasons to believe that a bank run will happen, they will scramble to the exit to avoid being trapped, triggering the very bank run they feared.  The same process is at play with the current sovereign runs: if investors start to think a sovereign run will happen, there is a good chance it will happen.

Some commentators are claiming that the high Italian bond yields are justified by its high public debt, or by its high deficit (3% is a high deficit?), or by Berlusconi’s antics. Perhaps, but this oversees the fact that Italians collectively have high savings and low private debts. As in Japan, a high level of public debt should not be much of an immediate macro-economic concern in such conditions. And what about Slovenia, which has 10-year bond yields at around 7%, about the same level as in Italy. The public debt of Slovenia was 39% of GDP last year, less than half Germany’s 83% and about a third of Italy’s 120%. Strangely, those who try to explain the sovereign debt crisis on the basis of fundamentals are not commenting much on Slovenia.

To be continued …


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