After describing since inception how the euro zone was going to get to where it is, here’s my guess on what’s coming next.  

First, to recap, it took them long enough and it got bad enough before they did it, but they did decide to ‘do what it takes’ to end the solvency issues and, after the Greek PSI thing, make sure the markets stopped discounting defaults as subsequently evidenced by falling interest rates for member nation debt.

But it’s solvency with conditionality, and so while they solved the solvency and interest rate issue, the ongoing austerity requirements have served to make sure the output gap stays politically too wide.  The deficits are high enough, however, for an uneasy ‘equilibrium’ of
near/just below 0% overall GDP growth and about 11% unemployment.

However, all of this is very strong euro stuff, where the euro appreciates at least until the (small) trade surplus turns to deficit.  This could easily mean 1.50+ vs the dollar (and worse vs the yen) for example. This process at the same time further weakens domestic demand which supports a need for higher member govt deficits just to keep GDP near 0.

So at some point next year I can see deficits that refuse to fall resulting in more demands for austerity, while the strong euro results in demands for ‘monetary easing’ from the ECB.  Of course with what they think is monetary easing actually being monetary tightening (lower rates, bond buying, everything except direct dollar buying, etc.) the fiscal and monetary just works to further support the too strong euro stronger.  

All this gets me back to the idea that the path towards deficit reduction in this hopelessly out of paradigm region keep coming back to the unmentionable PSI/bond tax.  Seems to me we are relentlessly approaching the point where further taxing a decimated population or cutting what remains of public services becomes a whole lot less attractive than taxing the bond holders.  And the process of getting to that point, as in the case of Greece, works to cause all to agree there’s no alternative.  With the far more attractive alternative of proactive increases in deficits that would restore output and employment not even making it into polite discussion, I see the walls closing in around the bond holders, along with the argument over whether the ECB writes down it’s positions back on page 1. And just the mention of PSI in polite company throws a massive wrench (spanner) into the gears.  For example, if bonds go to a discount, they’ll look towards ECB supported buy backs to reduce debt, again, Greek like.  And if prices don’t fall sufficiently, they’ll talk about a forced restructure of one kind or another, all the while arguing about what constitutes default, etc.

The caveats can change the numbers, but seems will just make matters worse.  

The US going full cliff is highly dollar friendly, much like austerity supports the euro.  In fact, the expiration of my FICA cut- the only bipartisan thing Obama has done- which apparently both sides have agreed to let happen, will alone add quite a bit of fiscal drag.  This means less euro appreciation, but also lower US demand for euro zone exports.  So the cliff does nothing good for the euro zone output gap.  

And Japan seems to be targeting the euro zone for exports with it’s euro and dollar buying weakening the yen, as evidenced by Japan’s growing fx reserves (where else can they come from?).

The price of oil could spike, which also makes matters worse.

In general, I don’t see anything good coming out of the current global political leadership.

Please let me know if I’m missing anything!

28 Responses

    1. i like equities but scared we’re about to shoot ourselves in the foot with this cliff so on the sidelines right now
      the usual causes for oil spikes are still out there- mid east goings ons, etc

  1. So austerity is favorable to a currency because it makes the currency scarcer, or because FX markets think they are swallowing the ‘tough medicine’ and will somehow lead to growth? Or both?

  2. “Of course with what they think is monetary easing actually being monetary tightening (lower rates, bond buying, everything except direct dollar buying, etc.) the fiscal and monetary just works to further support the too strong euro stronger.”

    If the ECB buys dollar directly, is this positive for the Euro-zone because it weakens the Euro, or because buying dollar is more than an asset swap?

  3. Warren,

    Always great to hear your thoughts on these matters. On the whole I agree with you here and certainly respect your experience in thinking about the Euro zone’s troubles. One aspect you don’t really discuss is the potential for political unrest to spike in the really high unemployment countries (e.g. Greece and Spain). While those countries have been relatively sanguine, to date, about their economic prospects, how likely is a Middle East-type uprising is if the dynamics don’t change? Is the potential for something similar still years away?

      1. @WARREN MOSLER, history affords us many lessons, right? a possible trigger is when someone says…..”let them eat cake”….(an updated version: let me take my private jet from LA to San Fran for a cup of starbucks”…..:-)

        Another more likely trigger is unemployment that breeds too many people with too much time on their hands…which is why we all agree it’s better for people to have a job and go to work.

  4. “Please let me know if I’m missing anything!”

    There’s a big comet approaching Earth orbit at the end of 2013.

    Perhaps there was an ‘off by one’ error in that Mayan calendar calculation thing.


  5. Just a quick question regarding currencies. Isn’t fx movements most ly determined by speculation? Even if the fiscal cliff makes dollars scarcer, if the speculators don’t think so, would that still be bullish for the dollar?

  6. A German friend tells me that the story starting to be sold to the German public is that, now, after 5 years of cuts to Greek budgets, the German government, having “brought about the necessary efficiencies” and “curtailed corruption in Greece,” will commit itself to righting the ship by investing in the “PIGS” as it did for East Germany.

    Hypocritical twaddle if true, but it might provide a justification for large deficit spending in the Northern nations. A glimmer of hope?

  7. Warren,

    A lot of people (not sure if you were amongst them?) used to say that the amount of EUR debt Greece could sustain, without a devaluation, was nil: ie that a full write-off was required.

    The rationale for this was that Greece has had a stubborn structural current account problem.

    But recent Greek data (if it is to be trusted) suggests that the current account deficit in Jan-Oct 2012 had tightened drastically vs Jan-Oct 2011 (EUR 4bn vs EUR 16bn)!

    So does this mean they can struggle by with some debt intact?

  8. @Anders, So long as the ECB continues its OMT program Greece can sustain any level of debt, because the central bank (which can’t run out of money) is funding bond purchases. The question is how much more austerity will be forced on them, and how much of OMT will it nullify.

    If they’d just let deficits go Greece’s debt/GDP ratio would fall rather quickly, given how much growth potential there is.

  9. in my opinion currency is driven by :

    1) ratio between commercial balance of 2 country => Us external deficit greater then Eu need $ undervalued.. ok target 1.5 may be

    2) action of Central Bank = Fed print & buy Euro in hte last 5 years every time cross go 1.2 / 1.25 => artifical support

    3) panic by default of Euro because Bce (until now and autumn 2013 German election.. but I am not so sure after) print less then Fed) => this push down to 1.2 and without Fed this could be also. 1.0 Euro/$

    4) on the very long run I agree with IMF = equilibrium 1.25 / 1.3

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