Friday, April 16, 2010

Economics 16/04/2010: The incoming train II

It is a good feeling to be ahead of the curve, especially when the curve is drawn by the likes of FT. Per today's FT Deutschland report: the ECB is warning about a new crisis, a return of global imbalances in the coming years. In its monthly report the ECB warns: “At the current juncture, global imbalances continue to pose a key risk to global macroeconomic and financial stability . . . The stakes are high to prevent a disorderly adjustment in the future that would be costly to all economies.” Jurgen Stark is predicting that we have entered a new stage in the financial crisis – a sovereign debt crisis which means that “dealing with [the resulting severe macroeconomic imbalances] will represent one of the most daunting challenges for policymakers in modern history.”

My own take on the same topic was published here.

Another issue, also raised repeatedly on this blog, is discussed in Joachim Fels' (Morgan Stanley) piece on FT Alphaville (here). Fels makes a claim that countries with a high degree of inflation aversion (Germany) might have an incentive to quit. Fels suggests three warning points for the crisis to develop:
  • First, any signs of moral hazard emerging in the fiscal policies in the euro area
  • Second, ECB failure to raise interest rates on time to cut inflationary pressures, and
  • Third, the political pressure rising against the Euro in Germany.
Hell, by these metrics, we are already in the midst of the euro collapse by 2 out of three measures (first and third). Alas, the second metric is a bogus one. There is plenty of evidence to show that ECB has not been an 'inflation hawk', acting often pro-cyclically before and targeting the likes of PMIs instead of hard inflation and monetary parameters. So the real question here is: What's the potential trigger for an exit?

Greece asking for the pledged money won't do. If you think in terms of game theory, once that happens in earnest (and it might be today or over the weekend), Germany will face the following two options:
  1. Grant request for assistance in full and thus pre-commit itself to the common currency at the sunken cost of an exit of ca 10-12 billion euro that it will commit to Greek deficits financing;
  2. Exit now, saving the aforementioned money, but destroying its political capital within the EU.
The problem is that the net cost of (1) is much smaller than the net cost of (2). And this means there has to be another - non-Greek - trigger. Italy or Spain?


Anonymous said...

if greece triggers the bailout money this is a declaration of insolvency.
The big money is on shorting the euro and assuming greece defaults, the euro could reach par with the dollar very quickly.
Referencing game theory,I think this will suit the germans more than any other EU country as a devaluation of that order will likely deliver a major spike in its exports to the USA.I dont see the PIIGS benefitting in a meaningful way.
Also I think strategic german thinking has ensured security of gas supply lines with russia.Oil prices will skyrocket for europeans because of euro devaluation but will have a more damaging effect on the PIIGS than germany.
Could higher oil prices then deliver the coup de grace leaving germany smiling but blame free?
As in game theory its a possibilty but just how much salience can be attached to it?

TrueEconomics said...

Yes, possibly. I predicted last year that the parity with the dollar is the inevitable direction for the euro. Back then the prediction was based on my view that
1) Eurozone has not been quick enough to recognize banks losses in 2009, so 2010 will be the year of reckoning;
2) Eurozone deficits and debt problems will run into rising yield curves head on

Greece is providing an illustration of the second factor.

As far as German position goes, true - they will benefit from a devaluation on exports side. Given that German policymakers appear to be absolutely happy to destroy their own consumers to underpin their exporters, they will take this path. However, with a build up of delayed consumption, householders will start to get a bit uneasy about this 'exports-led growth' which is seeing Germany producing Mercs and BMWs for the rest of the world, while its own population is being left unable to afford the same luxuries.

Of course, higher oil prices and deflated euro will only reduce incentives for Germany to leave the euro, so instead of acting as a trigger, they will act as a buffer.