Tuesday, July 20, 2010

Europe is in a Deflationary Vortex That Cannot Be Stopped

Ambrose Evans-Pritchard says today that Europe is in a deflationary vortex that won't be stopped. Governments are applying a triple shock of fiscal, monetary, and currency tightening on an already broken economy. "They are doing so in a region where industrial output is still 14% below its peak, where growth barely scraped above zero over the winter "recovery", and where youth unemployment is shockingly high:

  • 40% in Spain
  • 35% in Slovakia
  • 29% in Italy
  • 26% in Ireland.

The ECB is winding down its £50B purchase of government bonds and is draining liquidity fast

In the U.S. the Fed has allowed M3 money to contract at a 10% this year. Pritchard calls it the the Great Depression rate.

"They seem unaware that China is slowing and the US is tipping into a second leg of the Long Slump. Last week's collapse in America's ECRI leading indicator to -9.8 marks the end of the V-shaped rebound. If this means what it normally means - recession within three months - Europe must take immediate action to prevent being drawn into a deflationary vortex. Spiralling public debt precludes further Keynesian spending, so this must come from central bank stimulus. Tight fiscal policy offset by ultra-loose money is the only option for Europe, the US, and Japan".

No student of Milton Friedman is surprised by the US relapse. The Fed has allowed M3 money to contract at a 10pc pace for much of this year - the Great Depression rate. The economy has hit the wall with the usual lag. Textbook stuff. Never ignore the quantity theory of money.
The US Conference Board's indicator is not yet flashing a red alert, but that is because it gives weight to "yield curve inversion", where long rates fall below short rates. This indicator is meaningless in a Japan-style bust where policy rates are zero.

"So what is the ECB doing to prevent southern Europe asphyxiating from debt-deflation, and knowing that M3 contracted in February (-0.3%), March (-0.1%), April (-0.2%) and May (-0.2%)? It is tightening, as it did in mid-2008 when the eurozone was already tanking.

Far from taking steps to offset Club Med austerity, it is winding down its €60bn (£50bn) purchase of government bonds - "sterilized" in any case to prevent net stimulus. It is draining liquidity fast. The ECB's loans to credit institutions fell from €870bn to €635bn in the two weeks to July 9.

In the meantime, the three-month Euribor has risen to an 11-month high of 0.86%.

The silly bank stress tests.

Evans-Protchard also comments on the so-called stress tests, European version. He says that tests worked in the US only because that was a banking crisis and nobody questioned whether the US Treasury could stand behind the system, or whether the US would hold together as a political entity. "In Europe, sovereign states are themselves the risk, and a dysfunctional EMU is the Achilles heel".

"... euroland solidarity goes only so far. Slovakia's new government has agreed to the EFSF but withdrawn from the Greek bail-out, refusing to uphold of the pledge of the last lot. The loss of money does not matter. The politics do matter. We see again that the eurozone is a network of democracies, each subject to its own political rhythm.

Any country may change its mind and walk away, at any time. Especially Germany".

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