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Saturday, May 10, 2003

More Accidents Waiting to Happen

This time the reference is to the European economy, to the foolhardy flirting with the deflation danger, and to the deadweight anchor role being played by Germany. And who is making the reference, why Stephen Roach, who else?

The European economy is an accident waiting to happen. Lacking in domestic demand, a sharply rising euro is crimping the continent’s main source of growth -- external demand. In my view, the combination of misguided policies, lagging structural reforms, and acute pressure on Germany leaves Europe both exposed and unprepared to cope with most shocks -- let alone the currency shock that is now unfolding. Europe needs to get its act together sooner rather than later. Steeped in denial, the risk is it won’t............

With most of Asia in deflation and US monetary authorities now sounding the alert, it’s hard to fathom the possibility that a structurally impaired Europe might be spared from this increasingly global phenomenon. If anything, the sharp appreciation of the euro makes the case for Euroland deflation all the more compelling. Yet the ECB’s stunning intransigence at its May 8 policy meeting takes the concept of denial to an entirely different level. I believe European policy makers are taking unnecessary risk when they can least afford to do so -- precisely the opposite of what is required to fight deflation. The strictures of EMU are being placed ahead of increasingly worrisome economic perils. Something has to give -- either the economy or an increasingly antiquated policy framework. I vote for the latter. Rules-based policy constraints don’t fly in an increasingly deflationary world -- especially if those rules are set with an eye toward fighting the old battle of inflation............

Obviously, it wouldn’t take much to push Germany through the deflationary threshold. That push may now be at hand. With the German economy probably contracting in the current quarter and the unemployment rate extraordinarily high (10.7%) and rising, there is every reason to expect further disinflation in this extremely low-inflation economy in the months ahead. A whiff of German deflation could be complicated all the more by the nation’s increasingly fragile financial system -- banks and insurance companies, alike. The Japan comparison is no longer a stretch for Germany. And if that’s the case, you have to wonder if the rest of Euroland has the capacity to avoid a similar outcome. As I see it, the German experience has revealed a critical and potentially fatal flaw of EMU: Without true economic convergence, it may well be that the big economies in this heterogeneous union have to be treated as special risks. If and when they are judged to be in a state of acute distress, pan-regional policies may need to be tailor-made for the weak link in the chain. The mounting perils of Germany are now screaming out for just such a remedy. Euroland’s once proud growth engine has been transformed into the deadweight of an anchor.
Source: Morgan Stanley Global Economic Forum

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