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Tuesday, May 13, 2003

On the Supposed Advantages of 'Being Close To Death'

One of the people who doesn't buy the euro rise bravado is Morgan Stanley's Eric Chaney. He's been doing some number crunching and comes to the conclusion that the with the euro valued at $1.15, the german economy is nothing less than 45% over it's neutral par with the US. He also considers the advantages of the 'being near to death' argument (ie when you have the gun pointing straight at you you have to do something). He, like me, is not convinced that this situation is necessarily any more conducive to reform. If anything, he feels that the real 'collateral damage' would probably be the growth and stability pact. Good riddance some might say. I beg to differ.

Models assume that economies react linearly to changes in macro inputs. The real world is different, I think, especially for reactions to exchange rate gyrations. I believe for instance that, when a currency is largely undervalued -- this was the case for the euro in 2000 -- an appreciation can be positive for growth, because positive wealth effects would largely overcome negative profitability effects. In the real world, producers know when a currency is far out of reasonable bounds and, in the case of an undervaluation, they know that super-profits cannot last forever. At the other end of the spectrum, if the initial conditions of a currency rise are already over-stretched, then the negative impact on the real economy is likely to be worse than model multipliers suggest, because of self-reinforcing effects on corporate spending, especially if deflation appears.

Models suggest that a 10% rise of the euro would cut inflation by 0.5% to 2%, most of the divergences coming from differently specified wage-price loops. Let’s assume that inflation would be cut by only 1.2%, after four quarters. Since our inflation forecast for 2004 is 1.5%, only 0.3% would be left. Whatever the uncertainties regarding the inflation measurement bias, often assumed to be around 0.8%, there is no doubt in my view that, without monetary reaction, Euroland would enter into deflation territory. Note that if inflation drops below 1% next year, it is most likely to print in red ink in Germany. Also, for highly indebted companies, the vicious circle of real debt increased by deflation would start, with straightforward consequences for banks: non-performing loans would rise faster than write-offs. I guess readers already have a feeling of déja vu and may stop here.

On more structural ground, is it possible that a sustained over-valuation of the euro would prove a “blessing in disguise” and act as a catalyst for structural reforms? According to my colleague Robert Feldman, the Japanese experience suggests that the answer might be yes, but also that a very large misalignment is needed to get there. Being “close to death,” to borrow from PM Koizumi’s own words is a necessary condition to gain the support of public opinion for reforms, in Feldman’s view. According to my colleagues Joachim Fels and Elga Bartsch, reforms in Germany would be accelerated by another year of zero or even negative growth and, in that case, other euro area countries will have to follow. Another school of thought, more popular in Washington than in Frankfurt or Brussels, considers that a super-strong euro would force European politicians to embrace the reflationary policies they have been reluctant to implement so far. No doubt in my view this will be debated at the next G-7 summit in Deauville. Practically, the reflationist camp thinks that the Stability Pact should be scrapped, so that the job of kick-starting the global economy by fiscal means would be more evenly shared between the United States and Europe. This camp also thinks that a super-strong euro will force the ECB to team up with the Fed in a kind of global fight against deflation.

I am not convinced by either camp and I am afraid that on these highly political grounds, there are more opinions than evidence. However, I would concede that the Stability Pact could be one of the collateral damages of a super-strong euro. If, instead of a mild recovery, Euroland is to fall into recession, I do not see how the governments of the three largest countries could cut their deficits below 3% of GDP next year. The rule of thumb is simple: a 1% loss in real GDP growth implies a rise of 0.5% of GDP for budget deficits. In the cases of France and Germany, which are likely to start from 3.5% of GDP this year, abiding with the Pact would imply a discretionary tightening amounting to 1% of GDP, which, I think, is not politically feasible. The same would hold for Italy, which, so far, has managed to conceal the deterioration of its public finances, in my opinion, by selling state assets.

Ditching the Stability Pact would not be in the interest of Europe, where big governments have accumulated huge debts and where baby boomers will start to retire in the coming years. Writing off the Pact would be an incentive for governments to endorse “muddling through” strategies and postpone reforms even more, because it would open the door to higher public spending.

Halting the rise of the euro has become an urgent necessity, I believe. The European Central Bank missed an opportunity to send a first signal last Thursday. But even a bold action on interest rates might not be sufficient to stabilise currency markets. Interventions, if they are backed by a strong commitment to respect the Stability Pact and meaningful decisions on structural reforms (pensions and/or labour markets), should be considered as well.
Source: Morgan Stanley Global Economic Forum

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