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Saturday, March 01, 2003

The Durably Deflationary World

Now Morgan Stanley's Eric Chaney argues the point: Europe is risking a very close call with generalised deflation. Top of the 'at risk' list: Germany. Gee, their boss, Stephen Roach, is really getting through to them.

From 1973 to the late-1990s, a popular macro game between industrialised economies was to export inflationist pressures. The strong-dollar policy in the Reagan period and also during the Rubin one, and the strong Deutsche Mark policy in the boom years that accompanied the German unification were textbook examples of this not really zero-sum game. Nowadays, in a durably deflationary world, the game is different. Its name is "exporting deflation" and I am afraid that Europe could be on the wrong side, this time. The analytical case is three-folded. First, the euro is already non-competitive, on a unit labour cost basis. This is particularly flagrant for Germany. Second, three years of sub-par growth have widened and continue to widen considerably the output gap. Third, the euro might rise even higher, if the US economy does not recover convincingly and oil prices stay high.

In other terms, even at 95 cents, the euro was slightly overvalued, from a pure productivity-adjusted costs standpoint. Euroland manufacturers could have lived with that. For a region where restructuring is a compelling necessity, a 10% over-valuation of the currency is not that bad, in our view. But at today's rate, 107, Euroland relative labour costs (ULCs) stand at 123. A 20% to 25% over-evaluation of the currency is clearly excessive for a sector already in recession. Put simply, it is deflationary for Europe. Note that, for Germany alone, things are much worse: on the same estimates, German ULCs are now 38% higher than US ones.

As the decline of the US dollar carries on — the US currency is only half-way on its way down, according to my colleague Stephen Jen — the situation will get even worse if the euro is the only counterpart to bear the burden of the rebalancing of the US economy. Well, it seems that this is the case, since most Asian currencies are practically linked to the USD. Using the weights used by the Fed for its own currency basket, it appears that a 10% effective depreciation of the USD would require a 50% rise of the EUR/USD rate. If only half of this is behind us, there is more pain coming for Europe. In addition, it seems that the well-established correlation between oil prices and the USD exchange rate is now inverted and that, practically, the euro has now taken the status of "petro-currency." Just imagine what would happen if crude oil prices stayed around $40 for some time. As the US and Asia export their own internal deflation risks, Europe seems to be the main recipient of this poisoned calice. Has Europe the means to absorb deflation? The answer is clearly negative, given the still very high rigidities most regional labour markets suffer from.
Source: Morgan Stanley Global Economic Forum

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