Our friends at Fasanara Capital have released a new report, which in keeping with the Mayfair fund’s recent trend of gloomy predictions, has looked beyond the current set of adverse socioeconomic development jarring Europe, and looks forward to the “last act of the Euro”, explaining why “whatever it takes” is now over, and why the time to panic about the future of the common currency is once again nigh.
Here is their latest analysis:
The last act begins for the EUR peg
Why the EUR-peg is likely to break
Why new QE is deflationary and counterproductive, so it may soon be up for review
We have long been negative on the prospects for the EUR peg to survive the test of global structural deflation and local ineffective policymaking. Back in 2013, we wrote of the instability and unsustainability of a currency construct set for failure. At the time, we highlighted three big problems with it:
- Structural Deflation / Secular Stagnation: debt overhangs and chronic over-supply (misallocation of capital), bad demographics (aging population, falling working population), technological disruption (‘Amazon effect’, 4th Industrial Revolution), falling productivity of credit (diminishing marginal impact of new lending, while also credit growth decelerates) all conspire to the deficient aggregate demand, the structural deflation and the liquidity trap, across the globe: a process which began well before the Global Financial Crisis and the Lehman-moment.
Why does deflation matter that much? Because durable deflation in a period of economic stagnation is like a death penalty for debt-laden countries burdened with high unemployment: no matter how much virtuous they get fiscally their debt-GDP ratio is set to rise over time, i.e. their debt go up in real terms and make a recovery progressively less likely. So they remain trapped in a long period of debt deflation / balance sheet recession. Take the case of Italy, for example, at 132.5% gross public debt-GDP, where at zero inflation even a primary surplus of ~8% would just about manage to prevent debt ratios from rising further. And such surplus would be heavily contractionary, thus a self-defeating strategy. Such is the evil of deflation. No wonders the ECB embarked on unprecedented expansion of the monetary base. But it failed at stopping deflation. Here are our thoughts in 2014 on that.
- EU mistaken diagnosis: instead of seeing Secular Stagnation for what it is, EU policymakers saw a problem of low productivity caused by a lack of structural reforms and fiscal discipline. The ensuing quest for austerity drove by ‘internal devaluation’ and aggravated the crisis, helping the inner workings of secular stagnation.
- Dysfunctional politics: the inability to reach an agreement and put to work sound crisis resolution policies at the EU level has become proverbial. It is still fresh in memory the epic struggle to tackle the restructuring of Greece, which accounts for a ~1% of the bloc’s GDP, while it took over 90 meetings – between EU summits, EU ministers etc – to reach a temporary solution. Gridlock reigns and stands in the way of efficient policymaking. Not so long ago, lack of coordination and a flawed currency construct led to the ‘Black Wednesday’ ERM’s fiasco, with Sterling breaking away disorderly.
The implosion of the EUR may not be such an outlier in financial history: after all, each and every fixed exchange-rate regime in history was let go, sooner or later. However, there was reason for hope this last June. The Brexit referendum sent an unequivocal message in rejection of the current state of affairs of EU policymaking. In addition to issues with migrations flows and income inequality, the anti-elite stance taken against Brussels was hard to miss. The more so as it added to several other indicators of anti-elite discontent all over the world, from the rise of Trump in the US to support for extremists in Austria and Hungary, etc. Brexit was part of a trend, not an isolated data point.
Sure thing, secular stagnation, technological disruption and globalization all conspire to feed on income inequality and stagnant real wages to a point where they can easily serve as scapegoats. But the EU crisis policymaking fell short (unable to avert deflation), if not backfired (new QE is disinflationary), while the EU red tape super-state exacerbated the crisis (further impediment to growth), leading to the political defeat of Brexit. First and foremost, it was a defeat for the EU.
On grounds of logical thinking, it should have worked as the proverbial canary in the coal mine, the last minute wake-up call averting disaster. It did not.
In the aftermath of the Brexit referendum, we thought Europe had the unmissable chance to seize the opportunity for building consensus for deep structural reforms of the EU, acknowledging defeat and learning from past mistakes. Yet, despite the second biggest GDP in the EU opting to drop out, the EU is very much business as usual, much as Brexit never happened. To this day, no grand action plan is in sight, no sense of urgency, except the idea of bullying the UK upon negotiations in an attempt to deter further uprising across Europe.
The list of past mistakes is long and getting longer:
- Pushing for fiscal austerity at a time of secular stagnation, mistaking a problem of deficient global aggregate demand for one of lack of structural reforms.
- Wasting a most precious monetary expansion through QE without accompanying it with redistributive fiscal expansion. QE was then able to purely buy time and kick the can down the road some more
- Failing to complete the Banking Union, providing the safety net of deposit insurance and other structural reforms of the banking system. To the contrary, bail-in rules were introduced, which only led to financial instability and a crisis of confidence in the banking system, further undermining their profitability, thus curtailing bank lending to the real economy and wasting the efforts at the monetary level
- Preserving the supremacy of EU bureaucracy over pragmatic crisis policymaking, thus dampening already-scarce animal spirit, and ultimately leading to disaffection for the EU project
On the other hand, we believe only a dramatic shift in narrative at the EU level could derail the train before it hits the wall, with measures including:
- Temporary Suspension of the Fiscal Compact
- Banking Union completion via a deposit guarantee, in exchange for fiscal controls post-normalisation of growth rates/inflation
- Allowing for State aid of troubled banking sector (e.g. Italy), before State intervention has to occur anyway but at zero-periodic equity valuations
- Programming substantial Fiscal Expansion, possibly Helicopter Money down the road (discussed below), as ways of forcing income redistribution policies (Brexit vote had inequality, not just immigration, as key tipping factor). Deflation is the elephant in the room, that needs to be taken care of, or else all bets are off.
- Democratic elections for Brussels’ bureaucracy-enabling functions
- Diversion of Brussel policymaking away from red tape overdrive, clear endorsement of member states for most matters
The biggest threat to EU survival is then not so much Brexit but the lack of response that followed. The dramatic warning signal shot by Brexit fell on the deaf ears of inadequate EU policymaking.
We doubt the UK will ever prove weak enough to help the case of the EU current policymaking. If anything, so far it seems like the UK is performing remarkably well, if one is to look at the business and consumer confidence surveys of late. The GBP is weaker than any QE by Mervyn King/Mark Carney could ever achieve/dream of. But is surely too early a time to draw conclusions, Article 50 has not even been triggered yet. Chances are, though, that the UK will do ok even after that, relative to the rest of Europe. We expect a mild recession, if any, and a rebound afterwards. And that is just more problem for Europe (see also Fasanara Interview at CNBC: Brexit: don’t think UK is ‘standing on the cliff of a disaster’). The UK doing well will send another unequivocal message to struggling EU countries: there is life after the EU.
Professor Joseph Stiglitz has recently reaffirmed his view that the EUR will break, as ‘the cost of keeping the Eurozone together probably exceeds the cost of breaking it up’. Earlier this year, former BoE’s Governor Mervyn King predicted the collapse of the Eurozone. Russia’s President Vladimir Putin recently said that Russia holds 40% of its FX reserves in EUR, while he thinks the Union may comprise fewer stronger countries in the future (see BBG interview), thus leading to an appreciating EUR. The time for treating the EUR-peg as a taboo may soon be past us, and an open discussion become the dominant narrative, in pursuit of a long-term durable solution to economic stagnation, in an attempt to save the European Union, so to orderly drive the process as opposed to end up being overwhelmed by the trending course of events.
Timeline for a EUR de-peg
In terms of timing the de-peg, other than saying that whatever is unstable and unsustainable will necessarily have to come to an end, that no fixed currency regime ever survived the test of time, the next obviousness is to say that it is impossible to know what precise trigger will precipitate events. However, one can look at the steady growth of EUR-sceptics across Europe, and interpolate from there to get some rough idea.
At present, when looking through populist parties and EUR-sceptics, an estimated 30%-40% of the European electorate would stand to vote against staying in the Monetary Union (which does not necessarily mean leaving the EU). That number shrunk somehow after the Brexit vote, in fear of disaster hitting the shores of the UK. One year from now, it may be evident that the UK is doing just fine, while some parts of Europe further crumbled. At that point, the 30%-40% will have become 50%-60%, offering the political capital for a regime change. That may trigger the change in course for crisis policymaking that might have happened today if only the strong message of Brexit was not wasted. At that point then, the EUR-peg may be going, in one of two ways: orderly sacrificed in an attempt to preserve the EU, or disorderly as momentum/chaos takes the upper hand.
So far QE provided the glues and tapes to stick the broken pieces together in Europe. Now though, it seems that QE may be running out of steam.
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Tomorrow we will present the second part of Fasanara’s analysis looking at why QE no longer works.
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