Euro as the new Deutsche Mark

Germany practically controls the euro as if it were its own currency but it would gain more being less in charge

Being a big fish in a small pond can have its benefits as Germany is discovering in its dealing with Europe.  Its powerhouse economy means that Germany was one of the few countries left standing after the Eurozone crisis.  Germany has used this position of strength to turn the euro into its own de-facto currency.  It dominates the decisions over monetary policy and has influences spending decisions by politicians outside of its borders.  This level of control is alienating many others in Europe while still being insufficient to keep Germans happy.  As a result, more could be gained by Germany trading away its power to secure a brighter future for Europe as a whole.

Benefits of being the boss

Control over monetary policy is not something that Germany fought for but it came as a by-product of the Eurozone crisis that hobbled the other powers in Europe.  More prudent management of government finances meant that the government has less debt and the economy has been resilient due in part to its exporting prowess.  This left its Chancellor, Angela Merkel, as one of the few politicians who is backed by voters and in a strong position to dominate European politics.

It has allowed Germany to impose its own policy measures over the Eurozone.  Germany has set the tone regarding austerity as well as its concerns over inflation limiting the scope of monetary policy.  Countries such as Spain and Italy would benefit in the short term from more government spending and looser monetary policy.  But Germany has pushed for a range of policies which are a better fit for its own economy than others in Europe where the shortfall in demand is more pronounced.  The aim is to bring others into line in terms of implementing reforms which would improve the outlook for Europe in the future.

Along with setting policies, being the boss of a widely used currency comes with a host of benefits.  For starters, investors looking for the safest place to park their euros will choose Germany over other European countries and this keep down interest rates in Germany.  Worries about a sluggish economy in Europe are a further boost to Germany by keeping the value of the euro weak.  The euro is both too strong considering the economic circumstances of many of the countries in Europe but considerably below what a truly German currency (a new Deutsche Mark) could be valued at. 

Getting more from less

As is often the case, its power has become like a poisoned chalice.  Not only is Germany out of tune with many of its neighbours but the euro is also increasingly unpopular at home.  The rapid rise of an anti-euro party in Germany (called the Alternative for Germany party) suggests that there are many Germans who feel as if they are getting a raw deal from being part of the Eurozone.  This party joins a growing list of populist parties in Europe worried about the level of integration needed to maintain the euro. 

If a position of strength does not come with many rewards, sometimes more can be gained from giving power away.  Germany could soften its strict stance on fiscal and monetary policy as a trade for more reforms in other countries.  This bargain would help deal with the short-term issues of a weak economy needing stimulus as well as concerns about the prospects for Europe over the long term.  Compromise also seems more likely now that deflation is a growing threat and the German economy itself is flagging.  It is time for Germany to cash in now as it may be too late if the situation in Europe gets worse. 

Europe – finding a way out

Europe seems trapped with a sluggish economy but a way out may be close

Getting out of a hole that you have dug for yourself can be tough.  This is what Europe is struggling with as the Eurozone crisis seems to have passed only to be replaced with a slow strangling at the hands of deflation.  Infighting among politicians about the best way to deal with the economic stagnation in Europe has resulted in few reasons for hope of an escape.  Yet, this may change due to recent developments such as a flagging German economy and the rise of reform-minded governments in some countries.  Sometimes things need to get worse before a way out is possible and the situation in Europe may have finally got bad enough for positive change to occur.

An economic escape route…

An economic recovery is typically an automatic progress but may not always be easy.  Companies going bankrupt and workers losing their jobs cause considerable pain but is actually something that is good for the overall health of the economy.  A cull of weaker businesses provides more space for more successful firms to grow and prosper.  This process has the label of “creative destruction” in economic theory due to the idea of the old needing to give way for the new. 

In this way, economic growth returns after a recession as resources such as workers move to more productive uses.  The economy can grow faster as a result but a certain level of economic freedoms are needed to allow this to happen.  In this way, there is a trade-off between economic growth and the potential for instability.  It is not possible to have the former without the latter but any instability can be limited through controlling economic excesses (which often show up in the financial system).

Getting the balance right is not easy.  Companies in finance have been given too much leeway and created havoc as a result.  Yet, in other areas, businesses have been burdened with too many rules.  One example is regulation which makes it difficult for firms to fire workers.  This may seem like a good way of keeping people in jobs but such regulation has an adverse effect in that companies will not want to take on new workers if their employment is almost permanent.

… and the politics to make it happen

Many countries in Europe are in desperate need of policies to free up business from such regulation but implementation is often tricky.  At a time of rapid change, voters often crave stability of bygone eras that are no longer viable.  This does not stop populist parties making false promises to turn back time and dismissing the need for reforms.  It is heartening for the outlook in Europe that some countries such as Spain have made progress with its reforms.  Others such as France and Italy also have governments that are making the right noises in terms of reforms even if not actually putting new policies in place.

The lack of reforms has been preventing the recovery in Europe in other ways.  Germany, who has a firm grip on the reins of power in Europe, has stubbornly refused to offer much help to struggling European countries.  The reasoning behind this is that offering an easy way out would mean that these countries would not deal with the problems within their own economies.  The flip side is that, once reforms begin, Germany may be more accommodating in providing support. 

This opens up the possibility of a grand bargain, such as reforms as a trade for looser monetary policy and less focus on austerity.  More action from the central bank seems likely as the German economy is beginning to falter and genuine fears about deflation in Europe grow.  Its own weak economic growth and low inflation will highlight to the Germans that the problems are plaguing Europe as a whole rather than just individual problem countries.

Your Neighbourhood Economist penned this posting with comments from readers in mind.  Europe and the euro was seen as a lost cause by one reader while others have been annoyed that this blog always had to be so pessimistic.  Hopefully, this post will hopefully prove them wrong (but in a good way).

Monetary Policy – who to save?

Central banks have a host of people needing help in the economy but it may be those not yet in trouble that get priority

There are still many people struggling in the economy but the central bank does not know which of the victims to save.  Like a lifeguard having to decide which of a handful of struggling swimmers to save, central banks have some difficult choices.  Unemployment is falling but many people are still stuck in low paying jobs.  Inflation is low but fears are running high that loose monetary policy will inevitably see prices start to rise.  There is also potential for financial markets to go haywire considering all of the loose money around.  Yet, it seems as if central banks will deal with issues that have not yet arisen despite all of the people still in the water.

Monetary policy to the rescue

The global financial crisis has expanded the role of central banks.  No longer is inflation their sole concern as other issues such as unemployment or financial stability take on increasing importance.  Fulfilling one primary objective, keeping prices from rising too much, is much easier than achieving competing goals.  This was not a problem in the past as a weak economy created an overriding emphasis on shoring up the economy.  The improving situation in the UK and the US will push the Federal Reserve and the Bank of England into sorting out their priorities. 

A falling unemployment rate in both countries means that more people are being put to work.  This suggests that the economy might be close to reaching full capacity and inflation might follow as a result.  However, at the same time, wages are not rising which is what would be expected if firms are employing more workers.  Improvements in productivity have also been poor due to low level of business investment.  This is a problem as firms need to be more productive to pay higher wages and bigger pay packets are needed to boost consumer spending.

The uncertainty would suggest caution but there is one more issue worrying central banks – financial instability.  Low interest rates and printing of more cash through quantitative easing has not made much of a mark on the actual economy but has been a considerable boost to financial markets.  The prices of stocks continue to push relentlessly upward in many countries despite the cloudy economic outlook.  The mass of cheap money has also seen a boom in property prices in some countries.  The continuation of existing loose monetary policies can only result in these problems getting larger.

Saving us from the phantom menace

Central banks have to keep all of this in mind when setting policy.  Interest rates in particular should be raised sooner if fears about inflation or financial instability are given precedence.  But a weak economy may not be able to cope with higher interest rates and the job market might suffer.  Changes to interest rates will affect all of us in different ways but there will be both good and bad. 

We are all consumers so few of us would want to see a jump in inflation as we could not buy as much.  Most of us have a little bit stashed away in the bank or in our pension funds so higher interest rates and less volatility in financial markets will be helpful.  But it is the overall health of the economy that will be felt most keenly.  Economists, with an eye on the bigger picture, are worried about the threat from inflation and financial instability with many pushing for the central banks to respond according.

Yet, the concern is that higher interest rates will be used to deal with problems that exist on paper but not in reality.  Central banks will forsake those already in trouble to save people that are not yet drowning.  Some of the worries of economist might on exist in their theories.  Inflation is different now than in the past and has not caused trouble for decades.  There are also other ways of dealing with issues in finance rather than the blunt instrument of interest rates.   Better to deal with what actually is than what might be.

Deflation – déjà vu with a twist

Signs of deflation I have seen before start showing up in my neighbourhood but falling prices have been with us for a long time

Your Neighbourhood Economist has been getting a sense of déjà vu recently – to do with deflation.  My past experiences of falling prices come from years spent living in Japan and I am seeing the same things again in my neighbourhood in London.  Japan and deflation make for a scary combination considering that Japan is a byword for prolonged economic stagnation and poor policy choices.  But deflation may have already been lurking around unnoticed for a while. 

This looks familiar

The symptoms of déjà vu started with the fast food chains such as McDonald’s and KFC offering cheaper menu options.  This first started in London a few years back but it was a sign that consumers did not have much cash to spend.  It is a sorry state of affairs when even the least expensive places to eat out need to provide food with even lower prices to attract customers.  But it is the same tact that similar companies had adopted in Japan around a decade ago in the face of increasing price conscious consumers.

The other memory of deflation in Japan was from buying groceries at the supermarket.  The most notable place was shopping at my local 100 yen store (which is like a pound shop or a dollar shop).  While the prices of the products on the shelves did not change (obviously), there was a noticeable increase in the range of goods that could be brought for 100 yen.  The same trend is becoming more obvious in the UK in the success of discount supermarkets such as Lidl and Aldi.  To keep up, the mainstream supermarkets have been slashing prices but shoppers are still switching to their cheaper rivals. 

The only areas in the economy where prices are still rising are sectors where the pressures of price competition are less fierce.  UK companies such as energy providers or train operators function in imperfect markets where consumers have less choice and few other options.  Spending on energy or transport often cannot be avoided so companies do not have to try hard to sell their products.  As such, it is large energy bills and higher transport costs that are increasingly responsible for inflation.  With nowhere else to go, consumers have increasingly turned to the government to prove an answer despite there being little that politicians can do.

We live in deflationary times

Yet, for good or bad, this may be the new world that we live in now rather than just a temporary blip amid a slow economic recovery.  In a new global era, firms and consumers can scourge the world for the cheapest places to buy whatever they want.  This impacts what we buy off the shelves at our local store as well as what we can purchase off the internet.  Technology further aids this trend by providing information on what is on offer outside of our neighbourhoods and for what price.  And we are increasingly consuming services through the internet at cheaper rates than ever before.

This is great for us as consumers but the flipside is that companies in our local economies face growing pressures and will not be able to provide the same level of employment opportunities or pay the same wages as before.  This is a problem for governments who want their national economies to prosper.  Jobs are seen as the primary gauge of the health of the economy but boosting employment is tricky when competing on a global scale.

Here today and here tomorrow

Deflation is often seen as a problem in itself.  The standard economic theory goes that, if prices are falling, consumers will wait to spend as goods will be cheaper tomorrow.  Yet, globalization and technology are not something new and we have had downward pressure on prices for a long time.  Inflation has been low for the past few decades suggesting that deflation may have not been that far away.  It is perhaps only the voracious appetite for raw materials in China and elsewhere that pushed up global commodity prices and stopped deflation setting in sooner.    

If it has been around for so long, deflation by itself may not be so bad after all.  Yet, an overreaction by policy makers might be.  The European Central Bank seems set to ramp up its measures to fight off threats of deflation (and a morbid economy in Europe).  The central bank in Japan has launched a renewed onslaught against falling prices but to little avail.  Yet, the forces of globalization and technology cannot be reversed using just monetary policy.  Falling prices are something that may be with us for a while so it is better to get used to living with the potential for deflation and focus our efforts on other economic evils.

Quantitative Easing – Waiting while Europe Sinks

As Europe cries out for more action against deflation, the central bank must wait until the situation gets even worse

It would be strange to hold off saving people in a sinking ship until the ship is just about to go under, but this is how monetary policy works in Europe.  The situation in European grows continues to get worse as economic growth stagnates and deflation sets in.  Yet, the central bank cannot help, as it is hamstrung by politics, and must hold off until the cost of inaction is too high.  This means that Europe will have to take on a lot of water until a rescue package can eventually be put in place. 

Politics muddies the water

Monetary policy is tough enough in one country, let along for the 18 countries which use the euro.  The European Central Bank has acted boldly when given the chance.  It took a stand in 2012 stating that it was willing to do “whatever it takes” to save the Eurozone.  This was the lifeboat that saved Europe from collapse at a time when national governments were absorbed riding out wave after waves of turmoil.  But the European Central Bank was only free to jump in once it seemed as if Greece and other countries were about to let go of the euro. 

Despite a temporary reprieve, the economies of Europe have been like a listless ship with leaks.  Reforms have been put off in the hope that the worst is over and economic growth would return without any further encouragement.  Yet it is not a surprise that Europe is close to being sunk again but this time in slow motion.  The problem is the rules and regulations that get in the way of more efficient ways of doing business.  Economic growth cannot be seen as a given and government policies must allow resources to move to more productive uses.   

Such reforms tend to be unpopular as the costs are borne upfront while it takes time for the benefits to show.  So politicians in Europe have put off these measures as pleasing voters is proving tough enough as it is.  Instead, it has been easier to blame others and wait in the hope that economic growth will return.  This wait-and-see approach relies on the central bank to help out with the economy but this is beyond what the European Central Bank can achieve.

The politics behind the European Central Bank is made even more difficult in dealing due to some countries floundering more than others.  Amid all of the concerns about deflation, it is already a fact of life in some countries such as Greece and Spain.  Yet, even Europe as a whole is edging closer to deflation which is typically the symptom of a sluggish economy.  The fear is that deflation will create its own problems if falling prices prompt consumers to hold of spending in the hope for cheaper goods in the future.

Waiting until things get worse

The central bank has already responded to the threat of deflation through a policy of negative interest rates.  Quantitative easing, which has already been used (with limited success) in other countries, is the obvious choice to ramp up monetary policy.  This option has been kept off the table due to its potential to cause inflation which raises hackles among Germans.  Since any measures by the central bank could be deemed to be inflationary, Germany has used its influence to restrict the ability of the central bank to act. 

Yet, even the Germans will eventually have to see deflation as the greater threat.  But, at the same time, it is tough to gauge when too little inflation (or too much deflation) will be enough for a change of tack.  Germany has stuck to its guns since the outbreak of the Eurozone backed by an economy which had until recently remained buoyant.  So Europe is likely to get quantitative easing sometime (soon) and hopefully before the Eurozone is too far under water.