[Cross posted at
Bopnews.com]
Europe's Central Banks are under pressure to cut interest rates. This comes because their economies in, or trundling towards, or hovering above recession.
In December of last year I urged Europeans to tak dramatic action to deal with the current currency misalignment. In March, I warned that a failure to pass the European constitution would lead to a cracking of monetary discipline. I argued that it would only be through the European Union that fiscal stimulus to hold the line would be possible.
With the failure of the European constitution, the sad, but predictable, result is occuring: every man for himself policies. Chirac of France - perhaps the worst major world leader not named "George" - tried to nakedly manipulate the budget to save his own political coalition - it was a savage low point. Also as expected the "liberalising" forces are now pressing for a thorough budget revision and for the dumping of the social system. The harvest of non is a Europe that can't say no anymore to the Dark pole of inflationary policy from the US.
We've been here before.
It must be emphasized that all of what is about to happen is optional pain. It was entirely possible for other policy paths to be taken, but, at this point it there are no exits.
What is going to happen?
The world currency system rests on oil, and most specifically light oil. This is not because there aren't other ways to make a profit, but oil is connected directly to rent. It allows the global housing bubble to occur - and it does not require an industrial economy to make industrial level profits from it. No commodity is like oil in producing so much profit without having a technological society attached to it.
The dollar is the predominant currency because oil is priced in dollars. Oil is priced in dollars because the US is both the largest consumer of oil, and the military force that protects the stability of access to oil. Those predicting that the Euro would become a "reserve currency" were, in effect, predicting that the European Union would begin to be able to protect the world's supplies of oil, or provide a counter-policy to Bush's militarism - and they were predicting that Europe, by producing a Euro-dearth in the middle east, could hold their energy prices stable while the US devalued.
It was a reasonable bet. However, the signs in February were that it had failed. The Euro will remain a hedge against the dollar - we aren't seeing a dollar buy 1.20 euros any time soon - there is now one pole of monetary policy, and that is the dollar.
In macro-economic theory there are three ways to stimulate an economy. One is monetary policy: lower interest rates and increase the monetary supply. This increases the velocity of money and the supply of money. However, it also increases inflationary pressures. If your economy has problems with inflation, monetary policy no longer is acceptable. If the source of inflationary pressure is exogenous competition - as it is with Europe's need for energy - monetary policy cannot be eased without generating inflation.
Which brings us to fiscal policy. The second way is to produce highly targetted spending to cool the hot areas of an economy, and warm the cold ones. In Europe a few areas are growing very rapidly, because the cost of land and wages are low there. Ireland and Spain are the hot corners of the European economy, as they attract investment and business. The individual states of Europe are limited by Maastricht in how much they can use fiscal stimulus, and it would not have helped very much. A single currency really, in the end, requires a single fiscal authority,
WIth the failure of the EU constitution, this unified budget approach will not happen, because there is no lever to make it happen. Without a constitutional process to put countries in the position of being willing to defer present gain in order to get into the EU, they will, instead, try and use the EU budget strictly as a way of solving their own problems.
This leaves one last means of stimulating economies: reducing regulation and liberalisation. There are two ways to do this. One is to lower regulation and therefore reduce prices in the present. For example, cleaner burning gasoline costs about 30 cents a gallon. If you are willing to allow people to externalize the cost of dirty air, the costs go down in the present. Not all regulations are good - many are foolish, out dated or obsolete. But most regulations exist because someone cheated, and a rule was put in place to prevent it from happening again. Regulatory reform of the "reducing red tape" kind can generate wins, but they are almost never as large as people think. Business reengineering in the private sector generally gets about 10% reduction in labor process costs, which generally means about 1% of total costs. This is nothing to sneeze at, but absent an EU process, hard to do.
Another way to use liberalization is to export more: focus more people on selling more abroad. This increases exports - but it only helps if those exports are generated without increasing inflationary pressure on what is imported. Since inflationary pressure is hitting Europe from resource imports, exporting more will have a rapidly diminishing return: the more Europe exports, the more it places inflationary pressure on resources and energy.
In short, the macro-stimulus curve from exporting gets less and less bang for the buck in the short term. It generally takes about 7 to 8 years to make up the GDP by shifting to exporting. Unless there is an untapped export market, this does not solve short term problems.
Liberalization can also be used to lower import barriers. This will provide stimulus by lowering prices. Europe is dropping barriers to agricultural goods, and considering opening up the extremely lucrative sugar market. This is problematic in that it produces local losers - those who produced whatever it was at higher prices - and puts pressure on budgets, since along with their jobs, go the ability to tax the manufacture of whatever it was. One loses the income and VAT taxes, and gains only the taxes on corporate profits. This means that while the economy as a whole is better off, labor is generally worse off, since it loses both income and benefits, and corporate profits take up much of the import surplus generated.
The final way of using liberalization is to equitize. This is the most controversial use of liberalization, but it is also the one where there are the largest immediate currency wins. Take something which the government does, privatize it. This allows equities to be sold based on the revenue stream. This means that not only is no inflationary pressure from competition over bottleneck resources, so long as people are willing to just get less, there might be no macro-price inflation at all, though there will be "real" inflation.
The equitization of public functions - selling off roads, health care systems and so on - can be done without a European wide system. If done by one large country, it will eventually force the others to follow suit - as they will get "health immigrants" who will push the cost on to the more generous systems. Paradoxically, Thatcherization rewards the stingy.
This is what there is going to be increasing pressure on European governments to do - regardless of the fact that the European public doesn't want it. However, the European public doesn't want unity and it doesn't want unemployment - and they have voted against unity recently, and are about to have an election in Germany over unemployment. If Schröëder falls, there will be a thatcherization consensus among the UK, France and Germany - and it will be very hard to stop.
In short, the only easy roads out of Europe's current economic slowdown are inflationary - either macro-inflationary in easing interest rates, which Trichet is loath to do, but the BoE will do. Or real inflationary through thatcherization. This is, quite literally, a blood for oil deal, but there are no other options at this point for a disunified Europe.
The inflationary pole policy has happened before - in the early 1970's, in order to climbe out of the 1969-1970 recession, Nixon began a policy of excessively rapid easy. He also began to lift import restrictions on oil, and this produced a run on the gold stocks of the United States. Countries could no longer use "oil arbitrage" to buy oil, manufacture it into goods to sell to the US, and pocket the dollars. As a result, they dumped dollars for gold as a way of solving their own fiscal problems.
The disintegration of global monetary discipline would contribute to the financial instabilities of the 1970s, and the rise of reactionary government.
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This means that the current trade order is on a death march. The three countries that benefit the most from it - China, The US and Saudi Arabia are soaking up virtually all of the benefits from it. The rest go to a few active hotspots, and to resource producers.
However, there is a problem, and that is that inflation in energy hits at the basis for the monetary order. Remember above how I talked about oil being attached to rent? Let's look at that.
In the 1970's oil was largely about manufacturing. Spikes in cost moved manufacturing off of petroleum, other ways of doing things were found, or ways of using much lower grades of oil were found. But what happened is that transportation consumed most of the savings from increased industrial efficiency.
On one hand this has meant that the US economy has been much more resistent to high energy prices than before. Why is this? Because when energy meant higher prices for goods, people could not borrow the money, so they pushed for higher wages immediately, or became two earner families. When the inflation is houses, people simply borrow more. With US interest rates still at "easier than a drunk sorority girl", banks had every incentive to lend, even if it wasn't wise.
But this does not mean that there will be no day of reckoning, it merely means that, like the 1920's, which is the last time the world made a big bet on the spread between nominal and real inflation - the reckoning, when it comes, will be much uglier than people expect.
This is because the great economic disasters are coupled with political disaster. At that point where people feel their reality is too divorced from that of policy - which is exactly what the spread between real and nominal inflation is, how much different the paper economy looks from the real one - they give up, they cease to particpate, and this produces both a demand shock, and a money supply shock.
The last exit for a controlled realignment of currencies is past, the next stop is for one or more currencies to dramatically fall, and with them the purchasing power of the people inside the currency zone. Bush-Greenspan are betting that this will be Europe, that the Euro and other European currencies will meltdown as its central banks lower interest rates, allowing the US to continue buying oil on borrowed money from the Asian central banks.
But this scenario, while possible, is hardly the only one. The other very likely scenario is that China is going to begin to use its massive dollar reserves to purchase Key US assets. For example, oil companies. In this scenario - which I subscribe to - the Chinese will continue to rev up the economy, work to gain access to oil supplies, and export even more to the US.
As long as the US consumer is living beyond his means, there is no reason for the oil producers and for China, to wake them from that slumber until it is far too late to turn back. It shouldn't take too much to point out that the current US policy of using inflation to tax Europe to pay for Iraq and tax cuts is, in the not very long run, short sighted, because OPEC and China do not have their long term interests aligned with the US, where as Europe, until recently, did.
