The euro project has not gone according to plan. It reminds me of the story of the James Bond character Q, based on the British intelligence officer Charles Fraser-Smith. It was he who invented a compass for spies hidden in a button that unscrewed clockwise. The contraption was based on the simple yet brilliant theory that the unswerving logic of the German mind would never guess that something might unscrew the wrong way. This is really what happened with the euro. New member states were supposed to take lower German interest rates and invest their resources wisely to improve and deepen their productive capacity. Instead, they used the advantage to finance speculative asset bubbles. The peripheral nations of Europe turned the wrong way. The Germans are unhappy.
But, desperate to cling to monetary union, the other European sovereigns have opted to default on their spending promises to voters rather than impose a haircut on their financial creditors. In the 1920s the pay-off structure had been very different. The first world war took an intolerable toll on the typical household both in terms of the loss of life and financial well-being; everyone had become poorer. Accordingly, there was little willingness on the part of the ruling political class to force austerity measures to redress the fiscal imbalances. The people had suffered long enough. Consequently, there was much procrastination and fiscal deficits persisted way beyond the end of the war, making capital markets reluctant to accept the waning security of government paper and forcing the sovereign to rely on the central bank’s printing press.
This time around, however, the political class has concluded that the Greeks (especially the Greeks!) and the other peripheral states have done so well off the back of the euro project that it is their turn to shoulder the burden. They calculate that the social pain would be less severe than the financial costs of a debt default and/or a euro exit. Of course, this is to neglect the financial consequences of bailing out the financial sector in 2008 and its ensuing impact on the ordinary household. Can an analogy be drawn between the first world war and the banking bail-out? Certainly both events had a disastrous impact on the sovereign fiscal balance. Consequently the social mood has darkened considerably. Emotions run high and the term speculator has even become pejorative. Today’s non-financial media are clearly of the opinion that the people have suffered enough.
Ireland is indicative of the social pain. Nominal incomes have already fallen substantially and the working population has endured severe job losses and wage cuts. Their reward is a second austerity package. The average household is now being asked to pay additional taxes, minimum wages are to be cut further and more job losses are a virtual certainty. The country itself is only held together by the premise that the economy will grow by 2.75 per cent a year for the next four years. Dream on.
I believe the European bureaucrats have badly misjudged the public mood. Perhaps they are too closely aligned with the plutocracy of the financial and banking sector. Contrast the mood of the ordinary household with that of my rich hedge fund friends. Today the average European long/short fund is running its most bullish risk exposure in many years and is feeling ebullient regarding the rising tide of corporate profitability as businesses pare back employment levels. My grumble is that I suspect the omnipotent powers of my peers’ central bankers might be found wanting just when they are needed most.
For the shadow of policy error lurks once more. The European Central Bank’s president even proclaimed his satisfaction with his bank’s decision to raise rates back in the cauldron month of July 2008. I salute him for his willingness to subject the bank’s decisions to open scrutiny. But tightening monetary policy amid the deepest economic crisis of the past 50 years was perhaps not his institution’s finest hour. And with headline inflation rates being boosted by relative price rises in the commodity sector, as Chinese policymakers continue to plug 10 per cent into their GDP calculators, another poorly-timed rise in European rates cannot be so easily dismissed.
The markets are already pricing in the near certainty of a quarter-point rise from the Bank of England by May with another increase expected before October. But perhaps not wanting to be left out, the zealous guardians of Europe’s monetary system, who measure inflation rates across the 17-country bloc to the second decimal point, have recently raised their rhetoric to such an extent that investors are openly speculating that in spite of the continent’s tight fiscal policy European rates are now likely to rise before the end of summer. As they say in the land of macro investing, the cycle isn’t over until the Europeans lift rates. Just don’t bet on money staying tight for long.
Hugh Hendry is chief investment officer and founding partner of Eclectica Asset Management
via FT.com print article.