Wednesday, January 14, 2015

The European Economic Permafrost: Why QE Won't Work

For those of you who haven't heard yet, the eurozone crisis is back. Although at this point, I'm not sure if "Eurozone crisis" is the right term anymore. In my opinion, a more appropriate term might be "The european economic permafrost".

A permafrost, for those of you unfamiliar, is when the ground stays frozen all year round. This happens in areas close to the Poles (think; northern Canada, Siberia, Greenland etc). It's not that these places don't have seasons - the temperature does go up in the summer in Siberia as well - it's just that the weather never stays warm for long enough for the ground to really thaw beyond the surface (according to wikipedia, the upper 3-6 ft of soil may thaw in the summer, but anything deeper than that remains frozen).

This is an accurate analogue for the state of Europe's economy: It's not that we don't have "seasons", that is, economic cycles - it's just that the booms don't last long enough and never get hot enough to reach beyond the "surface" - that is, the very rich who rake in profits from the stock market. 

Greece is set to hold a snap election on the 25th of January. Current opinion polls show the radical-left party SYRIZA with a comfortable stable lead (between 2.8-8 % in the past week depending on who's polling). This is a party that has pretty much promised to put Greece in default if elected - more specifically, they are going to demand a renegotiation of Greece's government debt, something Germany and really everyone else who provided Greece with emergency bailout loans really cannot allow. Not mainly for financial reasons, but because politically it would be impossible to grant debt forgiveness to Greece without a massive backlash from a Eurosceptic public that is already plenty tired of the Greeks. 

In addition to the debt restructuring, SYRIZA promises massive increases in public spending. If this seems like a strange combo, it's because it is: Restructuring debt is not the kind of thing that gives lenders confidence in you. If SYRIZA were to fail to convince the EU to let them off the hook with some of their debt, then they will have to convince private investors to lend money to their country, even though they've already admitted themselves that they have more debt than they can possibly afford (hence why they want a restructuring). 

Analysts have widely concluded that SYRIZA is irresponsible, something I fully agree with. They have also concluded that Greece is better off inside the Eurozone, and that the key to saving both the Greek and Europe's economy as a whole is to unleash quantitative easing. If only it weren't for those stubborn Germans, they reason, the Greeks wouldn't have to turn to extremists like SYRIZA.

I disagree with both these conclusions. 

Let's start with the first one: The idea that Greece is better off inside the Eurozone is based on predictions that Greece leaving the Eurozone would cause massive capital flight as investors would flee before their money was converted into (very much devalued) drachma. That's certainly true, but people forget that the pain caused by capital flight is only in the short term, until the drachma is reintroduced and has a stable exchange rate (which, with reasonable monetary policies, shouldn't take too long). 

Analysts have completely forgotten about the medium and the long turn. Here's the problem for Greece: They have a tourist-dependant economy, but they don't really offer anything unique that no-one else in the mediterranean doesn't offer, and they are twice as expensive as their main competitor - which happens to be neighboring Turkey. It is the last problem that would be solved with a return to drachma, as with it, Greece would once again have a cheap currency and be able to steal tourists not only from Greece but also Spain & Italy, two other tourist destinations that are now more expensive since they joined the euro. This would cause an influx of capital, at least partly offsetting the initial outflow.

Those who believe that Greece is better off inside the eurozone are under the false belief that things are going to be alright in the end. After all, the economy always recovers, sooner or later. 

Maybe. But what if the boom that follows the recession isn't long enough to return the country to anything remotely close to full employment? Greece's unemployment rate is 25 %. Even if the economy were to go full speed ahead from now on, we're talking anything from one to two decades until the unemployment rate can possibly be described as low. And here's the thing: It's very unlikely that we'll suddenly get a decades-long period of economic expansion. The last boom only lasted for about six years or so, and that's a pretty normal length. What this means is that it's quite likely that when the next recession begins, Greece's unemployment rate is still going to be above 15 %.

Simply put, Greece is stuck in the permafrost - a permanent state of economic winter, where the summertimes are never long enough to compensate for the brutal winters. 

The Alaskan tundra. Still hotter than Europe's economy.
The Alaskan tundra. Still hotter than Europe's economy.
Now you may be asking; even if Greece hasn't fully recovered by the next recession, so what? What is to say that the next recession won't be just a tiny speedbump like the relatively mild recession that occurred when the dotcom bubble burst in the year 2000? 

The problem is that the Eurozone is virtually designed to ensure that every minor downturn turns into an economic disaster. With no monetary devaluation available as a tool for member states, a member state that needs to regain competitiveness (such as Greece) is forced to use real devaluation - an economic term that in english means; cut salaries. This has to be happen during every recession, and every time it does, it is likely to produce strikes, civil unrest, rising support for extremist parties (particularly bad if it coincides with elections) and so on. This is not temporary; this is the permanent state of the Eurozone, by design. 

This may sound like a problem that could be solved by the ECB devaluing the euro when one of the member countries fall into recession. However, the question is always "by how much" - not all countries in the eurozone will be in recession at the same time, and not all of them will experience equally big recessions at the same time. If we devalue enough to help the worst hit countries (in this case Greece & Spain), this will produce massive credit bubbles in the rest of Europe, not to mention cause extreme spikes in the prices of imported goods - something that is unlikely to be popular in the countries that are not so badly hit by the recession. On the other hand, a light devaluation enough to lift the least-hit countries out of the slump would not be enough to help the worst off, and they would then have to resort to wage cuts and other forms of austerity (financing a stimulus program with deficit spending is going to be impossible for the foreseeable future due to huge government debt).

A quantitative easing program is not going to change that. While QE in the United States has been considered a success, it is worth noting that wage growth is still dismal and that despite the falling unemployment rate, the labor participation rate is still getting worse. See, QE is great for driving down interest rates and creating a stock market boom, but when it comes to helping everyday people, it's not much use. And those are the people who need help in Europe. Also, interest rates are already very low, rendering the positive effect from QE even smaller.

In fact, I believe that the main reason the ECB has held off on QE is because they fear that it won't work, or at least not work as well as people expect. As things are now, whenever the stock market takes a dive the ECB can simply issue a press release or make a statement implying that they are considering QE and it will shoot back up. 

What if the ECB launches QE and it doesn't work? I honestly believe that may cause panic. Once it becomes clear to investors that the eurozone is stuck in an economic permafrost from which printing presses cannot save it, they may very well end up effectively pulling the plug on the entire euro project. That's not all though - once the ECB is officially out of options, a lot of the people who have so far waited patiently for a recovery are going to say "enough is enough" and emigrate.

We should also expect the trend of radical left parties winning elections to continue; Spain, Ireland and France are three other countries where the radical left is making progress. It has become painfully obvious that the establishment has no idea how to counter these parties. I believe that in order to stop these parties, we need a conservative countermovement that stands up for the nationstates and for every people's right to govern their own country. Such a movement can present an alternative vision for the future, something the establishment has failed to do. 

Ultimately, the Eurozone project must be dissolved so that the member states will be free to design their own solutions to their own problems. But until that happens, my advice (to paraphrase Eddard Stark) is this: Brace yourself. Winter is staying.

John Gustavsson

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