Ireland Takes One for Germany

Here's Ambrose Evans-Pritchard at his gloomy, apocalyptic best describing the danger of Ireland falling into a debt deflation cycle not seen since the 1930s. As Evans-Pritchard notes, the most tragic part of this slow-motion trainwreck is that it does not have to happen: if the ECB aggressively cut rates, and Ireland had monetary sovereignty to devalue its currency, then they could perhaps settle for a lost decade instead of an outright depression. Unfortunately for the Celts, the Germans exert de facto control over the ECB, and the Germans are far too worried about the potential inflationary pressures of quantitative easing to pursue such heterodox monetary policies. Apparently memories of needing a wheelbarrow of cash to pay for a loaf of bread scar a nation's collective psyche for generations. From the Telegraph:

If Ireland still controlled the levers of economic policy, it would have slashed interest rates to near zero to prevent a property collapse from destroying the banking system.

The Irish central bank would be a founder member of the "money printing" club, leading the way towards quantitative easing a l'outrance.

Irish bond yields would not be soaring into the stratosphere. The central bank would be crushing the yields with a sledge-hammer, just as the Fed and the Bank of England are crushing yields on US Treasuries and gilts.

Dublin would be smiling quietly as the Irish exchange rate fell a third to reflect the reality of trade ties to Sterling and the dollar zone....

Brian Lenihan, Ireland's finance minister, said the economy would contract 8pc this year on top of the terrifying 7.1pc drop in the final quarter of last year.

But what caught my ear was his throw-away comment that prices would fall 4pc, which is to admit that Ireland is spiralling into the most extreme deflation in any country since the early 1930s. Or put another way, "real" interest rates are rocketing.

This is torture for a debtors' economy. You can survive deflation; you can survive debt; but Irving Fisher taught us in his 1933 treatise "Debt Deflation causes of Great Depressions" that the two together will eat you alive.

Don't blame the victim. Ireland has been betrayed twice in this saga. Once by New Labour, which led Dublin to believe that Britain would join EMU at the same time – covering Ireland's dangerously exposed flank of Sterling trade.

It was betrayed again by the European Central Bank, which opened the monetary floodgates early this decade to nurse Germany through a slump, holding rates at 2pc until late 2005, despite flagrant breach of the ECB's own M3 money targets. Fast-growing Ireland and the Club Med over-heaters were sacrificed to help Germany. They were left to cope with credit bubbles as best they could.

Ireland struggled. Construction reached 21pc of GDP – a world record? – compared with 11pc in the US at the peak. Mr Lenihan hopes to shield banks from the calamitous consequences by creating a buffer agency. It will soak up €80bn to €90bn in toxic debt – or 50pc of GDP.
He borrowed the plan from Sweden's bank rescues in the early 1990s, but overlooks the key point – it was not the bail-out that saved Sweden's financial system, the country recovered only by ditching its exchange peg and regaining its freedom of action.

Without that sort of liberation, Ireland's property slump will grind on for years and more multinationals will join Dell in decamping to cheaper plants in Poland. Ireland risks a deflationary slide into bankruptcy.

Of course, it is not the job of the ECB to set policy for Dublin's needs. But it would at least help if Frankfurt began to set policy for Europe's needs. Has the ECB noticed the collapse of industrial output in Spain (-24pc), Germany (-23pc), Italy (-21pc), France (-14pc)?

If Europe fell into depression, would the ECB notice? Don't answer.

Switzerland Falls Into Deflation

As Ambrose Evans-Pritchard notes, Switzerland is the latest country to join the deflation club. Swiss CPI fell 0.4% in March on a year-on-year basis, and is projected to fall to -1% by July. The Swiss franc's status as a currency safe haven has exacerbated this downward pressure, as the franc has gained value, driving the value of imports down, and hence forcing domestic goods to become cheaper as well in order to compete. The Swiss National Bank (SNB) has promised to aggressively move to lower the exchange rate to counter this threat, raising the specter of competitive devaluations. Evans-Pritchard explains:

Yet even the SNB's hard men have thrown away the rule book, taking emergency action to force down the exchange rate of the Swiss franc.

Here lies the danger. If other countries try to export deflation by this means, we will face a second phase of the global crisis. Taiwan is already devaluing. Korea, Singapore, and Sweden all seem tempted to follow. Japan is chomping at the bit.

"We don't fully realise in the West what a catastrophic collapse Japan has suffered," says Albert Edwards, global strategist at Société Générale. "The West has dumped a large part of its economic downturn onto Japan by devaluing against the yen."
This is about to go into reverse as Tokyo hits the ping-pong ball back across the net. "As the unfolding collapse in the yen gathers pace, the West will see its green shoots incinerated to dust," he said.

By devaluing, a country makes imports more expensive, pushing up prices across the economy. There is a concomitant fall in prices abroad, as the country's exports become cheaper, pushing down prices with its trading partners. But this only works if it is pursued individually. If a host of countries try to gain a competitive advantage by devaluing, then there is a race to bottom that nobody wins. Relative prices between exports and imports remain the same, while the prices of real assets - commoditites, real estate, and stocks - jump. This is a path towards mutual ruin. Because wages are sticky, households will find it harder and harder to pay for the basics of housing and energy.

Will world leaders - particularly from trade surplus countries where there is an incentive to export troubles away - be able to organize the type of collective action necessary to avert such disaster? Not likely.

And Now Some Good News...

This was our last chance. So warned George Soros and Ambrose Evans-Pritchard in rather apocalyptic exhortations to world leaders on the eve of the G20 Summit. According to Soros

If the G20 is nothing but a talking shop then he thinks we are heading for meltdown. “That could push the world into depression. It’s really a make-or-break occasion. That’s why it’s so important.” The chances of a depression are, he says, “quite high” – even if that is averted, the recession will last a long time. “Look, we are not going back to where we came from. In that sense it’s going to last for ever."

With that in mind, the happy news that the G20 actually produced meaningful action on increased funding for the IMF and trade credits, as well as a commitment to crack down on tax havens is especially heartening. World leaders woke up and realized that letting emerging markets go bust - particularly in Eastern Europe - would likely lead to a new round of financial contagion in core countries. There is hope we can avoid a global lost decade.

Highway To Hell

What do you do if your neo-Hooverite policies get you booted from office? If you're ex-Czech Prime Minister Mirek Topolanek, you take some inspiration from AC/DC, and claim Keynsian fiscal policy is a "road to hell". From the New York Times:

“AC/DC played here last week,” Mr. Topolanek told the daily Lidové Noviny. “And their cult song ‘Highway to Hell’ might have led me in that very improvised speech to use the phrase ‘road to hell’.” According to the Czech newspaper, Mr. Topolanek’s prepared remarks included the less resonant phrase “the way to destruction.”

On a more serious note, Prime Minister Topolanek's evocation of Keynsian as a road to perdition speaks to the reticence of many European countries to run up more debt when their debt-to-GDP ratios are at generally higher starting points than the United States. But if this slump persists and European governments stick to their fiscal austerity, the crisis could take on a new political dimension, with governments falling, and perhaps resorting to protectionist measures. As Ambrose Evans-Pritchard reports

the Czech crisis has unnerved investors even more because the country has been seen as a rock of stability. It kept a tight rein on credit and avoided the stampede into euro and Swiss franc mortgages that occurred in other parts of Eastern Europe.

The fate of premier Mirek Topolanek – toppled in the middle of the Czech Republic's EU presidency – shows how fast the crisis is moving from finance into the core economy. Czech industrial output fell 23pc in January as car plants moth-balled production lines.

"This is the next leg of the crisis," said Neil Shearing from Capital Economics. "We're seeing the political backlash as this spreads into the labour market. The risk is that we will see a move to populist nationalism in some countries. That could prove dangerous."

So far we have not seen the type of rabidly nationalistic or xenophobic extremist parties gain power in Eastern Europe as did in interwar Europe during the Great Depression. Hopefully, we will be wise enough to avoid repeating that chapter in history.