To Be or Not to Be ... a Member of the Eurozone?

In times of market turmoil such as these otherwise relevant and important news often get caught in the maelstrom of incoming data. Whether this is the case here I am not sure. In any event, I think that the following small snippet (the rest is behind the firewall) from the FT is rather important.

Slovakia has applied to join the eurozone next January, dismissing the concerns of some European central bankers and economists that its economy is not ready for the rigours of membership. If the application at the weekend is successful, Slovakia will become the sixteenth of the European Union’s 27 countries to adopt the euro. It will also be the second former communist country to do so, following Slovenia, which joined last year.

Ultimately this is a good piece of news if there ever was one. In a historical context the entry by the CEE and Baltic transition economies into the EU as well as Slovenia's and now potentially Slovakia's entry into Eurozone are all signs of economic development at work. However, as me and my colleague Edward Hugh have also been steadily arguing since the advent of the credit crisis in the summer of 2007 not everything is fine in the economic edifice of Eastern Europe; see this collection of blogs as well as the specific category here at Alpha.Sources. A dangerous mix of structurally broken population pyramids and excessive capital inflows have rendered many of the Eastern European economies particularly vulnerable to what potentially comes next in the global horror story of the credit crunch. However, time passes as they say, and even though Hungary definitively put any potential hopes and aspirations of Eurozone membership to rest by lifting the trading band on the Forint other Eastern European economies are clearly acting in expectation of a future open door into the league of Eurozone economies.

The inclusion of more countries into the Eurozone and the expansion of the EMU's reach inevitably coincides with what many commentators have coined as the collapse of the Dollar in the context of the subprime crisis which has the US economy moving steadily into a recession. There can be only one 'top-dog' currency and ever since the subprime crisis gripped the US housing and financial markets the Fed has been cutting rates to accommodate a faltering US economy. In the context of the global economic edifice of global imbalances and Bretton Woods II many commentators have during the past six months been revelling in the demise of the US economy and its currency. Especially, commentators and analysts have seen the moonshoot rally of the Euro as a decisive sign that things were changing in the global economy. Things are indeed changing. However, I have always been skeptical of the claims by the proponents of the original and hard variant of de-coupling and global re-balancing. This is the discourse where the Eurozone economy ascends to take over from the US proxied by a continuous hawkish stance by the ECB thus paving the way for a widening interest rate differential in favor of the Eurozone where the Euro as a result becomes the vessel for re-balancing. This is obviously what we are currently observing but I also think that any serious economic analyst at this point needs to take a long hard look at the incoming data from the Eurozone which does not exactly has de-coupling written all over it. For more economic data on the Eurozone this aggregate list of blogs should be useful.

The US economy, the Fed and the financial system it oversees have thus indeed taken a lot of flak in recent months. Yet, where there is a thesis there is also an anti-thesis.

Pick your motive; perhaps it was to aid the struggling buck or perhaps it was to bolster investors' confidence in US capital markets, I am not sure. In any event, US economist Barry Eichengreen alongside Marc Flandreau recently sported a commentary in the FT about why the Euro is not very likely to beat down the Dollar as the main global currency. The heat was turned up another nudge in Forbes a couple of days ago when Avi Tiomkin even spoke about the demise of the Euro musing the rather ridiculous claim that the Eurozone would cease to exist within 3 years. Common to the arguments on both sides of the dividing line in this Eurozone vs US debate is that the debate often is reduced to a dirty and poorly played football match without the flare and details of clever and well thought arguments. Eichengreen et al's piece is not that bad actually as it centers on a rather technical argument about the nature of international central bank reserves in the 21st century. However, Tiomkin makes some outright silly claims. One is of course the prediction of the Eurozone's implosion within 3 years; it could happen of course but staying within the realms of probable scenarios I think we need to be a bit more ... well, clever. He also, and this is a common mistake, tries to draw a false dichotomy between the Eurozone countries as he says;

"(...) an inflation-obsessed German bloc (including Austria, Luxembourg and the Netherlands) and the Latin bloc of France, Italy and Spain."

This is nonsense. France is not Latino and certainly not part of Southern Europe and more importantly I think that this idea of an inflation obsessed Germany may soon need to be revised on the back of a steady but certain slowdown. In short, what we are seeing here is an attempt to paint a picture of the Eurozone which is not adequate. Also his advice for investors also seem every bit as alarmist as those who recently have claimed US risky assets should be dumped and never bought again. In fact, the main puzzle at the moment seems to be the purchasing of the presumed US risk-free assets given the negative real return on these instruments (oh yes, the bond conundrum lives).

So, as I take the self-proclaimed 'high ground' here in this football match between Euro and US centrists am I then really devoid of an actual opinion on this? Of course not and besides, I always was a sucker for a nice football match. In essence, I think that all this is very natural. There has a been a lot of mud throwing from European commentators and now many think that they should give a little back. Unfortunately, for analytical and serious purposes this football match discourse is not very useful.

However, and as they say in that wonderful European country ca bouge. Essentially, we have talked about all this in the context of Italy before and whether one or more countries would be 'forced' to leave the Eurozone given the underlying structural weaknesses of one country relative to another. The theoretical economic argument for this is also quite straight forward. The Eurozone economy was never one single economy and the merits on which the economic edifice was built in the first place always looked a bit shaky. You see, the one-size fits all interest rate policy practiced by the ECB with inflation targeting as a the holy grail was always meant to bring the economies closer together. Yet in fact, that has not been the case and in order to explain why we need to look at divergent demographics as well as divergent institutional setups. In this way and in the current context I don't think it was ever a question of whether the Eurozone would self implode or anything but given the fact that the ECB has chosen to play the 're-active' game vis-รก-vis the rising EUR/USD and thus de-coupling potential it may end up with a lot of egg on its face. And why might I be saying this then? Well, I do think that Tiomkin has something right. In particular I believe, given the bind in which the ECB finds itself as inflation is set to linger well into the coming cyclical downturn, that the result may well be for some Eurozone economies to drift even further from each other. Additionally, what we have on our hands in Italy and Spain is a serious risk for a backdrop into deflation once we get further into slowdown. This is dangerous politically. Obviously, I think that Germany may soon move towards an inclination for lower interest rates too, but that could even be politicised too since why should the ECB cater more for Germany than the rest? Well, if you think about the way they look at the aggregate data it is of course not that difficult to see. I have always thought that since Italy was clearly the first to fall in the ranks the ECB would need to knit together some kind of special arrangement. In fact, in my analyses of the Eurozone economy I have implicitly been working with the inbuilt assumption that an internal 'memo' was circulating within the ECB for Italy to have a spell with deflation before things would brighten up. On this I have also always been very skeptical by the merits of such ideas since the experience from Japan suggests that once a rapidly ageing economy with an already high median age runs into deflation it is very difficult to escape. Moreover, if Spain also now thunders down they (the ECB and the EU) may really have put themselves in a bind. Remember here that Spain was originally one of the old cohesion countries and my guess is that we could see all kind of political ghosts re-emerge when the new reality is clear in Spain. Remember also that the whole idea with the Eurozone was for the 'new' members to converge steadily and not the boom/bust we are likely to observe in Spain. Clearly, if the US emerges in the second half of 2008 with the Eurozone going further down (i.e. reverse re-coupling) the problem could really be piling onto the ECB's table.

Having engaged somewhat in the aforementioned football match do I emerge untarnished? Probably not. But I still maintain that we need to remove ourselves from the US vs Eurozone discussion since it does not get us anywhere in terms of comprehensive arguments. Personally, I am sceptical towards the functioning of the Eurozone as I have explained above. However, I do not see any kind of collapse or implosion; far from it. What we need to understand is that the Eurozone is not one single economy and that this fact is the prime source of the predicament. Yet, this does not necessarily mean that the system will collapse but it does point to tremendous challenges in the future. The Eurozone could very well look different in the future but the ECB and the EU do have something to say if they play their cards properly. At the moment I feel they (the ECB) may be bending the stick too much in one direction by not lowering the short term nominal rate. But I also agree that this is a dilemma if there ever was one since the hallmark of a central bank is its inflation fighting credentials something which the ECB has certainly solidified since the credit turmoil began. It will be a long and hard climb down that horse for Trichet et al.