A Deflationary Vortex

¹²Stress-Testing Europe's Banks Won't Stave Off A Deflationary Vortex

Euroland's authorities are inflicting a triple shock of fiscal, monetary, and currency tightening on a broken economy. They are doing so in a region where industrial output is still 14% below its peak, where growth barely scraped above zero over the winter "recovery", and where youth unemployment is at 40% in Spain, 35% in Slovakia, 29% in Italy, and 26% in Ireland.

By Ambrose Evans-Pritchard | 18 July 2010

They seem unaware that China is slowing and the US is tipping into a second leg of the Long Slump. Last week's collapse in America's ECRI leading indicator to -9.8 [[to -10.5 this week: normxxx]] marks the end of the V-shaped rebound. If this means what it normally means— recession within three months— Europe must take immediate action to prevent being drawn into a deflationary vortex. Spiralling public debt precludes further Keynesian spending, so this must come from central bank stimulus. Tight fiscal policy offset by ultra-loose money is the only option for Europe, the US, and Japan.

No student of Milton Friedman is surprised by the US relapse. The Fed has allowed M3 money to contract at a 10% pace for much of this year— the Great Depression rate. The economy has hit the wall with the usual lag. Textbook stuff. Never ignore the quantity theory of money.

The US Conference Board's indicator is not yet flashing a red alert, but that is because it gives weight to "yield curve inversion", where long rates fall below short rates. This indicator is meaningless in a Japan-style bust where policy rates are zero. I suspect that Fed chair Ben Bernanke knows the economy buckled around the Ides of June, but is stymied by hawks at the regional Feds.

All he can do for now is to talk down credit costs through hints of more quantitative easing, or QE2. In this he has succeeded. The yield on two-year Treasuries fell to an all-time low of 0.5765% on Friday. It's Weimar, all right: circa 1931, not 1923.

So what is the European Central Bank doing to prevent southern Europe asphyxiating from debt-deflation, and knowing that M3 contracted in February (-0.3%), March (-0.1%), April (-0.2%) and May (-0.2%)? It is tightening, as it did in mid-2008 [[just before the gargantuan crash of that year: normxxx]] when the eurozone was already tanking. Far from taking steps to offset Club Med austerity, it is winding down its €60bn (£50bn) purchase of government bonds— "sterilized" in any case to prevent net stimulus. It is draining liquidity fast; the ECB's loans to credit institutions fell from €870bn to €635bn in the two weeks to July 9.

"This is the equivalent in central banking of the Charge of the Light Brigade," said Tim Congdon from International Monetary Research. Cash reserves in the interbank market have fallen by a third in days. No wonder three-month Euribor (the stress gauge) has risen to an 11-month high of 0.86%.

The funding squeeze has turbo-charged the euro rally, pushing the currency to 8.67 Chinese yuan. German exporters can take the pain. It is the strappado for Spain and Latin Europe. They are smiling in Guangdong.

Perhaps the stress tests for Europe's banks will clear the air and unblock the credit system. But such tests worked in the US only because that was simply a banking crisis. Few questioned whether the US Treasury could stand behind the system, or whether the US would hold together as a political entity. In Europe, sovereign states are themselves the risk, and a dysfunctional EMU is the Achilles heel.

A memo from Germany's regulator BaFin earlier this year said the worry is contagion from "collective difficulties" in Club O'Med, not an isolated default. Once under way, the crisis might turn into a conflagration. Investors know this. It is why the simulation test by RBS adjusts for €400bn of losses in Spain and €1.3 trillion for the eurozone, and called for "overwhelming policy intervention" by the ECB to stop this happening. Will the EU carry out such tests? Of course not.

All now hangs on the credibility of the EU's €440bn rescue fund or Stability Facility (EFSF), itself subject to challenges in Germany's constitutional court. Will the EU stress test the "non-negligible" risk that the court will block it? No. The EFSF is a bluff that Italy could provide its rescue share for Portugal, Spain, and Ireland, on top of Greece, in the context of a serious crisis without suffering its own debt run. Is this credible?

Should any rating agency give this body a AAA grade given that 10 of the 16 states are rated lower, and knowing that Germany has refused to allow 'pre-funding'— so that it cannot raise money until matters are already out of hand? Besides, euroland solidarity goes only so far. Slovakia's new government has agreed to the EFSF but withdrawn from the Greek bail-out, refusing to uphold of the pledge of the last lot. The loss of money does not matter. The politics do matter.

We see again that the eurozone is a network of democracies, each subject to its own political rhythm. Any country may change its mind and walk away, at any time. Especially Germany.