December 20, 2010 Patrick Oliver-Kelley

Can the Euro survive? A break up would be even worse.

Germany is fed up with paying for other country’s mess, and talk of a ‘Strong Euro Area’ is becoming commonplace.  Say Germany, Austria, the Netherlands and France set up the ‘strongs’ to reconsider their place in the union, maybe even create a two-tiered Euro?

And, say Spain, Portugal, Ireland, Italy and Belgium cobble together to form an ‘others’ zone. This zone is for the ones that precipitated their fall in risky bank lending or, in cooking its books, as Greece did. Spain is now moving into the crosshairs. Zapatero, Spain’s prime minister must take quick action to give credible evidence of a medium term fiscal plan by enumerating debts in the banking system, raising the retirement age, and by showing that Spanish business can compete. Once it is clear that Spain can grow, it debts will look less scary. But the cries for breakup are becoming louder and boulder.

Lest we forget, tiny Cyprus is wobbly on the euro area periphery. There is an outsized budget deficit and a clutch of outsized banks on the island. Property values are bust and economic growth is moribund which risks attracting contagion that helped bring attention to Greece and to Ireland. Cyprus owns five billion euros in Greek government debt and were the debt to suffer a markdown in bond values, would wipe off twenty-five percent of Cyprus’ tier one capital. It has become a haven for Greek depositors. This works so long as depositors are convinced of the solidity of the island’s institutions.

German unwillingness to underwrite the weak and profligate euro economies is understandable, but the alternative is worse.  The costs would be enormous and the complexities hardly imaginable, but it does not mean serious thought is not being given the idea.  German Chancellor Merkel said, ‘If the Euro fails, Europe fails.’ But investor unease can rattle the entire Eurozone. The idea of a postwar Europe moving closer to a complete unity is increasingly in question, succumbing to a new populist spirit and to a new anti-foreign sentiment. Adjust, is the new Norm.

How to generate growth in the 21st century is likely to be the defining economic question. Thanks to globalization, and good policies, the rest of the developing world is catching up.  The lack of growth in the rich world is the conundrum. The stagnation of the West is due to the scale of the recession of 08/09; slowing of the supply of workers and their productivity which depends on the rate of capital investment and the pace of innovation; the hangover from the financial crisis and the feebleness of the recovery. The longer demand remains weak, the greater the damage is likely to be. We, the rich world, need to foster growth by supporting short-term demand and by boosting long-term supply.

On the American Front, ignoring the warning against using currency as a policy weapon, the Fed continues its policy of quantitative easing. It means to create more money in the banking system. This explains why gold, equities and government bonds are performing well. Competitive devaluation is an inherently unstable system. Someone must lose its share of world trade. Boosting exports can too easily become one of blocking imports. Beware.

Corporate profits in America have benefited from the return to profitability of the banks and the growing contribution of foreign operations- gross overseas profits.  The explanation lies with costs: Lower interest charges and lower depreciation because so little has been going into investment in equipment.

However, the biggest economic help comes from the lack of hiring new employees, lack of pay raises, and the increase in productivity with existing levels of staff. Production has grown, since the end of 2008, 4.2%, while employment crept up by a rate of 2.1%. Companies are sitting on their cash. Business is producing the same GDP with fewer employees. And even if employment is inching up, woefully slowly, wages are not.

Home sales of new and pre-owned homes continue weak. The inventory of new homes is likely to last into 2012. GDP growth is estimated to hover around 3%, but Unemployment remains high and will remain near 9% by end of year 2011. Interest rates will remain low throughout the year which is why we will continue having commodities price bubbles. America’s economy is in for a long, hard ride.  Debt reduction will last until around 2014, but politicians have not prepared for the consequences. The government should be encouraging more write-downs of mortgage debt; this would make it easier for people to move to where the jobs are. It should also create more training schemes.

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