Deflation in Europe

During the fourth quarter of 2011, Italian nominal GDP declined by 0.7%qoq, or at nearly a 3% annualised rate. This decline followed a smaller decline during the third quarter and this has been only the second time in the available history of the data that Italian nominal GDP had declined for two consecutive quarters (the other time occurred during the global financial crisis). Meanwhile, in the Italian retail sector, volumes have been falling for nine months and thus far this year there has been no sign of any improvement despite the much heralded improvement in reported consumer confidence. Indeed, reported levels of business confidence in the retail sector recently fell through their 2008/9 lows.

Export growth in nominal terms, is now close to zero and has been slowing consistently since June 2010. Within the industrial sector, itself, we find that Italian industrial production (IP) volumes are down by over 3% over the last six months and January seems to have been quite disastrous for the economy. Car production has now been flat for three and a half years. Elsewhere, Italian service sector business confidence is only just above its 2009 low (and this is March 2012 data) while service sector companies are reporting the lowest level of hiring intentions on record. The transport sector, often a bell-weather for the aggregate economy, is now reporting early 2009 levels of activity while even the IT sector seems remarkably weak. Aggregate employment is falling slowly but unit labour costs are still rising at a more than 2% rate. In the banking system, loan growth is continuing to slow sharply but more significantly aggregate deposit growth is only just positive (although we may suspect that what deposit growth there is, is due to quasi public sector entities not private savers – the latter seem to be quitting the banking system) while the MMF industry has lost a third of its funds under management over the last 12 months.

Unsurprisingly, this seeming implosion in the domestic economy, which has yet to yield any tangible improvement in the country’s underlying competitiveness, has already rattled even its appointed PM and although it is not entirely unexpected, even judged by its narrow fiscal aims, the ECB’s prescription of austerity seems to have failed. As a clear result of the ongoing severe deflation of the nominal economy, total tax receipts only rose by just under 1% last year despite higher tax rates and a number of anti-avoidance initiatives. Government spending meanwhile rose by more than 2% last year despite the authorities’ attempts at austerity and hence, far from contracting, the budget deficit is beginning to widen again.

This is, of course, not only an Italian problem; Spain’s numbers would seem to be broadly similar in tone and magnitude – and in impact on the budget accounts. Indeed, even in France in which nominal GDP growth was at least reasonably positive last year, tax receipt growth slowed to 3% from 2010’s 15% rate. French government spending did fall last year and hence the budget deficit narrowed but is seems that political imperatives have led to a rebound in government spending of late and hence France’s budget deficit has begun to move higher once again. We suspect that these widening deficits have been as much a catalyst for the recent market instability as the protests themselves against the policy regimes.

Of course, none of this should come as a surprise. Throughout history, overly draconian austerity regimes have in general failed to reduce budget deficits, but it is surprising that the ECB’s efforts with its LTROs etc, designed not only to fund Europe’s budget deficits but also allow a re-organisation of the debt holdings back into national boundaries (i.e. one of the unwritten aims of the LTROs was that they should have allowed the German banks and others to dispose their ‘foreign’ bonds to domestic banks in the issuing countries and so solve the cross border debt ownership problems), seems to have failed so quickly. In theory, lending seemingly elastically to the Spanish and other banks all the money that they possibly might need in order to acquire all the new and existing supply (including that offered by German banks as they retreated back home) of domestic bonds should have placed some form of floor under the Spanish bond markets but instead it seems that the cracks in the Euro are becoming simply too large for even the ECB’s giant LTROs to paper over. As the crowds in Spain, Greece and elsewhere are demonstrating, austerity and deflation are simply not politically practical in modern democracies. Moreover, they make the task of fiscal consolidation all but impossible and hence stress levels in Euroland are rising again.

Financial markets had been trying to ignore this increasingly visible development (for some time and at times even to deny it) perhaps simply because they had funds to deploy: the one area of the monetary data that had looked quite perky following the ECB’s actions had been the financial sector and the corporate bond markets, and these factors are normally constructive for asset prices, at least until fundamentals become too bad to ignore.

Despite the terrible position, it may not be right to assume that the euro must fail. Despite its massive injections of funds through the LTROs, and its clandestine credit extension to the periphery via TARGET2, the ECB has so far only succeeded in creating a modest (€300 billion?) rise in excess reserves in the capital adequacy/sentiment constrained German banking system and little or no excess liquidity elsewhere. As the events of the last few days have shown, the peripheral banking system currently has a huge demand for settlement cash as its deposit bases shrink and this demand for intra financial system liquidity has probably absorbed much of the money that the ECB has added (in fact, the ECB actually allowed the level of excess reserves in Europe’s banking system to fall in March). Hence we still do not think that credit conditions are easy in Europe. Moreover, the money supply is barely expanding despite these massive injections and private sector credit growth is still negative.

So despite having a ‘true’ aggregate balance sheet of circa €4.8tn (more than half Euroland annual GDP), we are not sure that the ECB has yet succeeded in creating easy monetary conditions and hence even with the news flow noted above, the euro seems to be finding it hard to fall – it may still be a scarce currency outside the domestic banking systems.

Ultimately, we must come to a point at which the ECB must decide whether to placate protestors in the periphery (not just those on the streets but more particularly those voters that will before long vote down any pro-Euro government) by printing so many euros that the supply of euros outside the banks rises or face a very real risk of the system failing.

Mr Draghi’s next move therefore may be to ease so as to save not only the euro but the Bundesbank itself (which is now hugely exposed to any breakup of the euro via its now huge TARGET exposure) despite the higher inflation in Germany that such an easing and weakening of the euro might cause.

We can conclude that the euro situation remains an untidy mess but as popular opposition to their policies rises, the ECB may soon have to act to appease its second (i.e. non-financial sector) constituency which ultimately is more numerous and more important than the financial sector constituency that it believed it had saved via the LTROs.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla