Euroland deposits and loans, part 3

Given the authorities’ inability to solve the Euroland problems, and Germany’s clear unwillingness and perhaps even innate inability to inflate its own cost base, and in so doing bail out or price in the periphery, there is a clear and present danger that the ‘Euro project’ fails at some point. Indeed, the latest German credit data show no sign of a new inflationary cycle forming in Germany at present and it follows that if the cost differentials that exist between the periphery and the core are to be resolved, then they must involve either acute deflation in the periphery or a break up in the Euro and a realignment of national currencies.

It would seem that most market participants have hoped, and continue to hope, that the periphery will somehow deflate its way back to competitiveness though a tightening of belts. There are however two major flies in the ointment that make this route very tricky.

First, prolonged deflation is painful for all affected, and is hard to maintain in democracies where electorates typically vote for ‘good news’. Perhaps the only economy in recent times that has faced prolonged deflation was Hong Kong in the late 1990s, but this of course is not a democracy and did suffer protests and some of its only riots of the modern era. None of the other Asian economies attempted deflation for anything other than a few months during the Asian Crisis and even their toying with IMF-sponsored deflation brought virtually every government down and the election of more pro-growth leaders. Quite simply, democracies frustrate managed deflation and it is illuminating that both Greece and Italy presently have unelected technocrats at the helm.

Secondly, the level of cost deflation required in the periphery is very significant. There are estimates of 20%-30%, but even if this was endured, it would not be the end of the pain. To service and repay the debt established to date would require a further 10-20% of on-going incomes, and therefore an economy such as Greece would need to see its population’s nominal disposable incomes halve through the process of deflation and debt retirement.

We would make two points. First, the process would also only be worthwhile if post deflation and de-leveraging, the Greek economy can compete, but there is no evidence that the tensions would not simply re-build. Secondly, on the face of it, such painful medicine has been taken before. Thus, Thailand, Malaysia, Korea, Argentina and others all experienced comparable declines in their disposable incomes as measured in US dollars, during their respective crises. But and this is the critical factor, in each case it occurred via the currency, and not through deflation of domestic prices and incomes.

Of all the Euroland peripheral economies, perhaps Ireland is best placed to cope with deflation and deleveraging, given its demographics and tax regime but even here we can be doubtful and, even if nominal incomes were to decline, we suspect that the impact on tax revenues, debt servicing ratios and default rates would likely be so immense as to be entirely counterproductive.

Despite the huge costs that would normally accompany Euro break up, we are nevertheless left with the conclusion that if Germany won’t or can’t inflate, and the periphery won’t or can’t deflate, then sooner or later the system must fail, if only under the weight of political backlash and popular protest.

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