Euro zone faces QE2 pain test
QE2 — a second round of quantitative easing — means that soon the U.S., Japan and Britain will all be busily exporting their deflation, raising the question: Just how much pain can the euro zone take?
If by November we have three of the largest economies printing money and buying up their own debt, the outcome — in fact the intention — will be to drive their currencies lower against their trading partners, opening new international markets for their goods and, by raising the price of imported goods, fighting deflation before its debilitating psychology can take hold.
That is the plan, at any rate, and, unless something else happens, it will force the euro up against all major currencies, including, as it is tied to the dollar, the Chinese yuan. The euro has risen about 9.5 percent against the dollar in the past month, a trend that ultimately will murder European exporters and its stock market.
For reasons of history, society and sheer cussedness, the European Central Bank does not seem inclined to join in, though as usual there is dissension.
Speaking in New York on Tuesday ECB President Jean-Claude Trichet said that the ECB’s own version of QE, buying bonds of euro zone weak links and other liquidity support, will continue as planned at least until the end of the year, at which point, “We will see.” In contrast governing council member Axel Weber, speaking in the same city on the same day, pointedly called for an end to special measures immediately, saying the risks do not justify the benefits.
Forcing Europe to absorb more of the global deflation is really nothing more than a “back at ya” by the U.S. and others. Europe, in deciding to cling to its currency union and impose austerity on its weaker members, was doing exactly the same thing; exporting deflation, both in terms of a weaker euro and through the desperate actions of Greek and Irish residents who will consume less and must export more.
So, why won’t Europe simply power up its own printing presses and join the currency debasing party? In part it is a matter of history; the old Bundesbank horror, bred in the bone, of the inflation that devastated Weimar Germany.
Economist Michala Marcussen of Societe Generale also argues, convincingly, that Europe’s more generous social welfare net makes periods of slow growth and high unemployment easier to bear. It is a contrast that while raising the retirement age brings Europeans into the streets in their millions, it is in the U.S. that people flock to Wal-Mart at midnight on the eve of the first day of the month, filling their shopping carts with food and baby formula as they wait for government benefit credits to hit their accounts.
BREAK IN EMERGENCY
So, the Federal Reserve, the Bank of Japan and quite possibly the Bank of England will all print money and buy their own bonds, while the European Central Bank will, as it has in the past, wait until it is forced by events to make radical moves.
While this means that European stock markets will at best underperform and at worst plummet, there is one sector that may be an unintended beneficiary: banks. European banks are far less well capitalized than their global peers and will be hit badly by the imposition of new capital guidelines under the latest Basel agreement. While more robust capital makes sense in the long run, in the here and now it will hit growth, so expect implementation to be about as fast as the revaluation of the yuan.
As for the Federal Reserve, it is important to note that, as it did when it bought up mortgage bonds, it is sailing into waters dangerous to its independence. QE2 will work in large part because it will weaken the dollar, but managing the dollar is not the Federal Reserve’s job, it is a trust belonging to the Treasury.
In the end, it may be the fate of Greece, Ireland, Portugal and Spain which forces the ECB’s hand, as the desire to keep the euro together outweighs the fear of buying groceries with wheelbarrows full of cash. Remember that an appreciating euro and the deflation it will bring make the debts of the weak peripheral nations that much harder to bear. At the same time, a Germany that is suffering as its economy rolls over as global trade slows and its relative competitiveness suffers will be less willing politically to support the project.
Faced with this, expect the ECB to ultimately join the QE2 party, perhaps under the cover of the end-of-year holidays and amidst a major sell-off in shares and peripheral euro zone debt.