Euro-zone – converging on the best?

In his April 2016 Ahead of the Curve, Neil Williams, Group Chief Economist at Hermes Investment Management, analyses the health of the euro-zone economy and whether the worst of its macro strains are over. 

By ‘pushing out the boat on QE2’ a little further, cutting rates again and setting up new longer-term refinancing for banks, the ECB is taking out as much as it can for now from its emptying policy ‘tool-box’. But, even more negative rates may follow.

Negative policy rates have been tried before, evidenced in the early 1970s by Switzerland’s tax on deposits to weaken the franc. It had only limited benefit. Their effectiveness now will be in keeping bond yields down. With some two-thirds of euro-zone private borrowing – consumer and corporate – being long-yield, rather than short-rate, driven, further rate cuts seems the more hopeful, albeit indirect, route to growth.

‘Helicopter money’ may be hampered by the liquidity trap & lack of a fiscal agency...

‘Helicopter money’ is considered a next step. But, this works only if consumers and firms pass on to each other what falls their way – that is, the ‘velocity of circulation’ builds. If hoarded, it’s unlikely to be inflationary. Euro-zone velocity (ratio of nominal GDP to M3 money supply) has done little more than flatline at about 0.25 since 2008.

The risk is the euro-zone is caught in a ‘liquidity trap’ where consumers and firms, worried about jobs and deflation, hold onto the cash or pay off debt, no matter how hard the cash ‘falls’. This plus the absence of a region-wide fiscal agency probably preclude a US-style ‘drop’ from being effective. (In the US, tax-rebate cheques were ‘helicopter dropped’ to consumers in 2001 and 2008 to cushion its recessions.)

Convergence is correcting - necessary, though not sufficient, for the zone’s economic health...

To test whether the macro strains are still spreading, we update our ‘Misery Indices’ (MIs), which are based on euro-zone members’ prospects for inflation, deflation and unemployment (please see explanation in the report). The chart below shows our predictions for 2016 and 2017. Rising MIs predict greater economic hardship relative to that country’s recent past.

On this basis, our MIs offer the following observations. First, after a marked deterioration in euro-zone members’ MIs during the global crisis, improvement since 2014 looks like it’s going to be sustained in 2017. As a bloc, the euro-zone’s (weighted) MI at zero next year should be the lowest since 2007. Second, it’s not surprising to see as the ‘most miserable’ those members running austerity to cut deficits and debt. Unemployment and deflationary pressure from the fiscal squeeze keep their MIs elevated. In 2016, for the seventh year running, Greece, Cyprus and Italy will lie in the above-average-misery zone in the chart.

But even these are much improved on 2010-14. Average misery is back down to when the euro became the single currency. Most revealing is what our MIs say about convergence. The combination of reducing macro strains in the periphery without as swift an improvement in the core means the unhelpful divergence since 2008 is correcting (see chart 5 in report).

This is encouraging, though it is not enough to tackle the underlying cause of the crisis - which is a monetary union lacking economic union. This will take years to solve.

Tackling the cause needs more than just QE, which, as we know from the US and UK, is more likely to generate asset-price than demand inflation. Yet, without it, some of the benefits to Spain, Italy and others from their competitiveness gains may be offset by an even stronger euro.

QE could thus be with us for many years to come, including as a counterweight to another probable Greece restructuring. But, while far from fixed, our analysis suggests the worst of the euro-zone’s macro strains may at least be over.