Expectations ahead of the recent summit between Angela Merkel and Nicolas Sarkozy were low and the majority were not disappointed. But we believe that important and disturbing progress was made between the two leaders of the Greater European Non-Prosperity Zone. They have laid the conditions which will lead to eurobonds but not before there is significantly worse economic conditions in the periphery.
These conditions require a common finance ministry as well as a transfer union and further debt devaluations. This is because the debt brake championed by the two leaders will lead to coordinated and severe fiscal austerity across the region. It will create the paradox of thrift that in turn will force these economies into recession and undermine attempts to reduce the budget deficits.
The wide gap between Germany and the rest of the Eurozone in terms of economic growth and labour market productivity is as wide as the immediate aftermath of German Monetary Union. Between 1991 and 1993, there was a series of devaluations against the Deutschemark which effectively appreciated the currency against the rest of the zone. This is not possible within the single currency. Currency appreciation can only be effected in real terms through German inflation rising faster than the rest of the eurozone.
Germany has made it clear that it is unwilling to accept higher inflation, which in turn means that the other economies, particularly the uncompetitive peripheral economies, must accept deflation. As Keynes high-lighted, wages are sticky and a modern industrialised economy requires deep domestic recession to produce deflation. Creditor nations counter correctly that wage stickiness is also the product of rigid labour and product markets.
The rating agencies, particularly S&P, have adopted the “new Puritanism” of the creditor nations and have given primacy to fiscal intent over economic growth in these economies. They have accepted for the time being the rosy scenarios provided by the respective governments. This is unsustainable and the next phase of the European sovereign debt crisis will be increasing concerns over deepening recessions among the periphery and indeed Germany. In this environment, the ECB will have to reverse its two highly irresponsible rate hikes over the next six months and should go further with the benchmark two-week repurchase rate falling to 0.5 per cent during 2012.
This in turn will lead to questions over debt sustainability in these economies. It should highlight the inadequate size of the European financial stability fund and the ability of the ECB to finance Italy and Spain over the next few months. The inevitable conclusion is that they need low funding costs to limit concerns over debt sustainability. This will lead to common issuance of eurobonds to minimise interest rate volatility.
This will not be the end of the European sovereign debt crisis, it will be the end of the beginning, shifting the focus away from interest rate volatility towards political volatility. The net result will be bearish for the euro.
Stuart Thomson is chief market economist at Ignis Asset Management