By John Mauldin
In 2009-10 it seemed like this letter was all Europe all the time. There was a never-ending crisis from one corner of the Continent to the other. That time seems to have slowly faded from our collective consciousness, but the Eurozone crisis is not over, and it will not end quickly or soon. Even if it seems to unfold in slow motion – like the slow build-up in a Game of Thrones storyline to violent internecine clashes followed by more slow plot developments but never any real resolution, the Eurozone debacle has never really gone away. The structural imbalances have still not been fixed; politicians and central bankers have still not agreed to solve major fiscal problems; the overall economy still disintegrates; unemployment is staggeringly high in some countries and still rising; and the people are growing restless.
Just as in the Game of Thrones, the Eurozone drama seems to drag on interminably. It seems to take forever to get to the next installment. I think GRR Martin (the wickedly brilliant creator of the series) should be confined to his Santa Fe villa until he finishes his epic – one of the few lapses in my personal belief that we should be allowed the freedom to control our own time. I read the first of the books in 1996 and the fifth when it came out in 2011, and he will need to finish at least two more. You can do the math, but it is clearly taking longer and longer between books – just as Europe seems to be taking longer and longer between successive peaks of its crisis. Perhaps we should confine the leaders of Europe to a far-northern Scandinavian hotel with hard beds and minimal amenities until they resolve their problems.
In the latest installment of the Eurozone crisis, deflation is back and winter is coming. This week we’ll look at what is shaping up to be a very interesting year in Europe. I am going to visit a number of themes and offer links to readers who want to delve more deeply, as to develop each one would take several months’ worth of letters. Next year it probably shall.
One of the continuing themes in the Game of Thrones is that a winter of epic proportions looms in the immediate future, and the world is not prepared for it. “Winter is coming” is whispered by worried wise men who urge various leaders to prepare, yet they put off the necessary in the face of the urgent. Signs that a European winter, too, is coming have lately been cropping up.
Key measures of inflation are decelerating across the Eurozone, and the region is as close as it has ever been to a deflationary bust. It’s troubling enough that Eurozone headline CPI collapsed from 1.1% in August to 0.7% in September and that core CPI fell from 1.0% to 0.8% over the same period; but measures of Eurozone money supply (M1, M2, & M3) are also decelerating rapidly, suggesting that the deflationary trend will most likely continue without decisive action from the ECB, which has been strangely absent from the current rush by central bankers to print mountains of money. And the ECB could actually make a case for such action!
Even worse, this new round of borderline deflationary data is coming not just from a small number of lost causes like Greece or Cyprus. Ten out of the seventeen Eurozone countries experienced rapidly decelerating inflation rates over the past few months, including Italy and France. Spain officially fell into deflation for the first time since February 2010. In many ways, the situation is even worse than the CPI numbers suggest. Note that Italy, France, and Germany all hover barely above 1% inflation. And their numbers are falling.
There are two major problems associated with an extended period of ultra-low inflation or deflation in the Eurozone. First, peripheral countries will have a much harder time servicing and retiring their debts without the extra boost to nominal GDP that positive inflation provides. Even if you are working on lowering the absolute amount of your debt, it is impossible to improve your debt-to-GDP ratio when GDP is falling and your debts are growing. Moreover, outright deflation works to crush debtors (and debtor nations) by increasing the real weight of the debt and triggering the destructive debt-deflation cycle described in Irving Fisher’s Debt Deflation Theory of Great Depressions (1933).
The second major problem is that currency appreciation always accompanies deflation – all else being constant – so that affected economies also become less competitive in terms of exports at the very moment that a positive trade balance is most important.
These are problems that I have written about for years. The effects of a common currency and monetary policy are spread around very unevenly in Europe, creating a boom in certain countries (chiefly Germany) and a sad bust in others. This disparity is the very predictable result of a currency union sans fiscal union. And trying to fix the Eurozone fiscal structure after the fact is akin to fixing the engine of an airplane while flying at 30,000 feet.
The rapidly weakening inflation we are seeing in Europe is a very big deal, because deflation can become a chronic, crushing condition, making it even harder to deal with excessive debt, undercapitalized banks, and runaway fiscal deficits in major countries like Spain, Italy, and France. Over time the masses begin to expect falling rather than rising prices, and these expectations can be very difficult to reverse without credible, decisive, and powerful action from the central bank.
Up to this point, the ECB has been almost completely unwilling to squarely confront the issues at hand. The ECB balance sheet has been inexplicably shrinking for the past year (more on that in a moment). That is why ultra-low inflation readings should not come as a surprise. Not only has the ECB not been easing, it has actually tightened its balance sheet considerably over the past year. To many observers, this trend clearly demonstrates German dominance within the ECB.
“This is just like Japan,” says Lars Christensen of Danske Bank. “The central bank thought money was easy when in fact it was much too tight. But effects could be much worse in Europe because unemployment is so much higher.” In addition to a central bank seriously behind the curve, structural problems are holding back economies across the periphery, including Spain, Italy, and, yes, even France.
“Like Japan, necessary structural reforms prior to the crisis were delayed and now these will have to be implemented in an environment that is both economically and politically more fragile,” said Takeo Hoshi & Anil Kashyap in a recent report for the IMF. Germany looks like an exception precisely because it undertook structural reforms well before the crisis, which is part of the reason that Germany is doing so well and much of the rest of Europe is not.
You can see the disastrous difference between German industrial production and Italian industrial production in this chart from my friends at GaveKal. This chart would look much the same whether it was France, Italy, Greece, Ireland, or any of the peripheral countries contrasted with Germany. Structural reform of labor policies requires massive social disruption in the best of times. I think we can all agree that for southern Europe this is not the best of times.
True, the risk of government funding crises has receded since Mario Draghi’s July 2012 commitment to “do whatever it takes” to preserve the Euro; but debtor countries like Greece, Cypress, Spain, Ireland, Portugal, Italy, and France have been forced to bear most of the economic cost. Like Japan, the Eurozone has failed to adequately recapitalize its banking system, and troubled economies have failed to address structural problems through reforms.
Ambrose Evans-Pritchard recently noted, “While the risk of a Eurozone bond crisis has greatly receded since the ECB agreed to act as a lender of last resort in July 2012, this has been replaced by slow economic attrition.”
Outright Monetary Transactions (or OMTs) by the ECB are limited by the size of its balance sheet, and the German Constitutional Court may further limit the ECB’s capabilities when it rules on OMT in early 2014. No one really seems to be talking about this fact, but the ECB is losing firepower each and every month as its balance sheet contracts. This trend is going to require Germany to change its stance in the face of the next crisis, but the question is, what will Germany demand in return? Germany always seems to have a price for action. While the market was willing to give Draghi the benefit of the doubt in the last crisis without his really having to fire a shot, it is entirely possible that it will question the limits of his ability to find the funds necessary to solve multiple crises at once. And if France is one of those countries that needs aid? Mon Dieu, c’est une catastrophe!
To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.
© 2013 Mauldin Economics. All Rights Reserved.
Thoughts from the Frontline is a free weekly economic e-letter by best-selling author and renowned financial expert, John Mauldin. You can learn more and get your free subscription by visiting www.MauldinEconomics.com.
Please write to [email protected] to inform us of any reproductions, including when and where copy will be reproduced. You must keep the letter intact, from introduction to disclaimers. If you would like to quote brief portions only, please reference www.MauldinEconomics.com.
To subscribe to John Mauldin’s e-letter, please click here: www.mauldineconomics.com/subscribe
To change your email address, please click here: http://www.mauldineconomics.com/change-address
Thoughts From the Frontline and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President and registered representative of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA and SIPC, through which securities may be offered. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.
Note: Joining The Mauldin Circle is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for investors who have registered with Millennium Wave Investments and its partners at http://www.MauldinCircle.com (formerly AccreditedInvestor.ws) or directly related websites. The Mauldin Circle may send out material that is provided on a confidential basis, and subscribers to the Mauldin Circle are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private and non-private investment offerings with other independent firms such as Altegris Investments; Capital Management Group; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Investment offerings recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.
PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments.
All material presented herein is believed to be reliable but we cannot attest to its accuracy. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs may or may not have investments in any funds cited above as well as economic interest. John Mauldin can be reached at 800-829-7273.
