Volume 61 | Number 8
Europe lurched a step closer to recession this week as the Euro zone PMI remained at 46.4, but declined in both Germany and France. Since the disastrous German bond sale a week ago, the pace of political maneuvering has increased significantly – culminating in a coordinated international intervention to lower overnight rates for European banks. Unfortunately, this is still treating the symptoms (a liquidity crunch) rather than the sickness. No sooner had the central banks acted to buy time for the politicians, than new ECB President Draghi and German President Merkel both indicated there would be no further action without a stronger commitment to fiscal union. And therein lies the rub. Europe is at a tipping point where it must become more integrated or split apart. Outside the Euro zone most still see a rupture, while inside the ECB, the Germans, the Greeks, etc are all doing things that seemed impossible a year ago. We still expect the Euro to hold together – but with a significant shift toward fiscal union and after a recession in 2012 which emphasizes the risks of rupture.
We are frequently asked about the European crisis, so I am going to take time and again lay out our simplified view of how we got here and where we think we are going. The Euro concept gained traction after the fall of the Berlin Wall in 1989 and the subsequent reunification of East and West Germany. France and others feared that Unified Germany would look east to the newly fried FSU and Russia for growth, so they advanced the long simmering Euro concept. Unfortunately, in setting the transition price for each currency into Euros, Germany gained a huge advantage. The oh-so Bundesbanker Germans had printed scads of currency in converting the Ostmark into Deutschemarks weakening their currency – and setting off a boom in Europe as West Germany alone could not produce enough goods to satisfy the newly rich East Germans – which strengthened other European currencies. When the Euro zone dropped its trade barriers, the Germans gained in trade and ran a substantial surplus – something they had never been able to do before the Euro as their currency would appreciate and offset their higher productivity. So for many years the German economy has operated by overproducing goods and exporting them to the rest of Europe, with French banks providing much of the financing. Good for Germany and France (and the rest of Northern Europe), but leading to the current debt crisis in the periphery.
Now Europe is faced with a dual crisis: 1) will the periphery repay their debts, and if not what will happen to those who depended on those assets; and 2) how will Germany reform its economy if it can no longer sell excess production to French financed peripheral debtors? At the heart of the matter is the inability of wages to adjust efficiently with a single currency. In the past, German success was rewarded with a stronger currency – which effectively was a haircut on the value of foreign held debt. Moreover, the rising labor cost in Deutschemark led to shrinking margins and stronger competition from foreign producers. With a single currency, labor cost must rise in Euros in Germany and/or decline in other European countries. This hasn’t happened until recently in part because access to cheap credit has allowed weaker domestic economies to sustain their spending (like the housing bubble in the US.) Now, that option is void. Austerity has replaced currency revaluation, and Greeks and Spaniards cannot afford German goods (or their own.) German export sales are sliding, and the whole Euro zone looks headed for recession – which hopefully will generate new policies that lead to a more sustainable unified European economy.
Ultimately, the question is how much Germans will pay to remain at the head of the Euro zone and how much will the rest of Europe pay to keep Germany looking west rather than east. History is not kind to coalitions which break up. The fall of the British Empire, the dissolution of Yugoslavia, the break-up of the FSU — none of these was economy friendly in the short run. In particular, the core central player suffered from a sharp decline in export sales as newly freed smaller economies resorted to protectionism and currency depreciation. German companies know this even if the broader electorate does not. The recent surge of money into Germany temporarily strengthened the economy leaving German firms with the wherewithal to bear some of the coming costs of adjustment. We expect recession, not break up, with the pain making the unthinkable thinkable.
The events of recent days indicate just how far the Europeans are willing to go. For the ECB to act so precipitously before it had a commitment from the fiscal authorities simply would not have happened under Trichet. For the Euro zone to fund the IMF so that it could act as an external source of funds and fiscal arbiter is an open admission of a missing function within the Euro zone. As we have discussed before, the solution to a recession is the shifting of assets from weak hands to strong hands that can wait out the downturn. In Europe, the hunt for strong hands had funds running first from Greece, then Italy and Spain, then France and finally Germany. The needed strong hands are now either the ECB, which refuses the role, or the IMF – an organization controlled by the US and with a growing influence from China. If the Europeans will give up that much sovereignty in the short run, can’t they find a solution closer to home? There is still plenty of money in Europe to fund a solution – they have a trade surplus – but it appears likely it will take a recession with the subsequent reduction in wealth to scare it into a domestic European solution. For us, the basic result is a significantly weaker Euro as European growth underperforms in 2012.
Not So Fast In the US Either
The US economy appears to be operating on the high side of muddle through in the fourth quarter of 2011, but we see little reason to alter a forecast of 4% nominal growth in 2012 – with real growth and inflation both roughly 2% give or take a 0.5%. The ISM for manufacturing index turned up slightly in November to 52.7 from 50.8 in October, with new orders and production at their highest level since April. This compounded on an even stronger Chicago PMI reading, with new orders at a heady 70.2. The post-quake rebound and tight inventories seen in the third quarter GDP data are sparking a modest improvement in the factory sector. However, the political and policy quagmire in the US still leaves huge swaths of the economy – defense, health care, state and local government, finance, and housing – with far too much uncertainty to expect an upside breakout in 2012. One bullish sign recently was the indication that the 2% payroll tax would be extended along with the traditional year-end package of the AMT fix, Doc fix for Medicare and extended unemployment benefits. Still no one has identified how it will be paid for – probably through the smoke and mirrors of already assumed cuts in defense and ethanol – but having no Jan. 1 tax hike is a blessing.
The same old, same old in the US economy was apparent in the payroll employment report, which showed 120,000 new jobs in November, and sizable upward revisions (+72,000) to the previous two months. Private sector payrolls rose 140,000, slightly below the 145,000 average of the previous four months. During the second half of 2010 and the first half of 2011, private sector job growth also averaged 145,000, though with periods of sluggishness in late 2010 and mid-2011 as indicated by the deviations between payroll and household employment counts. Over this entire six quarter period (assuming real GDP growth of 3.0% in the fourth quarter of 2011), real GDP averaged 2.0%. Nominal GDP ran at 4.0%, leaving the economy constantly on the knife’s edge of stall speed. Slumps brought about new waves of monetary intervention to shore up growth, but no change in the path of fiscal policy has developed as we await the upcoming election still eleven months away. The original post-2008 election cycle stimulus injected in early 2009 has run its course, and the main concern is now the reversal of those policies – as indicated by the payroll tax issue. Early 2013 holds the end of the Bush tax cuts and the start of Obamacare, two more significant hurdles for an economy muddling at stall speed. We see no reason for US firms to shift into a risk taking mode – especially when tight labor markets make it difficult for new competitors to disrupt the status quo.
However, the quality of jobs continues to disappoint. In November, 50,000 of the increase came in retail activity and another 22,000 in temporaries, suggesting strong Christmas hiring that will reverse after January. Reinforcing this view was an -0.1% drop in average hourly earnings, as the mix shifted toward low income jobs. Even though job growth has a very slight upward tilt from early 2010 until now, our wage proxy (based on hours worked and average hourly pay) has a distinct negative slope – much more like the end of cycle period in 2006-2007 than start of cycle periods like 2002-2006. Given the economy is already resting on a knife’s edge with respect to nominal growth; we believe the risk remains decidedly to the downside. Apparently, the Governors of the Federal Reserve Board share this view, as reflected in recent comments by Vice Chairman Janet Yellen. Bottom line, we see the muddle through persisting in 2012 – with risk of a recession in 2013 unless swift fiscal policy action is taken after the election.