Posted on 05/11/2003 8:20:14 PM PDT by demlosers
The fracturing of the world political order that occurred in the run-up to the Iraq war has finally caught up with the currency markets. Again, the Anglo-American way of doing things looks like being the winner and Old Europe the loser. For the euro is in as much disarray as French and German foreign policy and the timing has never been better for Gordon Brown to say his five economic tests have been failed.
We are witnessing some of the largest currency moves for years. The pound has had its biggest devaluation since 1992 and this will give the economy a huge stimulus. The foreign exchange market is the most active in the world, turning over about £300 billion daily. It represents thousands of individual decisions and we should listen carefully to the roar of the bazaar.
The big concern is deflation, or continuously falling prices. In the early 21st century, this is the monetary equivalent of the "asymmetric threat": puzzling, and difficult to get your head round. Last week, both the US Federal Reserve and the European Central Bank signalled that they were worried about the D-word. But while the Fed has declared war on deflation, the ECB is courting it assiduously.
Most people are used to the opposite of deflation: inflation, or continuously rising prices. With the exception of Japan, nobody has really experienced deflation since the 1930s. Put simply, the £100 you spend on your weekly groceries will, in a deflationary environment, soon buy your groceries plus a CD. Deflation brings advantages for anyone with ready cash, but pretty well everyone else is a loser.
The worst off are those with debts. The real value of money keeps going up, and therefore the real value of a debt goes up too. A debt that would take 10 bags of groceries to pay off this year will take 11 next, and so on. With deflation, consumers defer purchases in the expectation that things will get cheaper. House prices fall.
Profits decline as companies have no pricing power. Unemployment also tends to rise, as companies anxious to rebuild their profits stop hiring. Deflation is a nightmare for young people, especially those in their twenties as they are most likely to be running up debts and looking for jobs. In Japan, one reason the birthrate is so low is that couples spend years putting themselves on a sound financial footing.
Deflation's root cause is an excess of supply over demand. There was too much investment in the 1990s. In America, there was a speculative mania as investors poured money into the stock market. The result of this investment bubble was too much of a lot of things: phone lines, internet companies, and even pick-up trucks.
In Europe, there was also over-investment, although mostly through bank lending underwritten by the state. A good example is the German car industry. Last week, Volkswagen said its profits had fallen by two thirds, as sales of its new Phaeton model have disappointed. The Phaeton is not a people's car. It is far too expensive, and over-engineered with too many gadgets. The banks that provided the loans for this investment frenzy are groaning under the burden.
Getting worried? Don't be. The free-market tradition of Britain and America is well suited to dealing with deflation. The best cure is to rebalance supply and demand. The Second World War effectively achieved that last time by destroying factories, thereby removing supply. This time we thankfully have more peaceful means at our disposal - cutting interest rates aggressively and printing money so there is plenty of it about.
Governments can also run up deficits. That is what the authorities are effectively doing in Britain and America. Gordon Brown's spending spree is less desirable than George Bush's tax cuts, which will improve productivity, but the effects are similar.
Which leads us to Europe. With the American and British authorities happy to let the dollar and pound fall, the euro is incredibly strong. The situation is being made worse by the dirigiste design of the single currency. Even though Germany, the biggest economy in the euro zone, is suffering from a crisis of historic magnitude and is close to deflation, the European Central Bank has refused to cut interest rates. It must give equal weight to other members like Ireland, where inflation is close to five per cent.
Furthermore, the Stability and Growth Pact, which underpins the euro, restricts government borrowing and the German chancellor, Gerhard Schröder, is actually having to raise taxes even though growth is stalling. No wonder the latest poll shows support for his Social Democrat/Green coalition has fallen to only 27 per cent.
Those accustomed to complaining about "the strength" of sterling and claiming we would be far better off in the euro now find their world turned upside down. One of the advantages of having your own currency and a free, floating exchange rate is that it goes down as well as up. With deflation putting on its flat cap and preparing to take to the road like a Jarrow marcher, now is just the moment to run a loose monetary policy.
If we were in the euro, our currency would have risen in value by nearly 10 per cent since the beginning of the year and exporters would be in even worse difficulties. Bureaucrats from the European Commission would be crawling over the Treasury's books, tut-tutting away and telling Mr Brown to cut his spending or raise taxes.
Tony Blair still wants to hold a euro referendum. But events are going against him, just as they did during his desperate negotiation for a new UN resolution in March. The euro is another example of how the dogmatic approach preferred by so many European politicians is the wrong course to take. As a currency trader would say, the trend is not Mr Blair's friend.
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Are you listening Dashole?
BTTT
A wild speculation - How long before a small European country dumps the Euro and adopts the American Dollar as it's cirulating currency ?
I think right now the small Euros have their economies financed by Germany and France because they are holding interest rate steady in order not to cause too much inflation there. It could crack of course, with Germany and France abandoning that goal and infuriating the small Euro countries.
The whole process is arbitrary and there is no real mediation nor representation between the ECB and individual nations. It's crazy.
Actually, the "what the government can do" part of the article sounds a bit like warmed-over Keynesian dogma....
A useful discussion of the effects of deflation, though.
If you want to see a real-world historical example of why it's a Bad Thing, the U.S. farm crash in the first couple of decades of the 20th Century would seem to serve.
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