European quandary

Competitive devaluation is an attractive policy choice for countries facing very slow growth that have large trade or budget deficits, or both. In Europe today, those countries are the PIGS — Portugal, Ireland, Greece, and Spain. Spain’s current account deficit is about 10 percent; Ireland’s is about 5 percent. The Greek budget deficit will probably reach 4 percent of GDP this year, according to Standard & Poor’s, which downgraded Greece’s sovereign credit rating to A- in January.

Rating agencies have already issued warnings or downgrades on each of these countries, and the yield differential between their sovereign debt paper and that of core-EMU country Germany has already risen to 2 to 5 percent. In theory, EMU countries should have long-lasting convergence in bond yields because of the common currency and common monetary policy. But because the EMU lacks fiscal capabilities, divergence is instead resulting.

Some commentators had said some of the PIGS countries, and perhaps Italy, will have to depart the EMU, which is almost unthinkable today. The financial and economic disruption would be enormous. The countries would have to print and reissue their legacy national currencies, recalibrate their accounting books, and placate the public. At what rate would the new-old currencies be pegged? Nobody doubts it would be a devalued level from the Euro today.

The probability of the EMU breaking up or having its membership reduced is pretty low at this time. It doesn’t help that in the U.S., UK, and Japan, national governments can assist in restoring order to the financial sector by “quantitative easing,” which is a 10-gallon word for buying government bonds and bad paper from the banking sector using public money. This is a lot harder in the EMU, where the European Central Bank (ECB) would need new authority to buy members’ national bonds. The ECB is able to buy bad paper from the banking sector, including central banks, but only on a repo basis. At some point the paper has to be returned to the banks, whereas in the U.S. and elsewhere, there is no legal reason why the central banks can’t hold it forever. The rules of the EMU forbid any country or the ECB from “bailing out” another. The no bailout rule is an obstacle in today’s world.

The ECB’s institutional constraints are not the only reason the Euro is faltering today. The Euro is also on a downtrend because economic growth is faltering. The export-led German economy is getting a chill wind from China’s manufacturing sector, itself beset by falling demand, mostly from the U.S. And stimulus plans are piecemeal and relatively small compared to the U.S. and UK.

Most of all, there remains an element of denial of the scope of the current crisis. For example, the ECB disclosed that it as able to get unanimous approval for the 50-basis-point January rate cut only by promising not to take any rate action at the February meeting, delaying it to the March meeting. This means some members still feel inflation is or should be the abiding concern, even as inflation data is falling like a rock — 1.6 percent year-over-year in December (under the ECB’s 2-percent cap) from 2.1 percent in November. The December consumer price index (CPI) reading was the lowest since October 2006.