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In our last briefing before our summer break, our main focus is the disappointing eurozone recovery;
  • Eurostat confirmed that the economy stagnated during Q2; with Germany and Italy down 0.2% qoq, and France stagnating;
  • German 10-year yields dropped below 1% for the first time ever, as investors are now betting serious money against the ECB’s inflation target;
  • the main point of interest in the German press is not the next leg of the recession, but the French budgetary overshoot, which has given rise to an expression of outrage;
  • In Italy, Matteo Renzi was telling reporters: See, it’s not just us, it is a European problem;
  • Renzi also said that he expects “the lady” to soften her stance on deficits at the next European Council;
  • Simon Wren-Lewis explains the eurozone’s latest crisis in terms of household savings rates – they declined in 2012 to counteract the effects of fiscal tightening – which means the domestically-generated recovery has already happened;
  • Paul de Grauwe says policymakers are trying to fix a demand crisis with supply-side reforms, a policy that is now leading to a downward spiral;
  • Ambrose Evans-Pritchard argues that the policy is now too tight even for Germany – and is kept too tight for purely ideological reasons;



The price we are paying for serial policy errors

This is our last briefing before our annual break. We will resume Monday, September 1.

Our overriding focusing today is, of course, the eurozone economy, which continues to disappoint. We were just able yesterday to give you the news of the German 0.2% fall in GDP during Q2. Eurostat followed up on this with the flash estimate for eurozone-wide GDP, which came in at zero. It is not hard to imagine the sheer volume of outraged editorials in the media: something, surely, must be done.

Just as the ECB re-iterated for the millionth time that inflation expectations remain firmly anchored, German 10-year yields defiantly dropped below 1% for the first time ever. We are not generally overawed by “records” – but this is the clearest sign yet that the markets are betting against the ECB’s inflation target. The message from the largest and most liquid fixed-interest rate market in Europe is telling us that Inflation expectations have firmly de-anchored despite of what the ECB says. The ECB is still clinging on the 5y-5y inflation swaps in defence of its views that, in the long run, inflation expectations are anchored, but we are not sure that this derivative instrument is all that meaningful. For us the question is no longer whether inflation expectations have come unstuck. They have. The question is: can they be re-anchored?

It is interesting that Frankfurter Allgemeine and other German newspapers hardly mention any of this – they cover the overshooting French deficit obsessively. The paper’s Paris correspondent has an outraged editorial, which fails to mention that the French economy outperformed the German economy in Q2 (and for the period since the beginning of the eurozone as well).

The Italian papers focus on Matteo Renzi’s comment: See, it’s not just us. The whole of the eurozone is in crisis. La Repubblica reports on Renzi’s comment that these data will soften Angela Merkel’s views on the fiscal overshoot. We at Eurointelligence are not sure that they will – also in view of the FAZ’ comment on France. The German consensus view is that one should never allow a recession to get in the way of a good deficit reduction.

Among the interpretations of what happened, we noted Simon Wren-Lewis’ observation on household savings. He found that in the UK the savings rate increased after the crisis, and the recovery started just as the savings rate began to fall. In the eurozone that decrease in the savings rate already occurred earlier in response to the austerity. Wren-Lewis says the eurozone already had its recovery, which came in the form a declining savings ratio helping mitigate the 2012 recession. The key question is now to which extent financial balance sheets of consumers are restored?

From the eccentric Ambrose Evans-Pritchard we learn of Paul de Grauwe’s interpretation of what happened. EU policy makers are treating a demand crisis as if it were a supply crisis by imposing reforms. De Grauwe:

“They are doing everything they can to stop recovery taking off, so they should not be surprised if there is in fact no take-off. It is balanced-budget fundamentalism, and it has become religious. We know from the 1930s that if everybody is trying to pay off debt and the government then deleverages at the same time, the result is a downward spiral. The rigidities in the European economy have been there for ages. They have absolutely nothing to do with the problem we face today.”

Pritchard himself makes the point that policy is even too tight for Germany. This is so “because otherwise Latins might get off too lightly”.

On the economic dynamics: we very much agree with the Wren-Lewis/De Grauwe viewpoint. This is a recession caused by policy failure. It was not a financial crisis that has damaged the eurozone as much as the policy response to it. Obsessive deficit cutting in a poisonous conjunction with obsessive central bankers (who obsess about everything, except meeting their own inflation target).
On Italy: there is an economic reform we could propose that would cost nothing and is easy to implement: stop publishing your GDP figures before everybody else. If you tank then, there is a chance that the world might be focusing on others.
On the continued obsession with deficit reduction. Watch out for the politics. When German and French debt to GDP ratios were roughly similar, a French overshoot did not matter all that much. But now that Germany has been focusing its national energy on repaying the debt - a strategy that will, over time, lead to a significant fall in the debt ratio - France and Germany will be diverging. Expect to see more German attempts to insulate themselves from any liability arising from fiscal deficits elsewhere. The politics of deficit reduction is an issue investors do not yet have on the radar screen. We will come back to that theme after the break.
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