Euro: Austerity, Breakup or Devaluation?

In a new book, Nomura’s lead currency strategist warns that the Euro is on an unsustainable path.

“I wrote this book because I care about Europe”, writes Jens Nordvig in the preface to The Fall of the Euro.

European by birth and living in New York, Nordvig, who is Global Head of Currency Strategy at Nomura, has a unique understanding of the factors that led to the creation of the Euro, and of the impact that the Euro crisis has had on financial markets.

He also has some unsettling insights about the future.

Breakup or Exit

Many people have speculated on the breakup of the Euro. But is a breakup feasible?

Legally speaking, It would be relatively easy for each Eurozone country to redenominate the Euro assets and liabilities which are within its jurisdiction back to its national currency. But, writes Nordvig,

“What would happen to financial assets and liabilities that were outside the jurisdiction of the Eurozone countries if the euro ceased to exist?… What would happen to a loan made in euros by a US investment bank to a big industrial company in Poland? Would the loan now be in US dollars? Would it now be in Polish zloty?… The lender might have one preference and the borrower another. There would be a potential dispute of this nature for every single financial contract…These disputes would be the catalyst for widespread legal warfare…There would be trillions worth of assets and liabilities denominated in “zombie euros” and outside the reach of Eurozone governments… There was no example of this in history.”

If the obstacles to a full breakup seem insurmountable, the exit from the Eurozone by one or several countries look by contrast to be more manageable. Here as with many Euro-related decisions, the outcome will likely be dictated by politics.

Although the weaker countries are seen as likely candidates for exit, Nordvig notes that any benefit they would derive from reverting to their weaker national currencies would be largely offset by the magnified burden of having to service their Euro-denominated debts.

Nordvig also explores the scenario of a German exit, an option which he views as feasible but improbable.

Austerity or Devaluation

A “hard currency equilibrium” has prevailed since 2012 but this equilibrium is entirely dependent on periphery countries (Italy, Spain, Portugal, Greece, Cyprus) sticking to tough austerity measures. In this scenario, adjustment will take several years before a strong recovery can return.

Should austerity prove unsustainable, the Euro may find a “soft currency equilibrium” in which debt limits are ignored and rescue conditions are relaxed. According to Nordvig, this could turn the Euro into a weak currency not dissimilar to the former Italian Lira.

Bond spreads have tightened and stocks have risen since the dark days of 2012 but Nordvig cautions against complacency:

“Investors should be on the alert and not be fooled by the relative market calm observed since the summer of 2012. There is a difference between bond yields that are consistent with fundamentals and yields that have been artificially pushed lower as a result of insurance from the core.”

US Demographics not as Strong as Widely Believed

A recent op-ed in the Wall Street Journal by Mr. Ben Wattenberg, a senior fellow at the American Enterprise Institute, takes an optimistic view on US demographics and on their likely impact on the economy.  The WSJ today published my response in which I repeat the argument I made in America Heading Towards Zero Population Growth? that the growth of the US population is in a multi-decade decline.

Text of my letter:

“Regarding Ben J. Wattenberg’s (“Immigrants and ‘Comparative Advantage’,” op-ed, Aug. 9): It is true that the U.S. is in better shape than Europe or Japan, but the rate of growth of the U.S. population has fallen below 1% per year and will decline further over the next four decades. Due to the passing of baby boomers in increasing numbers, the two decades starting in 2030 will see no population growth except for immigration.

Mr. Wattenberg’s figure of 400 million Americans in 2050 is too high and would be reached only if the birth rate, life expectancy or the number of immigrants rises significantly in coming decades. My own estimate is 375 million in 2050, which is 61 million more Americans than we have today. This may appear nominally attractive, but the population grew by 60 million, or 24%, in the 22 years since 1990. A 60 million increase by 2050 would be equivalent to growth of only 19% in 38 years.

Even Mr. Wattenberg’s optimistic scenario would be growth of 27% in 38 years, a rate which is well below that of recent decades, with predictable consequences for domestic consumer demand.”

End of letter.

Mr. Wattenberg is not alone in holding an optimistic view.  In fact, robust population growth is seen by many as one of the unique assets of the US economy.  Last month, Goldman Sachs CEO Lloyd Blankfein argued that US economic prospects look promising in part due to demographics:

“The U.S. has a number of major competitive advantages that we sometimes overlook — especially given the focus of the 24-hour news cycle on sensational, and mostly deflating, events. First, the U.S. has favorable demographics — thanks to its relatively high birth rates and immigration. While the BRIC countries — Brazil, Russia, India and China — have generated extraordinary economic growth, the U.S. remains a magnet for many of the smartest, most ambitious people in the world. […] Immigration is one of the main reasons why the U.S. has grown faster than many other developed economies. The growth in the foreign-born population contributed roughly 30 percent to 40 percent of total U.S. population growth from 1980 to the mid-2000s. New immigrant workers provide a boost to economic growth. Just think about the effect new workers have on demand for housing, let alone creating new businesses.”

Because they are only partially accurate, some of these comments end up painting an overall picture which is too optimistic. First on the birth rate, it is higher than that of Japan or Europe, but it had been until recently near replacement level, equivalent to a total fertility rate (TFR) of 2.1 children per woman.  But since the financial crisis  began in 2008, the TFR has fallen below 2.1, as recently reported by The Economist. The TFR may well recover to replacement level as the economy improves. That is better than sub-replacement but a TFR of 2.1 is not sufficient to turn demographics into a source of economic strength. In addition, discussing birth additions without mentioning death subtractions presents only half of a full picture.  As increasing numbers of baby boomers pass away in the next three decades, the population will grow at a slower rate than in recent decades.

Another factor to consider within the overall population numbers is the evolution of each age group.  The expected increase in the number of older people has been widely documented and discussed, in particular as it relates to the pressure it will place on government social programs. A subsidiary measure of this development is the rise of the dependency ratio, which is the number of dependents (children and retired people) per working adult. In the US the ratio had been declining for decades and it is now set to start rising. (See Our Growing Inactive Population).

Turning to immigration, it is true that the US could open its doors wider to more immigration and by doing so, reach any population level that it wishes. But few commentators or politicians are advocating this approach. If we continue with the current run rate of 1 million new (legal) immigrants per year, the growth rate of the US population will continue to decline. And that would be true even if we raised annual immigration to 1.5 million newcomers.

There is nothing wrong with being too optimistic on demographics except that it could prevent policymakers from considering other steps to promote economic growth. If there is a widespread belief (as seems to be the case) that population growth will be a strong driver of the economy, we may forego some other growth-boosting measures which are in fact necessary.

In my opinion, growth for the US economy in the next few decades has to come from two main engines, first the perennial innovation engine, and second the manufacturing and export engine. The US can become once again an export powerhouse, not just in agriculture and technology, but also in other manufactured products along the entire value-added chain. Whether this requires a dramatic devaluation of the US dollar remains to be seen. If such is the case, we would not be the only country racing for a depreciated currency. Europe certainly does not want to see a stronger Euro, and if the Euro breaks up, virtually all countries except for Germany, Finland (and possibly France) will end up with currencies which are relatively weaker than the Euro. Germany may end up with a new Deutsche Mark which like the Swiss Franc will be stronger than its exporters would like to see.

Repatriating as many manufacturing jobs as possible and searching for new markets overseas are likely to be two important elements of a future growth strategy. Based purely on demographic trends, India and Sub-Saharan Africa look especially promising because improving health care and declining fertility rates (the two go hand in hand) could possibly yield the same kind of very large demographic dividend which we have seen in China and other Asian countries in recent decades.

Europe: Aging Population Undermines Longer-Maturity Bonds

ANCHALEE WORRACHATE writes in Bloomberg News and highlights the adverse rise of the dependency ratio undermining European debt reduction efforts:

The euro-region’s ability to grow its way out of the debt crisis faces a roadblock — an aging population.

While Italian Prime Minister Mario Monti and his Spanish and French counterparts push for measures to spur an economic expansion, Italy’s structural dependency ratio exceeds 50 percent. In other words, the number of working-age people is less than half the total population. The government forecasts the ratio will reach 63 percent in 2030 and 83 percent by 2065.

Aging and shrinking labor pools are adding to budget woes in the region where the unemployment rate is already at a record high. The risk is that without an overhaul of benefit programs, governments will be unable to balance their books as tax revenues shrink and unfunded pension and health-care liabilities balloon. Longer-maturity bonds in Spain, Portugal and Greece are underperforming their shorter-dated counterparts amid concern the nations’ finances will keep deteriorating.

“You just can’t create growth out of thin air and the demographic trend in the euro zone isn’t conducive to growth,” said Humayun Shahryar, who helps oversee $100 million as chief executive officer at Auvest Capital Management Ltd. in Nicosia, Cyprus. “For a long time, the economic expansion in the region was fueled by low borrowing costs that came with the monetary union. That’s no longer the case and the shrinking working-age population is a problem.” READ MORE.

Bundesbank: Germany Needs 200,000 New Immigrants Per Year

A report by the Bundesbank, published on April 23rd, comments on Germany’s impending demographic decline and asserts that the German economy needs an additional 200,000 immigrants every year (vs. 177,300 in 2011). The 200,000 annual influx would amount to 0.24% of the existing population, less than the usual 0.32% taken in by the US every year, but in line with the exceptionally low US immigration total in 2011. Because of the weak economy, the US took in only 703,000 immigrants in 2011, down from a more typical 1 million.

The report outlines other measures needed to compensate for the country’s demographic decline, including postponing the retirement age beyond the current age of 67 and facilitating child care for working parents.

It is not the first time that the Bundesbank models the effect of increased immigration on the German economy.  In a May 2011 report, the central bank had analyzed three separate scenarios with immigrants numbering 50,000, 100,000 and 200,000.

The Atlantic: Europe’s Real Crisis

Megan McArdle writes in The Atlantic:

“Not one country on the Continent has a fertility rate high enough to replace its current population. Heavy debt and a shrinking population are a very bad combination.”

The Continent’s problems are as much demographic as financial. They won’t go away soon.

All of us can breathe easy now: policy makers and analysts finally agree on how to fix Europe’s problems.

“Europe Debt Crisis Plan Hinges on Economic Growth,” declared the Los Angeles Times in October, after finance ministers announced what felt like the hundredth plan to seriously, no-foolin’-this-time, really rescue the European Union’s illiquid and insolvent states. read more.

Germany Reaps the Benefits of a Weak Euro

Germany is looking increasingly like the sole beneficiary of the Euro currency.

Since the introduction of the Euro in the late 1990s, Euro countries have greatly benefited from the convergence of interest rates towards German levels.  This trend cut the cost of funding for governments, corporations and individuals.  Some will argue that it also created the financial laxity which eventually led to the present-day crisis.  With the unfailing clarity of hindsight, it is now obvious that Greek borrowers should have paid a lot more in interest than German ones. For Greece and most Euro countries, the party lasted for several years but the brutal hangover has now set in.  Not so for Germany which has emerged in the last two years not just as a beneficiary of the Euro, but arguably as the sole beneficiary.

As The Economist pointed out recently, the German economy is booming:

“Its (Germany’s) GDP per head has risen by more than any other G7 country’s over the past decade. Unemployment in the troubled euro zone is at its highest since the single currency’s birth; in Germany it is at a record low. In most rich countries manufacturing exports have been hammered by foreign competition; in Germany they remain powerful drivers of growth.”

The Economist identifies several factors in Germany’s success, notably the resilience of Mittelstand manufacturers and the system of apprenticeships and vocational training, but it overlooks the most important factor:  German exports have boomed because the Euro is significantly weaker than the Deutsche Mark would have been.  If the Euro zone was disbanded and the strong Deutsche Mark returned, the competitiveness of German manufacturers and exporters would be adversely impacted.  In a strange irony amid the current turmoil, Germany can find solace in Greece being Greece, and Italy and Portugal, since the inclusion of these countries in the Euro zone has weakened the Euro vs. other leading currencies.

By contrast, the Euro has been too strong for Greece, Portugal and Italy, making their exporters less competitive with foreign counterparts.  Unlike Germany, these countries lack the skill, technology or competitiveness to produce the cutting edge industrial products which are now in high demand in the developing world.

The Economist recognizes that Germany has a serious demographic problem.  As for most European countries, its population is expected to shrink.  Domestic consumption, unlike in the US, has always been moribund, but if the export machine weakens due to a stronger currency or other reasons, there is little hope that the domestic economy can pick up the slack. The structural strengths of the German economy, real or imagined, will then appear of secondary importance.

See also The Economist’s interactive guide to diverging conditions in various European countries.