February 12, 2015    4 minute read

The EU: A Perfect Storm?

   February 12, 2015    4 minute read

The EU: A Perfect Storm?

Some have begun being optimistic about the EU, in fact, markets reacted positively to the introduction of QE, the Euro is weaker, which makes exports more profitable for companies and imports more expensive hence reducing the threat of deflation. Europe has not panicked as a result of Greece’s elections, yet. Additionally, economies that were once on the edge of collapse such as Spain and Italy expect significant economic growth in the next few years. Economic growth in Spain for 2016 has been forecasted at 2.5%, and unemployment should fall to 20.7%. In Italy growth for 2016 has been forecast at 1.3% by the EU and unemployment will remain stable, under 13%. Additionally, the Bank of Italy has raised the 2016 economic growth forecast to over 1.5% as a result of QE and the weaker Euro. Finally, lower oil prices mean cheaper costs of production for firms that rely heavily on the commodity.

However, not everything is as good as it sounds, and it seems to be that many are perhaps being over-optimistic about the political and economic situation that we face in Europe. The political situation in Europe is considered unreliable, but puts into question the effectiveness of the artificial monetary policies introduced by the ECB.

I am not a supporter of market regulation and instrumental monetary policies and therefore I, personally, oppose QE. James Grant published in the Financial Times an article that highlights the tragedy of actual monetary policies:

A bond is a promise to pay money. When the nature of quantity of that money is a government’s to manipulate, the value of the promise comes in for question”.

James Grant

He also points out that the pound has lost 98% of its value since 1917, and questions how central banks and governments may react to a new recession with QE and almost zero percent interest rates already established, and the effect that this will have on people’s money.

On the other side of the coin it is also worth reading what Dr. Krugman, a strong supporter of QE, thinks about its likely effect on Europe’s economy:

“Will the QE policy turn this around? Unless it’s shockingly larger and more aggressive than expected, it’s hard to see how. Unconventional monetary policy works, if it does, largely by changing expectations; but the markets know this is coming, and are notably unimpressed.”

Dr Paul Krugman

Even economists committed to Keynesian economics doubt the effectiveness of the QE programme introduced by the ECB in Europe and whether it will actually have a real impact on the rate of inflation. My perspective is similar to that of Bill Gross, a veteran bond investor and founder of Pimco. He believes that as a result of very low interest rates in Europe, banks are unlikely to use the money introduced by QE to invest in the real economy.

There are more reasons to worry about Europe’s economy. QE is supposed to address deflation and help Europe to reach its target inflation rate of 2%; but what if the policy does not have the expected effect? With interest rates set at historically low levels and a QE policy established through the continent, there is not much more to do, and if inflation levels remain low, the margin to introduce new policies to change that trend is null.

The political environment in the union is far from ideal. The rise of Syriza in Greece is a threat to the political and economic stability of Europe. Populism wins, stability loses. It is unlikely that Greece’s new governments will reach an agreement with Europe’s bureaucrats. This may push Greece into exiting the Eurozone leading to the monetary union losing all credibility. A number of European countries still have a large public deficit and are being financed through the ECB and financial markets. If populist movements expand across Europe and gain majorities in Parliaments, and Governments start questioning the repayment of public debts and austerity, the results can be devastating. It is logic not to lend money to someone who is not willing to pay it back to you. If governments run out of external liquidity, they will have to reduce expenditure, and this will lead to social unrest and will cause ramifications to the Eurozone.

The economy in Europe may become hostile in the upcoming year. Political instability will have some impact upon the macroeconomic environment. Worries of further deflation in the union are slowly disappearing, but political instability and a hostile environment could bring such worries back. The EU faces extremely challenging times, and while optimistic analysts are predicting better economic prosperity for the upcoming year, one should consider the possibility of a perfect storm, that may reach an unusual and devastating magnitude.

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