Ahead Of The Curve: Euro-Zone - Converging On The Weakest…

Neil Williams, Chief Economist for Hermes’ Global Government & Inflation Bonds team believes that, while helpful in providing liquidity and settling financial markets, the European Central Bank’s operations are doing little to raise solvency or growth, nor address an underlying competitiveness problem that may take a decade to solve.

To re-test our view that the ‘core’ euro-zone countries will struggle to pull the debtors out of trouble, we have extended our ‘Misery Indices’ out to 2013. Traditional misery indices simply add together a country’s unemployment and inflation rates, but become especially flawed in a low inflation or deflationary world when the two components may move in opposite directions.

Critically, a country’s nearness to deflation and what it means for wages and demand are surely as much a ‘misery’ to consumers as accelerating inflation. By adjusting for this, we offer a more reasonable alternative to both previous indices, and to conventional GDP estimates, which are produced with a lag and usually revised.

Misery Indices
Our adjusted Misery Indices (MIs) are summarised in the table below, and yield the following observations.

First, there has been a marked deterioration in euro-zone members during the global crisis, and further losses are expected. As a bloc, the euro-zone’s weighted average MI in 2012 and 2013 at over two percentage points should remain around its highest since the euro’s birth. This is in line with the bloating of government bond spreads, but in sharp contrast to the recovery in the US’s relative position.

Second, it is not surprising to see as the ‘most miserable’ the austerity countries trying to cut deficits and debt, preserve ratings and appease the IMF. For them - Ireland, Spain, Greece, and Portugal - high unemployment and deflationary pressures exacerbated by the fiscal squeeze will keep their MIs elevated. In 2013, Greece, Spain, Ireland and Portugal will, for the fourth-year running, face the greatest economic hardship, with Ireland and Portugal at least needing second bail-outs.  

Third, the euro-zone’s biggest economies, Germany and France – while starting from a stronger base - look set to deteriorate as the effects of their own fiscal squeeze come through. Italy this year hits its highest MI since the euro - according with GDP data confirming a recession. This is important given the three countries account for two-thirds of euro-zone GDP and are the drivers of intra-regional activity.

Even the smaller core members, Austria, Finland and The Netherlands stand to deteriorate as deflation pressure builds, as does Belgium.

However, most worrying is what our Misery Indices say about convergence. They quantify the two stages of convergence:  the impressive convergence from the 1992 Maastricht Treaty to the euro’s birth; then, with the euro, a steady re-widening as policy discipline waned. Economic convergence overall has improved markedly over the 20 years since ‘Maastricht’ - but our MIs confirm that increasingly it is convergence on the weakest.

The deterioration in Germany, France and other core countries offers little to lift the periphery. Moreover, the fact that, even in 2013, the euro-zone’s average misery should stay around its highest since the euro, suggests little fundamental scope for bond spreads to return to their pre-crisis levels once the ‘sticking plaster’ of the ECB’s longer-term re-financing operations (LTRO) is removed.

These disparities will again hinder the ECB as it sets rates. There may be just one policy rate, but insufficient economic union means up to 17 different inflation rates often precludes an appropriate real rate. Ireland, Greece and Spain are suffering the least preferential real rates despite running the most depressed economies.

So, with these sorts of anomalies and disparities persisting, the euro-zone’s woes will carry over well into 2013 and probably longer - no matter how quickly the US expands.