Sunday, May 25, 2008
Pigs might fly from euroland
Posted by David Smith at 09:00 AM
Category: Thoughts and responses


This is a time for celebration in euroland. The European Central Bank (ECB) will celebrate its 10th anniversary next Sunday with its reputation and that of the single currency riding high. The euro will be a decade old in January, having surprised the sceptics simply by virtue of its survival.

The days when the euro was described in the currency markets only by names unmentionable in polite company are long gone. It has been hitting new highs against both sterling and the dollar this year, having virtually doubled in value in terms of the greenback from its all-time lows.

The time when the ECB was a byword for amateurism is also long gone. The BBC may have been pushing it last week to describe its president, Jean-Claude Trichet, as the world's most influential central banker the Federal Reserve's Ben Bernanke surely holds that position but there is no doubt that the ECB's reputation has been enhanced and, as the BBC also suggested, in the eyes of the markets it has had a much better credit crisis than our own Bank of England. That, I'm sure, led to more than a little gnashing of teeth in Threadneedle Street.

Amid all this celebration, however, some of which verges on the smug, there is a danger at the heart of euroland. These days financial markets tend to look at the euro through the prism of Germany, forgetting there are 14 other members (Cyprus and Malta joined this year, Slovenia last). Some of those 14 have been in from the start and are finding life very tough and getting ever tougher due to the euro's rise.

I am referring to euroland's "Pigs". Pigs, like "Brics" is an acronym, though less flattering to those who fall into it. While Brics refers to the fast-growing emerging economies of Brazil, Russia, India and China, the Pigs are the struggling euroland countries of Portugal, Italy, Greece and Spain.
I don't want to upset anybody on the other side of the Irish Sea,
but I should say that in some versions there are two i's in Pigs.

A couple of recent issues have brought the Pigs issue to the fore. One was the release of first-quarter gross-domestic-product numbers for euroland. These showed a healthy 0.7% rise, vindicating the ECB's cautious stance on interest rates, but they also showed growth heavily tilted towards Germany, where GDP jumped by 1.5%, and against Spain, where the rise was only 0.3% and Portugal, where there was a 0.2% fall.

Figures for Greece are not yet available. Italy's GDP rose 0.4% on the quarter but was only 0.2% up on a year earlier. The Italian economy has been noticeably weak for the past few years. Silvio Berlusconi, recently re-elected as the country's prime minister, has been cool on the euro for some time, once memorably saying that the single currency had "screwed everybody".

Germany's first-quarter GDP jump was probably an aberration, though the latest Ifo index of business activity and confidence, published last week, was also upbeat. The federal republic is benefiting from the fact that it is not only the world's biggest exporter, with a large stake in fast-growing emerging markets, but also that it has gained competitiveness within euroland.

Germany's gain, however, is others' loss. When the euro started, nearly a decade ago, the original conversion rates from national currencies were helpful to weaker economies like Italy and unhelpful to Germany, which started at a competitive disadvantage. Ten years of productivity gains and cost-cutting have more than removed that disadvantage.

The fact that the Pigs are struggling is, in one sense, a simple reflection of the underlying problem of the euro, that the countries that joined it did not constitute an "optimal" currency area. They were not, in other words, either converged or flexible enough and have not adapted sufficiently to the challenge of living alongside Germany in a "one size fits all" currency area. This is compounded by particular problems in some member countries, such as Spain's building boom and bust. Greece's government debt is 95% of GDP and its current-account (balance- of-payments) deficit 14%.

Professor Andrew Clare of City University, in a research note for Fathom Consulting, entitled Pigs Might Fly, puts the problem simply: "The economic evidence that we have at the moment suggests that the 'one- size-fits-all' approach to monetary policy has benefited some economies and punished others."

This does not mean that any of the euro's members are rushing for the exits. It could be that even Germany will find life tougher as some of its export markets struggle and that euroland's economies will all soon be united in gloom.

It is also the case that the euro's weaker members, the Pigs, would have a lot to lose if they left the single currency. They would not merely suffer in terms of credibility and convenience, but it would hit any government opting for such independence hard in the coffers. Fathom estimates that the cost of official borrowing, measured by the spread of bond yields over their German equivalents, would rise sharply. Britain's departure from the European exchange-rate mechanism (ERM) in 1992 was child's play compared with untangling from the euro.

In the longer term, however, the problems for the Pigs may grow. "The failure of eurozone governments to implement the necessary reforms during the recent good times may eventually sow the seeds of the break-up of the eurozone and the demise of the euro," writes Clare. "Nothing lasts forever."

The 15th or 20th anniversary of the euro may be less celebratory than the 10th. Pigs may indeed fly.

PS: Some very senior policymakers in Britain think the rise in food and oil prices, the latter hitting $135 a barrel, is now a more serious threat than the credit crunch. A growing chorus in the City, led by Tim Bond of Barclays Capital, thinks the echoes of the great inflation of the 1970s are more powerful than those of the 1930s Great Depression.

Are commodity prices a huge bubble? Should we worry that the huge sums being poured by investment banks and hedge funds into commodities and index futures are the next sub-prime crisis in the making? That was the line taken by a rather good Radio 4 File on Four programme last week and I have a lot of sympathy with it.

However, the bubble goes on building, to the point where rational analysis goes out of the window. When a prominent oil investor such as T Boone Pickens says prices are going to $150 a barrel, the markets do not take it for what it is, a vested interest talking, but another excuse to buy. Even those who look at the economic fundamentals have almost given up the fight; the Bank of England in its latest minutes (an 8-1 vote for no change in interest rates this month) said it did not expect a significant increase in supply, and consequent fall in prices, for the next two to three years. Supply is increasing one estimate suggests a 700,000 barrels-a-day rise this month by the Organisation of Petroleum Exporting Countries but the market has got the bull by the horns.

Financial markets move quickly, with a 35% rise in oil prices this year alone, but the "real" economic response is slower. That response eventually happens, though, and any turnround in prices may be reinforced by the rush for the exits by investors.

Some people compare commodities with property, but there is an important difference. Everybody who wrote about the housing market, for example, recognised a long time ago that there had to be a limit on price rises and the debate was how we adjusted after a period of very strong increases. What worries me about commodities is that many in the markets seem to think there are no limits, believing it is onwards and upwards to $200, $300 or even $500-a-barrel oil. That's definitely bubble talk.

From The Sunday Times, May 25 2008