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Monday, October 20, 2014 1:26 PM

Eurozone Rotting to the Core; Four Possibilities; Beyond the Math

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On October 6, I noted German Factory Orders Slump 5.7%, Most Since January 2009.

The previous month was up 4.9%, so I averaged the two months noting "The average result is a decline of 0.4% per month, for the last two months. That process also means four consecutive months of decline."

German numbers were particularly volatile allegedly due to timing of school holidays, but there is no way to smooth out four consecutive months of decline as anything other than overall weakness.

Germany Slashes Forecasts

On October 14, and as expected in this corner, Germany Slashes its Economic Forecasts.

In stark contrast with the rosy forecasts made just six months ago of 1.8 per cent growth this year and 2 per cent in 2015, the government forecasts gross domestic product to expand 1.2 per cent in 2014 and 1.3 per cent next year.

The data follows last week’s release of dire German factory figures, which stoked fears among top financial officials gathered in Washington for the International Monetary Fund’s annual meeting that economic weaknesses at the heart of the eurozone could undermine the global recovery.

In spite of the growing pessimism, however, Berlin still expects Germany to avoid a recession, defined as two successive quarters of contraction. After a 0.2 per cent decline in the three months to June, Berlin forecasts some growth in the third quarter, contrary to the forecasts made by some bank economists.
German Manufacturers Cut Jobs

A recession in Germany is a given, but when? Its export model has held up better than I expected given a clear slowdown in the global economy.

Today, we have another sign a German recession will come sooner rather than later: German Companies Tread Unfamiliar Territory with Job Cuts.
When the flow of containers began to slow at the docks in Duisburg a few months ago, workers at the world’s largest inland port got an early indication that Germany’s export machine had begun to falter.

Container volume at Duisburg, which sits at the confluence of the Rhine and Ruhr rivers, is still expected to grow strongly this year. But the outlook for the docks – as with the rest of German business – is suddenly looking less certain.

German exports tumbled 5.8 per cent in August compared with July – the biggest drop since the peak of the global financial crisis in January 2009. The economy now risks slipping into recession in the third quarter, and the government has already lowered its growth forecasts for 2014 and 2015.

Indeed, with Chinese demand slowing, Russian orders slumping and the eurozone still in the doldrums, some companies have been left with a surfeit of production capacity and workers.

In the meantime, German companies are tightening their belts. Siemens, the engineering conglomerate, is poised to cut jobs at its German energy division due to a slump in European demand for its large gas turbines. The company would not confirm a German radio report that 1,200 jobs are at risk, out of a total of 118,000 in Germany.

Volkswagen, Europe’s biggest carmaker by sales, announced a €5bn annual cost-savings drive in July which may include a reduction in the use of temporary staff, its chief executive Martin Winterkorn, has said.

Rainer Hundsdörfer, chief executive of EBM Papst, a family-owned manufacturer of industrial fans, said it was “important not to be too pessimistic” because he believed Germany was experiencing a temporary lull and not “on the cusp of another crisis”.
Over-Reliance On Exports

Wolfgang Münchau writes Germany’s Weak Point is Reliance on Exports.
One of the biggest misconceptions about the eurozone has been a belief in the innate strength of Germany – the idea that competitiveness reforms have transformed a laggard into a leader. This is nonsense. The German model relies on the presence of an unsustainable investment boom in other parts of the world. That boom is now over in China, in most of the emerging markets, in Russia certainly. What we saw last week is what happens once the world returns to economic balance: Germany reverts to lower economic growth.

Previously, the main characteristic of the eurozone had been strong growth in the core that partially offset contraction in the periphery. Now both the core and the periphery are weak. And policy is not responding sufficiently. Add the two together and it is not hard to conclude that secular stagnation is not so much a danger as the most probable scenario.
Beyond the Math

I agree with Münchau on stagnation (actually, I think recession is a given and another eurozone crisis will follow). However, and is typically the case, I strongly disagree with Münchau regarding what to do about it.

It's a mathematical certainty that every country cannot have a trade surplus. Yet every country want's to export its way out of the mess. Germany in particular wants every country to be more like Germany.

It's mathematically impossible for other countries in the eurozone to become more like Germany unless Germany becomes less like Germany.

Math Not the Problem

It's safe to assume Münchau would agree on trade surplus math. But math isn't the problem.

France is an economic basket case because of inane socialistic policies, work rules, farm rules, and business restrictions in general. Italy is in a similar situation, but with an even more tangled government bureaucracy coupled with a monstrous debt-to-GDP ratio.

Both France and Italy want more exemptions from budget rules and more time to meet deficit targets. But more government spending can hardly be the answer. Government spending already accounts for about 57% of French GDP. France is in desperate need of less, not more government spending.

Reform alone is insufficient. The euro is fundamentally and fatally flawed.

Four Eurozone Possibilities

  1. Somewhere along the line, Greece, Italy, or France, is going to have enough of recession and stagnation and leave the euro in a disorderly eurozone breakup.
  2. Germany and the Northern European states need to bail out the rest of Europe.
  3. Germany can leave the eurozone in an orderly eurozone breakup.
  4. Decades of stagnation if the nannycrats succeed in keeping the eurozone intact.

Option two sounds nice but is fatally flawed. Germany would never agree to bailouts of that nature, and constitutionally couldn't if it wanted to. Besides, Italy and France are too big. Regardless of how unpalatable, there are no other options.

Widening Budget Rules Won't Help

Germany won't agree to modifying budget deficit rules, and even if it did, what good would it do?

The problem with Europe is not budget rules or too little government spending. Rather, the problem is too much government  and inane work rules on top of a structurally flawed euro.

Structural problems led to massive trade distortions and other imbalances within the eurozone, compounding the already serious productivity issues.

The eurozone experiment failed. The best option now is an orderly breakup. I believe Münchau knows that, but refuses to admit it publicly.

Mike "Mish" Shedlock

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