Economic Policy Tensions Poised To Soar In Europe

The Telegraph is reporting Biggest drop for the British Pound since 1992.

The pound suffered its weakest annual performance for 15 years in 2007, as markets bet that 2008 will be a miserable one for the British economy. The pound fell 6.1pc in the past year, which is the biggest annual decline since 1992 - the year in which Britain was ejected from the European Exchange Rate Mechanism.

The sterling exchange rate index, which compares the pound with a comprehensive basket of currencies, finished the year at 97.9, having weakened by 6.7pc in the past six months.

The currency's dramatic fall follows news earlier in December of a sudden doubling of the size of Britain's current account deficit, and comes amid growing speculation that the Bank of England will cut interest rates more aggressively than anticipated. Having risen above the $2.10 mark against the US dollar, the UK currency is now back at $2, and is expected eventually to drop to $1.80 or lower.

Pound vs. US$



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Against the US$ the pound rose slightly for the year even though it fell vs. a comprehensive basket of currencies. With the property bubble finally imploding in the UK, and with rate cuts in the UK coming, the strength in the pound vs. the dollar is unjustified. The recent selloff highlights that focus.

Economic Policy Tensions Poised To Soar In Europe

The Euro will be interesting to watch given that Cyprus and Malta tip balance.

Cyprus and Malta will tomorrow embrace the euro, boosting Europe's monetary union to 15 states and adding another two Club Med votes to the policy board of the European Central Bank.

The Latin and Hellenic cluster of states now has a majority of the votes on the governing council for the first time, with 11 of the 21 members. As the economic rift between the eurozone's North and South grows ever wider, the thorny question of which camp holds the majority of votes is likely to come into starker focus.

Both the French and Italian leaders have already called for a shift in policy to curb the rise of the euro and shield struggling industries.

"The lira-ization of the euro can no longer be excluded," said Professor Ansgar Belke, from Stuttgart's Hohenheim University.

What worries officials in Frankfurt is that the newcomers will tend to side with Greece, Spain, Portugal, Italy, France and Ireland should deflating property booms across the region prompt demands for a looser monetary policy.

Germany has not had a property bubble. Instead it has used the time since the launch of the euro to screw down wages and claw back competitiveness. Lean and fit again, it is gaining export share across southern Europe.

While Germany now has a current account surplus of 5.6pc of GDP, Spain has a deficit of 9.3pc, Portugal 10pc, and Greece 13pc. The deficits will have to be corrected, perhaps harshly.

"Tensions are likely to grow," said David Owen, eurozone economist at Dresdner Kleinwort. "If you get sharp slowdowns in the peripheral economies, they are going to want rate cuts. It could lead to much more heated discussions," he said.

The ECB maintains total secrecy over meetings, refusing to release minutes or reveal how members voted.

The new Cypriot bank governor, Athanasios Orphanides, was a top official at US Federal Reserve until mid-2007 and made his name as an economic theorist arguing that central banks should let inflation spikes subside naturally - if possible - rather than slamming on the brakes in a rigid or mechanical fashion

The doctrine is known as "the Opportunistic Approach to Disinflation". It has had a major influence over US monetary strategy.

Mr Orphanides played to his reputation as an inflation dove in an interview with Dow Jones in October, insisting that Europe enjoyed "an environment of very-well-anchored inflation expectations".

This puts him in direct conflict with the two German board members, Axel Weber and J�rgen Stark, who have both warned repeatedly that eurozone inflation of 3.1pc is reaching levels that could set off the beginnings of a wage-price spiral.

"Orphanides is going to bring a Fed-style framework to the ECB; the old Bundesbank perspective is progressively losing influence," said Julian Callow, eurozone economist at Barclays Capital.

A clutch of American-educated ECB board members from Italy, Spain and Greece is now taking over the key levers of power in Europe's monetary system.

The Bundesbank lockhold was broken two years ago with the retirement of Otmar Issing, the doyen of German monetarism who held unchallenged mastery of the ECB as both chief economist and head of the research apparatus.

A chunk of his empire went to Greek member Lucas Papademos, a former MIT professor and an intellectual force in his own right.

The ECB still cleaves to monetarist orthodoxy in a sort of ancestral deference to the Bundesbank - dutifully combing the M3 money supply data each month - but the bank is in reality shifting into a different orbit.

Lorenzo Bini-Smaghi, head of the ECB's international division, said a number of Eastern European states should ditch their pegs to the euro, which was forcing them to hold interest rates too low for the needs of their fast-growing catch-up economies.

The Mess In Europe

• There are property bubbles in Greece, Spain, Portugal, Italy, France and Ireland.
• Supposedly there is no property bubble in Germany.
• Spain, Portugal and Greece have deficits that must be addressed.
• Germany has a surplus.
• M3 is still soaring.
• There are fears of wage price spirals.
• France and Italy want to curb the rise of the Euro with currency intervention if necessary. See Currency Twilight Zone.
• The Eastern states arguably have rates too low, while France and Italy think rates are too high.
• Currency cranks trained in the US are now poised to take over ECB policy.

Economic tensions are not only going to rise, they are going to explode.

Euro vs. US$



click on chart for sharper image

In spite of all the problems in Europe, the Euro has been on a tear vs. dollar. Much of that move is based on diversification out of dollars by oil producing states. Given the problems facing Europe some unwinding of that rise in Euros vs. the dollar seems likely.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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