Continental European equity markets have rallied hugely since the US Federal Reserve began to cut interest rates. It’s an opportunity to sell.
The conjuncture of ostensibly good news about “new” IMF funding, Japanese and Asian bank bail-outs, and the Fed printing dollars to save the world, will fade along with global growth and corporate profit hopes. And in the next leg down in the global equity bear market, European equities will be the hardest hit.
The reason is this. Germany’s shift to the unreformed left shifts the balance of power in Europe. It liberates Europe’s other governments – predominantly socialist – to pursue the politics of economic nonsense.
It may take time, but the result will be bigger public budgets and deficits, higher taxes (particularly for corporations) and lower growth for economies and profits – and a weak euro/Deutschmark rate.
Booming European financial markets have been conditioned to believe that economic management in Europe has been depoliticized. They are mistaken: it has just been repoliticized.
New German chancellor Gerhard Schröder seems little more than a puppet of the much more leftist Oskar Lafontaine. Once the election was won, Lafontaine got the finance ministry for himself and took over all the significant powers of the economics ministry. He believes that power lies in economic control and he has a unitary political philosophy to achieve that.
As long as European Union countries were striving to get into the EMU club, the Maastricht criteria ticked away in the dark like an infernal machine threatening debt and deficit destruction on erring states. No more. The club has elected its members. There are no rules for expulsion.
Theoretically, the Maastricht criteria have been replaced by the stability pact. This would involve members of the club fining themselves if they ran budget deficits in excess of 3% of GDP. The goal is to achieve balanced budgets over the course of an economic cycle.
But the stability pact is still-born. And three of the four major EMU powers that brought it into being now have governments that never signed it and are on record as condemning it.
Europe is already suffering from fiscal-reform fatigue. Indeed, I believe that secret negotiations are under way between those three governments to alter the stability pact’s definition of budget deficits to exclude public-sector capital investment. That would allow them to spend an extra 2% to 3% of GDP. But it hardly seems worth changing the pact to do this, because club members will never vote to fine themselves anyway.
The threat of punishment for fiscal excess has been removed from the political process at national and European levels. Indeed, a high-spending Italian government that would once have been punished by escalating Italian interest rates hitting its public debt-servicing costs will now be let off the hook. Big budget deficits in one country will have only a minimal impact on the much vaster universe of euro interest rates.
It won’t take politicians in EMU’s more indebted states long to realize that this is the macro equivalent of a blank cheque – at least for a time. Germany’s shift to the left has economically empowered that kind of politics in Europe once again.
All of this matters to investors. Optimism about European financial assets since the collapse of communism has always been based on the implicit hope that the EU would transmogrify itself into an emerging US with all the inevitability of a dainty butterfly emerging from a chrysalis. European corporations, competing in a globalized economy, would force through supply-side reform irrespective of what politicians did. And the politicians would be held in check by the Maastricht criteria in the first instance and later by the universal depoliticization of economic management that is the inexorable consequence of globalization.
No longer. The Maastricht criteria and the stability pact are dead. Sure, globaliization may eventually prove to be an effective political policeman. But the world has become distinctly less free market minded in recent months.
The euro is supposed to be the Trojan Horse that will force Europe into the US mould. A single currency working in a single market supposedly raises competitive pressure, setting off a chain reaction among other miraculous supply-side modules – higher productivity, lower prices, increased earnings power and maximized shareholder wealth.
If politics featured at all in this ideal landscape, it was as a neutered hulk or in a shadowy decision-making body, where wise but secretive politicians backed the Emu Trojan Horse in order to achieve all the reforms they couldn’t achieve within the democratic system.
Alas, politics in Europe is neither wise nor neutered. Statesmen of conviction have left the stage with Margaret Thatcher and Helmut Kohl. Now it’s a career that pays for and attracts the sort of mediocrity that wouldn’t have a hope of succeeding in a market environment. So it can hardly be expected to understand or favour the market.
But government does have a guiding hand on some of the key control knobs of economic reform – such as its share of national output and income, trade and the labour markets. It is about to start twiddling them backwards.
Corporate Europe’s attraction was always the promise of reform. The share of corporate profits in national income, the return on assets and the creation of shareholder value all lag the US badly. Now, despite great promises from the likes of Siemens and Philips to slash and burn, little will be fulfilled.
David Roche is president of Independent Strategy, a research firm based in London. www.instrategy.com
