Well, that didn’t last long, now did it. Two consecutive quarters of minimal GDP growth seem to have exhausted the forces of a more than fragile Spanish economy. All the post-June data we are seeing suggests the economy has now turned the corner (in the bad sense), and we should expect a negative quarterly GDP reading in the July to September period.

Perhaps the clearest indicator we have so far of the shape of things to come is offered by the August services PMI reading, which shows the sector went back into contraction in August, a performance that for a country which depends to some significant extent on tourism is really pretty striking.

As Andrew Harker, economist at Markit and author of the monthly report commented:

“Months of broadly stagnant demand have now resulted in a decline in activity in the Spanish service sector, albeit a marginal one. It looks increasingly likely that the anaemic GDP growth seen during the second quarter of the year marks the high point of the recovery for the time being. The recent rise in VAT has further added to problems for service providers as weak demand has largely forced firms to absorb cost increases.”

The manufacturing sector continues to turn in a very slight positive reading, but both new orders and employment are falling.

Car sales were down 25% in August over August 2009, due in part to the withdrawal of the “cash for clunkers” programme, and in part to the rise in VAT, and finally industrial production data showed that output even fell very slightly in June.

Unsurprisingly, retail sales fell back sharply in July (by 3% month on month) following pre VAT rise purchases in June.

And unemployment, which is now heading up over and beyond the 20% mark (20.3% in July) was up again in August (even by 12,000 on a seasonally adjusted basis.

We don’t have the July construction data yet, but the position with retail sales is likely to be repeated, following a strong 7% (month on month) pre VAT surge in June.

Exports did recover to some extent during the “good times”, but to nothing like the extent they did in the more strongly competitive exporting countries.

And in fact, as we saw in a previous post, the net effect of the stimulus was to temporarily widen the trade deficit (strange, Monsieur Trichet on being asked by a journalist at the last ECB press conference when he planned to withdraw his stimulus, was most adamant that the ECB non-standard measures did not constitute “stimulus” – I guess it’s lucky for US citizens that Ben Bernanke doesn’t see things that way). Now, whether from the ECB or the Spanish government, the outlook is for gradual withdrawal of stimulus, which means the only realistic outlook for a badly structurally distorted Spanish economy is towards a slow but steady decline.

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Manufacturing lost 27k jobs and this was disappointing. The market had expected a 10k increase. This is consistent with the moderation in the mfg sector seen recently. It points to a soft industrial output report. Construction added jobs (19k) for the first time in a few months. Average hourly earnings rose a healthy 0.3%, which is favorable for income and consumption.

The debt market is selling off hard as the data means that, as already indicated the Fed will be in no hurry to renew its asset purchase scheme. On the other hand, the sell-off in US Treasuries is spilling over and weighing on European bonds, limiting the impact on the differentials.

The risk-on attitude is clearer in the currencies and the yen and Swiss franc have suffered against the dollar and on the crosses.

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• Jobs Data in Focus

The US dollar is mixed in quiet trading ahead of the US jobs report. With some risk-taking is returning to the markets on the back of data this week suggesting that the pace of the slowdown may be moderating and this is lending support to the euro and sterling and weighing on the yen and Swiss franc. The general consolidative tone that emerged near midweek remains intact. The US employment data is seen by many as the likely signal of the near-term direction, but as we review below, over the last three months the market’s disappointment has not been consistently been reflected or expressed in the dollar’s performance.

Global equity markets are finishing the week on a firm note after having suffered in August. The MSCI Asia-Pacific Index advanced about 0.5%, led by the tech sector. The benchmark is up 2.5% on the week. Of note, the 1.8% rise in the Philippine stock index puts it at a 3-month high while Indonesia’s 1.3% rise is sufficient to put it at a new record high. European bourses are generally around 0.5% higher. Their ability to hold on to the gains which are cap a good week (Dow Jones Stoxx 600 up 3.25%), depends heavily on the reaction to the US jobs data. Technology and financials are among the strongest sectors. The FTSE has been the best performing G7 equity market this week, advancing 4.6% as of midday in London. The Nikkei’s 1.4% rise puts it at the bottom.

Bond markets are slightly heavier with G7 sovereign 10-year yields mostly 1-2 basis points higher. Japanese government bonds suffered their largest weekly loss in a couple of years. The 10-year yield rose 15 bp to 1.135%. Peripheral European spreads are mostly quiet. Modest narrowing has been generally recorded this week, consistent with the improved appetite for risk noted elsewhere. In terms of policy, Indonesia’s central bank kept rates steady but did lift reserve requirements.

Currency Markets

The main focus today is on the US employment report. The fact that the service sector ISM is released shortly afterwards and that, given the Monday holiday in the US, and some markets will close early and could impact the market’s reaction to the jobs data itself. Yet, while the jobs report is regarded as among the most important economic releases of the month, the significance fore the foreign exchange market may not be as great as one might expect. Let’s review the recent history. The May employment report in early June was a major disappointment. The market consensus was 139k too high for the private sector non-farm payrolls. The euro declined and experienced follow through selling the following Monday. This did, in hindsight; turn out to be the bottom for the euro, but developments in Europe were arguably key. The June employment data out in early July was also disappointing. The actual private sector employment gain was 27k less than consensus. The euro did rally, but there was no follow through on the following Monday. The July private sector employment was 19k below consensus and the euro rallied but that day, Aug 6, marks the near-term high and it is now about 3.75% lower.

There are two other observations about the jobs data. First, the fact that the ADP estimate of -10k represents the first decline since January may be a bit unsettling. Yet the ADP typically under-estimates (roughly 85% of the time) the private sector job growth and that average miss is about 55k. So, even an average miss now would produce a near-consensus report. Second, the BLS also has difficulty estimating job growth and revises the data. The January through May data was consistently revised higher. June was the first revision lower. Generally speaking, the revisions take place in the direction of the underlying trend. Watch the direction of the July revision.

In terms of policy, recent Fed comments suggest that it will likely take more than a slightly disappointing employment report to spur the central bank to resume its asset purchases. This would seem especially true for the Sept 21 FOMC meeting. The next meeting is Nov 03, which is the day after the midterm election. But as Bernanke recently noted, there are other policy levels in addition to the monetary. The Washington Post reports that the Obama Administration is considering possible tax cuts to spur employment and investment. The measures under considerations are thought to include a payroll tax holiday and renewing R&D tax incentives.

The euro zone service PMI came in a little better than the flash reading. The 55.9 headline compares with the 55.6 flash and 55.8 in July. As we suggested yesterday, given the uncertain economic outlook, the market’s attention is really on the forward looking indicators, like new orders. In the non-manufacturing sector, new orders in the euro zone rose to 54.9 from 53.1 in July. Of note, Germany was a bit disappointing, coming in at 57.2 from 58.5 in the flash, but still better than the 56.5 in July. On the other hand, Italy, which had fallen below 50 in July popped back above in August (51.4). Spain was the weakest link with the first sub-50 reading since Feb. The euro zone remains a bifurcated economy. Just like the aggregate analysis conceals the largest deficits by Germany and the Netherlands surplus, so too does the aggregate analysis conceal the economic discrepancies. The debt market allows a clearer way to distinguish among the different members. When European officials claim, as they have recently, that there is no chance of a double dip, they seem to be cheerleading rather than offering a realistic assessment. In Germany and the Netherlands are the bright spots and they are largely export driven, isn’t that a real vulnerability if the risk of a double dip elsewhere materializes? The US economy expanded sharply in Q4 09 and Q1 10. Europe nearly stagnated then. The US slowed markedly in Q2 and into early Q3. The euro zone expanded smartly in aggregate in Q2. Is there really no chance whatsoever that the euro zone is simply lagging behind the US by 3-6 months as often appears to be the case?

Briefly turning to the UK, today’s service sector PMI disappointment caps the generally disappointing week. Each of the three purchasing managers’ surveys (mfg, construction and service) came in well below market expectations. For the record, the service PMI headline fell to 51.3 from 53.1 and the consensus had expected a smaller decline to 52.9. Sterling has the dubious honor along with the Canadian dollar as being the only G10 currencies to fall against the dollar this week. Sterling is off about 0.8%, but more telling that its performance against the dollar, it also appears to have reversed against the euro this week. The 5 and 20-day moving averages have crossed suggested further euro recovery against sterling in the days ahead.

Upcoming Economic Releases

Today’s focus will be on the US jobs report which is slated to be released at 8:30 EST/12:30 GMT. According to Bloomberg’s median survey, nonfarm payrolls are expected to drop by 105k with a 10k job added to the Manufacturing sector. In addition, the unemployment rate is expected to increase to 9.6% from 9.5%. Meanwhile, the ISM Non-Manufacturing Composite will be released at 10:00 EST/ 12:00 GMT. The market is looking for a small drop to 53.2 from 54.3

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Developments in Romania today support our recent bearish call on the leu. EUR/RON has risen after we went long Aug 30 around 4.24. We still target the record high 4.40 from June and expect this pair to creep upwards in the coming weeks. The 4.23 area represents the 50% retracement level of the big March-June rise, and is providing a strong base for the euro right now. Intermediate targets are retracement levels around 4.29, 4.31, and 4.33 from the June-August drop. We also take this opportunity to reiterate our bearish HUF call as well, with politics there also proving to be a big negative.

There was yet another failed bond auction today, as the Finance Ministry rejected all bids for RON300 mln 5-year paper offered. Officials continue to try and put a 7% ceiling on borrowing rates, but there are simply no takers in this risk-averse environment. As we wrote earlier this week, “The more auctions that fail now, the more trouble Romania will be in down the road. Indeed, one of the assumptions behind any debt sustainability framework centers around getting borrowing rates back to “normal” levels. We aren’t seeing that in the euro zone periphery, and neither are we seeing it in the weaker Eastern European credits.” Making matters worse, the unpopular government is undertaking a cabinet shuffle and Fin Min Vladescu will be replaced. He has been at the helm since the last cabinet shuffle in Dec 09. The government has undertaken austerity measures as required by the IMF, but is paying a political price in terms of low popularity. If the new Fin Min shows less commitment to austerity plans, then the IMF package will be at risk. It did just receive approval of its fifth review under the current program, but the 24-month Stand-By Arrangement expires in May 2011. There is no way Romania can stand without IMF aid, and so markets should watch closely for signals by the new Fin Min.

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The ECB left rate on hold, revised up both growth forecasts a notch and inflation. The lending facilities have been extended and the ECB will conduct special operations later this month to help ensure a smooth expiry for the large long-term refi operation.

There is little surprising here and after initially easing on the news, the euro has firmed back to new session highs–amid talk of leveraged account purchases. Equity markets firmed and general risk-on trades coming back to the fore, except it does not appear to be helping the dollar against the yen or Swiss franc. Sterling remains a laggard after a string of soft data. The Australian dollar is also not participating in the move against the greenback, but is seeing earlier losses pared.

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Highlights

The US dollar is mostly softer, though within yesterday’s ranges as market participants await the ECB’s press conference and US economic data. Sterling is under-performing perhaps being impacted by the softer string of recent data, including today’s construction PMI (52.1 vs 53.2 consensus and July’s 54.1) and the fifth consecutive monthly decline in Hometracks’ house price index. The euro is firm, but like yesterday the band of resistance in the $1.2850-$1.2875 may prove sufficient to check upticks ahead of tomorrow’s US employment report. The dollar remains pinned near recent lows against the yen, but the momentum remains stalled. Range trading between JPY83.50 and JPY85 looks set to continue. Emerging market currencies are generally firmer as the recent string of data—especially yesterday’s better than expected China’s (especially the increase in new orders) and US purchasing managers reports.

The strong US equity advance yesterday helped underpin Asian markets today. The MSCI Asia-Pacific Index’s 1.1% advance lifted the benchmark to a new two week high. The Philippine’s market led the way with a 2% advance to reach its best level since December 2007. News that Chinese auto sales rose 59% in August, 3-times July’s pace, helped the auto shares in the region. Foreigners were mostly net sellers of Asian shares during last month’s down draft, but appear to have returned to the buy side. European bourses are narrowly mixed after posting the biggest gain in more than three months yesterday. The raw material and technology sectors are generally stronger, largely offsetting the losses in telecom and health care.

The decline in pessimism over the global economic outlook is sparking a backing up in bond yields. European bonds yields are mostly 3-5 bp higher. The new supply from Italy, France and the UK was absorbed with out much problem and most peripheral spreads are coming in a couple of basis points, though Greece is an exception. Sweden’s Riksbank hiked the repo rate 25 bp to 0.75%. Surveys favored a hike by roughly 3 to 1, but the krona has marginally extended yesterday’s gains against both the dollar and euro.

Currency Markets

There are two sources of event risk. The first, and lesser of the two, is the US weekly initial jobless claims. The modest pullback from the above 500k reading in mid-August was a constructive development, but the 4-week moving average still ticked up to its highest level of the year (486k). It will take a weekly reading today below 482k to bring the 4-week average down (assuming no revisions). Now of course with the monthly national report out tomorrow, the market’s reaction may be more subdued. The market’s response may be asymmetrical in the sense that a move back above 500k may elicit a bigger market response than a decline in initial jobless claims. At the same time, note that recent comments from the Fed’s Plosser and Fisher have played down the near-term need for Fed to buy more long-term assets.

The second and more important of the event risk comes from the ECB meeting. There will be no change in rates, but there are two elements the market expects to be addressed today: decision on lending facilities and updated economic forecasts. Following confirmation that the euro zone expanded by 1% in Q2, the ECB is likely to revise up this year’s GDP estimate to reflect this. This is what economists will be trying to assess: how much of the likely upgrade reflect what has already happened and how much reflects new information—ECB’s real expectations going forward—and revisions to 2011 forecasts will also be important. Turning to the lending facilities, the BBK’s Weber opined earlier that the weekly, monthly and 3-month facilities should be extended into next year. Weber has been criticized in some quarters for apparently preempting the ECB, but this seems reasonable given the stresses that still are apparent.

The premium Greece, Spain and Portugal pay over Germany on 10-year bonds is greater than it was when Europe announced their so-called 750 bln euro package. We argue that “real water” was half as that when taking out the 250 bln euro that was said to come from the IMF but there was no commitment to give any funds to a region in general, and EU’s 60 bln euro contribution (as EU members not in the euro zone balked). Lastly, given that the vast majority of members do not have triple A ratings, the only way the EFSF could issue tripe-A paper is if the amount guaranteed was about 20% more than the amount of bonds issued. There is a modest risk that rather than simply indicate the extension of its liquidity provisions, the ECB announces something more to help address the 225 bln euro maturing long-term repo operation expiring this month.

Doubts about the trajectory of the global economy were not sufficient to keep Sweden’s Riksbank on hold. The 25 bp rate hike was partly justified by the upgraded economic assessment. This year’s GDP forecast was revised to 4.1% from 3.8% previously, though next year’s forecast was shaved to 3.5% from 3.6%. Inflation forecasts were skimmed 1.1% this year form 1.2% and 1.9% next year form 2.0%. The board still contains divergent opinions, mostly seemly over timing, but barring a major negative shock continued gradual tightening by Sweden the most likely scenario. Even though the euro losses against the krona have been extended, the momentum appears be flagging. Ironically, and counter-intuitively, Norway’s central bank edged its growth forecasts lower and the Norwegian krone is outperforming the Swedish krona (marginally). Note that the head of Norway’s stats offices Olsen is seen as the likely successor of the central bank governor Gjedrem who will step down at the end of the year, seems more dovish, warning that recessionary conditions persist in Norway.

Apparently for the first time recently, there has been market talk that quasi-government pension arms were selling yen. Some participants see this as mild intervention. That seems an unlikely interpretation. If Japanese officials think that intervention is needed to break the one-way market, they would want to make a big splash with the intervention. If there were intervention, there would be no doubt. Whether it would be effective or not is a different issue. In the past, Japanese intervention was sterilized through issuing financing bills, but intervention now might not be sterilized. In addition, there are tactics that officials could adopt that could also increase the impact of intervention, such as all-or-none type of orders.

Upcoming Economic Releases

The 8:30 EST/12:30 GMT productivity and unit labor cost reports do not contain new information. They are functions of the Q2 GDP report. This means that Q2 productivity will be revised down and unit labor costs higher. Weekly initial jobless claims will be watched closely and are reported at the same time. Factory orders at 10:00 EST/14:00 GMT may also attract attention and could continue the string of non-housing data that suggest the US economy may be stabilizing after slowing in Q2 and early Q3.

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Well, as we all well know one swallow doesn’t make a summer, and one data point doesn’t swing an argument one way or another, but the latest retail sales PMI reading for Germany is far from being either uninteresting, or (for my part) surprising. Basically after only two months (in the last twenty seven) of registering growth, the August PMI suggested that German retail sales once more fell back. And the anecdotal explanation for this: Spain’s victory in the world cup affected the shoppers appetite! Actually, from a long term aggregate point of view I think (and economic study would be a waste of time if it weren’t like this) that rather more factors come into play than football and the weather.

August data signalled a modest decline in month-on-month sales, reversing the solid upward trend registered in both June and July. At 48.4, down sharply from 57.2 in the previous month, the seasonally adjusted Retail PMI was below the 50.0 no-change value for the first time since May. The latest reading was the lowest for four months and slightly below the long-run series average (49.1). Anecdotal evidence suggested that less favourable weather conditions and reduced consumer footfall had negative impacts on like-for-like sales in August. Some retailers also noted that the end of the football World Cup had contributed to a decline in household spending.

Of course, the retail PMIs are not an exact science, and they only give us an indication of the retail environment. But their long term trend is not in disharmony with the actual sales data provided later by the statistics office, since sales in Germany have been generally trending down, and as the writers of the report say, the long-run series average (49.1) does show slight ongoing contraction .

Consumer confidence, on the other hand, has risen slightly in recent months, but it is still well below the pre-crisis level:

While the ZEW investor sentiment index – normally a forward looking indicator – has been dropping steadily for some months now.

So if we combine this with the August flash German PMI reading (which dropped back slightly over earlier months), it would seem that some easing off of German GDP is taking place, and indeed few will be surprised by this, since the very rapid rate of Q2 growth was clearly a one off. The issue really is that these very rapid (Leo Messi in-the-box type) accelerations don’t seem to pass through to self-sustaining (via the consumption pillar) expansions, and I do wish more people would start to ask themselves why this is.

Moving on to other parts of the Euro Area, French retail sales seem to have continued to grow in August, although at a rather weaker pace than in July.

But whichever way you look at it French retails sales have a decidedly more positive look about them than their German equivalents.

What really seems striking to me is the difference in outlook being expressed by the retailers in the respective countries. According to the German report:

Although retailers were downbeat about their actual sales in August, latest data pointed to a surge in optimism about the prospects for sales in September. The degree of positive sentiment about the outlook for sales in one month’s time was the most marked since April 2008. Almost one-quarter of survey respondents anticipate sales to beat their initial forecasts. A number of retailers linked their optimism to improving conditions in the domestic economy.

On the other hand, the French report talks of caution among those interviewed:

The value of goods ordered by French retailers for resale decreased for a second straight month in August. Panellists indicated that they preferred to take a cautious approach to stock decisions at the present time. Correspondingly, inventories declined at the fastest rate since January.

One wonders what the basis for such expectations actually are. It couldn’t possibly be that they are being influenced by the press and media coverage of the situation, could it, since in neither case do I see the expectations as especially realistic. The French seem to be too pessimistic, and the Germans way too optimistic.

Meanwhile over in Italy it was plus ça change, as retail sales continued their now customary decline (if at a rather weaker pace than in recent months), with the consequence that the Eurozone Retail Sales Index suggested that sales across the Euro Area fell very slightly in August (on aggregate).

Well, all meat for Monsieur Trichet to chew on before Thursday’s meeting.

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Not only is the French economy the grateful recipient and beneficiary of sustained German export growth, so too is Poland (I’m sure they’ll be glad to hear that in Warsaw!). According to the FTs Jan Cienski:

German recovery boosts Polish GDP

Poland’s economy grew by an unexpectedly strong 3.5 per cent in the second quarter; the country’s statistical agency said on Monday, thanks in part to continuing strong exports to the rapidly rebounding German economy, as well as resilient domestic demand.

In fairness to Cienski he then does go on to inform us that according to the statistical agency “the main driver of growth was domestic demand, which grew 3.9 per cent”. But then he falls back on himself again, since he immediately adds “many German manufacturers buy parts from Polish factories, and when the German economy grows – it is expanding by the fastest rate in two decades at the moment – it pulls Poland along behind it”.

But then, hold on there, just wait a minute: “For the first time in many months, however, Poland’s trade balance was negative, as imports surged 18.2 per cent, a sign of a maturing economic recovery”(a)

Can we run that again. The German economy is boosting Polish GDP by selling them imports? Can’t the people over at the FT do basic math? And can’t they get it into their mindset that there are export driven and autonomous consumer demand driven economies? And following the causal chain, it is those economies who take on debt (Poland and France in the current situation) and run current account deficits who become the customers of the last resort, and drive those who need to export to live. How can they possibly believe it is the other way round?

Of course, at the dis-aggregated level the whole world is interconnected, and I’m sure a lot of firms in the US benefit from domestic demand in China, even though no-one, but no-one in the US would argue that strong export growth in China was powering the US economy. The idea would simply not occur to them. More than demonstrating a high level of economic illiteracy, what is involved here is a certain lack of respect for the capacities of the the two countries involved (France and Poland, even if I suspect Cienski is himself Polish). Such is the power of the German Choo Choo train metaphor. I think a whole zeitgeist has to fall here, before we can make much more progress in our economic understanding of the situation.

For a fuller analysis of the current dynamics influencing the Polish economy, see my recent “Biting The Fiscal Bullet In Poland“. (And here if you want is a version in Polish).

(a) Incidentally, I take it here Cienski is referring to the combined goods and services balance when he says “for the first time in months”, since the goods trade balance has long been in deficit.

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Well, having just posted a lengthy study of the German economy on this blog, I started to lazily browse my way around today’s economic news headlines, and Lo & Behold, what did I find over at the FT, a contrarian voice. That of Wolfgang Munchau. In his comment column he berates the Euro Area for its lack of product market and labour market mobility – in the sense that there are large differentials in both price and wage levels, yet few seems motivated to either shop or work around in the search for a better deal. Few seem motivated to follow Germany’s earlier example of a real devaluation, with consequences which are, unfortunately, only too predictable.

Taken together, this means the intra-eurozone imbalances will not only persist, but probably increase. This will make the economic adjustment for Spain, Portugal or Greece even more difficult than it already is. Those persistent imbalances, much more than the build-up of debt, are my deep cause of concern about the long-term health of the eurozone.

But from a German perspective, this strategy boosts growth in the short term. It is, of course, a beggar-thy-neighbour strategy. The improvement in Germany’s economic growth is driven not by productivity gains but by real devaluation.

So while I expect the German economy to perform better than the eurozone average, it is important to keep some perspective and not draw false inferences from the 9 per cent annualised growth rate during the second quarter. If you look at the period since the beginning of the financial crisis, Germany’s economic performance has been dismal. If you compare levels of gross domestic product between Germany and the US since the crisis, you find the US significantly outperformed Germany during that period. That situation may still be reversed if the US were to go into a double-dip recession. But the best judgment we can make now is that of Christine Lagarde, the French finance minister, in her recent interview in the Financial Times: Germany is recovering faster this year because it contracted faster last year, when GDP fell by 5 per cent. So far, this looks like classic dead-cat bounce.

Given its export-dependence, the performance of the German economy will ultimately depend on the global economy. As the US is heading for another downturn, it is hard to see how Germany can maintain its recent rates of growth. To do so would require a sudden increase in domestic demand. But I cannot see where that would come from.

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The modern world moves at a breathtaking pace, even when most of us find ourselves on holiday. No sooner do we receive, read and start to digest one set of economic data than we find ourselves pushed to think about what the next set will look like. The clearest recent illustration of this undoubted reality is to be found in peculiar twist of events which meant that just as the news reached us that the German economy had expanded at a record rate in the second quarter, at almost the very same moment Federal Reserve officials meeting in Washington decided to significantly downgrade their economic outlook for the United States, saying the “pace of recovery in output and employment had slowed in recent months” and was likely to be “more modest” than anticipated in the near term. But this followed a month of May when it seemed Europe’s economies were on the brink of disaster, while over in the United States some sort of recovery was on the cards.

So what is going on here, does the earth switch it’s magnetic pole every six months, with what went up last time round now going down? Or could it possibly be some kind of common thread here, one common factor which unites the unprecedented expansion we have just seen in Germany, and the fears of renewed recession in the United States. Well, as it happens, indeed there could, and it has a name – the Greek debt crisis.

Structural Problems In The Currency Architecture?

So what is the link? Well, the fact of the matter is that we live in a bi-polar world, at least as far as currencies are concerned. Until our current global financial architecture evolves into something more sophisticated, we have two main currencies which rival one another for pride of place in central bank reserves and investment portfolios: the euro and the dollar, and when one of these goes up, the other must come down, and vice versa. It is as simple, and as complicated, as that.

Prior to February, and the outbreak of the European Sovereign Debt Crisis the US economy was seen as the weaker partner, and the euro was priced at a relatively high level. Then the euro slumped (falling at one point from around 135 to 120 to the US dollar in a matter of weeks) as attention focused on what appeared to be significant weaknesses in the Eurozone infrastructure. As a result of the change German exports boomed, while the US economic recovery steadily started to grind to a halt.

And with the rise of the dollar the global economy started to fall back into dangerous – pre crisis – habits. The US trade deficit started to open up again, and one exporting nation after another started to see yet one more time the US market as the global economy’s consumer of last resort. Indeed the US June trade statistics reveal the extent to which American consumers are once more sucking in large quantities of imports as their spending power recovers, while weak demand in the rest of the world coupled with the comparatively high dollar has been keeping a brake on American exports.

As the New York Times put it in an editorial, “China is mopping up demand everywhere you look with its artificially cheap supply of goods, while Germany, the world’s other exporting power, is cutting its budget and relying on foreign demand to drive its economic rebound. This isn’t sustainable”.

And the numbers prove the point. The United States trade deficit ballooned to $49.9 billion in June, the biggest since October 2008. In July, one month later, China recorded a $28.7 billion trade surplus, the biggest since January 2009. In the first five months of the year, Germany’s trade surplus, driven in large part by demand for machine tools in recovering Asian economies (many of them busily sending exports to the US), rose 30 percent compared with 2009.

And this impression is only confirmed when we come to look at the latest revision for US GDP in the second quarter. According to the revised data, US GDP increased at an annualised 1.6% rate (as compared with the 9% annual rate in Germany), after registering a 3.7% rate in the first quarter, according to the Bureau of Economic Analysis (BEA) today. The second-quarter growth rate was revised down by 0.8 percentage point from the “advance” estimate (of 2.4%), in part as a result of the new data on imports for June. The US Bureau of Economic Analysis report stated that slower GDP growth primarily reflected a surge in imports compared with the previous quarter and a slowdown in inventory investment. In fact, real exports of goods and services increased at a 9.1% rate in the second quarter, compared with an increase of 11.4% in the first, while real imports of goods and services increased by 32.4%, compared with an increase of 11.2% in Q1.

Effectively the American economy is simply too weak to carry this additional load, and is now showing signs of heading back towards recession, forcing the Federal reserve, which only a few months ago was moving towards a tightening in monetary policy to fend off inflation to now re-assert its policy of quantitative easing to avoid any possibility of a drift towards deflation.

Meanwhile the German economy turns in a 2.2 per cent quarterly growth spurt, unified Germany’s best-ever performance. The annualised 9 per cent growth rate, is, as the Financial Times noted, virtually unprecedented in developed economy terms. Such dramatic changes, rather than reassuring us that all is well, only lead to even more doubts. Is it really desirable for an economy to shoot forward so dramatically, only to fall back again in the second half, which is what almost everyone (Monsieur Trichet included) expects to happen?

Not only does the German performance seem exaggeratedly large, at the other end, on Europe’s periphery, the result was lamentably small. Greece naturally exceeded everyone’s expectations, on the downside, with a 1.5 per cent quarterly contraction (a 6 per cent annual rate), but Spain remained at the bottom end of the range, with a 0.2 per cent expansion, as did Portugal. Undoubtedly the Greek contraction will slow as the year advances, but the outlook there continues to be preoccupying. Only today the Greek manufacturing PMI, which showed the contraction in Greece’s industrial sector accelerated again in August, has reminded us of just how difficult it is going to be for the country to return to growth, and especially if the external environment now starts to deteriorate.

As the FT’s David Oakley said yesterday, in many ways Germany could be said to have had a “good crisis”, since the Greek issue pushed the Euro down and German exports up, while the current flight to safety is driving down the yield on German bunds to record lows even as it pushes up the spreads for peripheral Europe sovereigns. Among other impacts this gives German companies an even greater competitive advantage as their capital costs come down even while those for their competitors go up.

Spreads – which are the additional borrowing premiums countries have to pay over benchmark Bunds – hit a fresh record of 357 basis points in Ireland this week, following problems in Allied Irish bank and a Standard & Poor’s downgrade. In Portugal and Spain, spreads have been creeping back up, and are now once more close to their all-time highs. Spain’s 10-year bonds are trading at about 192 basis points above Germany, compared with 57 at the start of the year while Portugal is trading at 333 basis points, compared with 67 on January 1. The following chart shows how peripheral spreads have evolved since the start of the year (they have been indexed to 1st January). As is evident they shot up in May, then came down to lower levels in July, but during August they have once more been climbing.

All three economies are experiencing extremely weak growth and Ireland is even flirting with deflation. Higher government borrowing costs can harm economies in a number of ways, from higher borrowing costs for companies to added pressure on a country’s public finances as more is eaten up in interest charges, leaving less for public services and stimulus. Effectively the presence of a large spread differential means that monetary policy is applied unevenly across the Euro Area, despite the “one size for all” objective of the ECB. And doubly so with a credit crunch which means some banks struggle to finance as a backdrop.

Japan Trapped On The Ropes

And as if all of this wasn’t enough, Germany’s main competitor in Asia (where German exports have been clocking up large increases) has been effectively KO’d by the flight to safety produced by the Sovereign Debt Crisis. Japan’s exchange rate against the USD dollar is now hovering around a 15 year high.

The consequence of this is not hard to predict, while Germany clocks up record exports to China and other parts of the continent, the Japanese “recovery” is gradually grinding to a halt, as the latest manufacturing PMI report only confirms.

We Need To Seriously Address The Imbalances

At the end of the day it is hard to avoid the conclusion that we continue to live in a very unbalanced and essentially economically unstable world, where currency valuations and economic growth rates fluctuate with unnerving rapidity. Not only that, the recent Federal Reserve meeting seems to have constituted some sort of defining moment, the point when everyone finally recognises that the long promised recovery was no longer simply weeks or months away, and that emerging from the trough in which the developed economies find themselves is going to involve a long period of slow and painful effort, one where we will also need time to clean up the mess we have made in cleaning up the original mess, assuming that is that we have the dynamism and energy to do so.

On thing is clear, the old habits won’t work any better now than they did before 2007, and external deficits which were not sustainable then will not be sustainable now. So we need a new model, a model in which the emerging markets will have a much larger role to play than ever before. And if we are to move towards a more sustainable future, then we need to move beyond those simplistic headlines stressing the virile nature of Germany’s export prowess. There is no doubting the efficacy and competitiveness of many German companies, but for that very reason that country needs to shoulder more of the responsibility for sharing the burden which is involved in finding solutions. Here in Europe we don’t only need sacrifices in the South, some of them also need to be made in the north. German industry is enjoying real and tangible benefits (via artificially low interest rates and an undervalued currency) from the mess that the Greeks created for themselves, but in the interest of all European some of those benefits need to be ploughed back in again, since if Greece is allowed to fail, no one will be the winner.

Looking beyond Europe we need to think about how to best aid and abet the emerging economies in their quest for growth and better living standards. Earlier in the crisis I asked Nobel Economist Paul Krugman a question which is very much to the point. “At a time when the financial crisis is generalised across all developed economies – whether because those who borrowed the money now have difficulty paying back, or those who leant it now struggle to recover the money owed them – to which new planet are we all going to export?”

My response to him back in January was that maybe we don’t need to look so far afield. Many developing economies badly need cheap and responsible credit lines, and access to state-of-the-art technologies, so why not accept the world is changing, and go for some sort of New Marshall Plan, one capable of generating a win-win dynamic which would be in all our interests? At the time the proposal seemed totally unrealistic and unobtainable. Now, with every day which passes it starts to look essential. And who knows, maybe the rise of a number of other major economic powers would help solve that bipolar currency problem which is currently causing our policymakers so many headaches.

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Spain’s EU harmonised seasonally-adjusted unemployment rate (which is the interesting number) went up again in July, according to the latest data from Eurostat. It rose to 20.3% from 20.2% in June.

So despite a double digit fiscal deficit, Spain has not yet succeeded in putting a brake on the upward drift in the headline unemployment number.

And the number of those officially working continues to decline, according to the data on those paying insurance contributions from the Labour Ministry.

Clearly having broken the 20% barrier the number looks like heading up even further in the second half of the year, although quite how far up is hard to say, since my feeling is that some of the increase in unemployment is now being offset by the silent march of feet, heading for the door, and looking for employment abroad.

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• How Obama Got Rolled by Wall Street – Newsweek
• FT.com / Columnists / Martin Wolf – Obama was too cautious in fearful times
• Michael Gerson – Obama’s wandering economic message

My take:

• Barack Obama as Herbert Hoover
• The Democratic Party meltdown of 2010
• Grading Obama’s economic policy after one year
• Triangulating on deficit reduction, 2010 version
• Ron Paul has Barack Obama’s number

I would still sum it up this way as I did two weeks before Obama came to office:

The long and short of Krugman’s fuller analysis is that [Obama's economic plans] will NOT be enough stimulus to provide the economy the boost it needs. Moreover, Krugman asserts that the lesson learned if it comes up short is that government spending does not work. Therefore, Obama will be less likely to receive monies if he tries to add stimulus a second go ’round.

I tend to agree with Krugman’s political calculus here. Obama has one shot. From a political standpoint, he should be opting for massive stimulus and look for that to be cut back to a more palatable level in negotiation. However, he seems to be treading a cautious line, looking for bipartisan support that he may not receive.

I see this scenario as very negative for the U.S. economy. First, you have huge government spending that requires additional borrowing by the U.S. government. But, this spending does not give the economy the needed jump start to pull out of the deflationary spiral.

Read more: http://www.creditwritedowns.com/2009/01/obamas-stimulus-bill-is-a-tough-sell-so-far.html#ixzz0yHg3a9Na

The Usual Fare

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Highlights

The US dollar is broadly lower to start September as stronger data, especially from Australia and China encourage new risk taking. Yet this has not seen the yen and Swiss franc, beneficiaries of risk aversion, lose ground against the greenback, though they are under-performing on the crosses. This, coupled with the fact that some countries like the UK, Norway and Sweden, which have reported disappointing PMIs, have also seen their currencies raise against the dollar today, provides a sense that in addition to the risk-on story, there is a weak dollar bias. Given the over-stretched short-term technical studies, the risk is that if the US data disappoints (ADP and ISM), the price action could be reversed.

Global equities are rallying as the new month gets underway. The commodity sector helped lead the MSCI Asia-Pacific Index 1.1% advance. Stronger than expected Australian Q2 GDP (1.2% vs 0.9% consensus) helped lift the S&P/ASX 200 by a bit more than 2%. News that continued growth in Korea’s exports saw the Kospi rise 1.25%, and the helped lift the won by a sharp 1.2% against the dollar. Foreign investors were net sellers of both Taiwanese and Koran shares last month, but may return. European bourses are also fully participating in the rally with most major indices up 1%-1.5% near midday in London. Basic materials and consumer services and goods are leading the way, but all major sectors are advancing. US indices are called a bit more than 1% higher, though the ADP data will be out before the open of the NYSE.

The general increase in the risk appetite is also being reflected in the sovereign bond markets. Bond yields are mostly 4-6 bp higher in the core Europe. This includes the UK and Sweden where the PMI was considerable weaker than expected. Peripheral bonds are outperforming the core resulting in a modest narrowing of spreads, a little less in Ireland and Portugal and a little more in Italy and Spain.

Currency Markets

Given the slump in equity markets in August and the heightened concern of a global economic slowdown, there seems to be a collective sigh of relief, not just that the month is over, but that the economies, generally speaking, may not have performed so badly. Australia got the ball rolling with a stronger than expected Q2 GDP. Exports rose 5.6% in the quarter. The Australian dollar is the strongest currencies today, rising about 1.5% to test resistance in the $0.9050-$0.9080 band. China’s PMI rose to 51.7 from 51.2 in July. The market expected a 51.5 reading. What investors are most interested in is the forward looking aspect and here the China news seemed particularly promising as new orders rose to 53.1 from 50.9 and new export orders rose to 52.2 from 51.2. The fact that input prices leapt to 60.5 from 50.4 warns of upside risks to the upcoming inflation reports.

The euro zone PMI was largely in line with the flash reading (55.1 vs flash of 55.0), which is still off from 56.7 in July, but consistent with modest expansion. However, disappointing was the German retail sales report. Retail sales in July fell 0.3%. The market had expected a 0.5% increase. It is the second consecutive decline and the fourth decline in five months. It drives home a key concern: German growth is not a function of its own internal dynamics but remains heavily export oriented. As a percentage of GDP, Germany exports are on par with China, who faces international pressure to rely less on foreign demand. Nevertheless, the euro has rallied to its best level since Aug 20 and is approaching the 20-day moving average, which comes in near $1.2850, and retracement objective of the decline since early August and is found around $1.2875. Hourly momentum studies are over-extended and it should not be surprising if North America pares these euro gains. Initial support will likely be found in the $1.2750 area.

Other currencies are also advancing against the dollar despite reporting disappointing data today. They UK PMI came in at 54.3 vs expectations of 57 and, adding insult to injury the July series was revised to 56.9 from 57.3. New orders were particularly weak, falling to 52.0 from 58.5 and is the lowest reading since the middle of last year. Sterling is trading nearly a cent above yesterday’s lows, but remains well below yesterday’s $1.5475 high. Switzerland’s PMI also disappointed, but at 61.4 remains at relatively lofty levels. The market had expected a 65.8 reading after the July’s 66.9. The SNB meets in two weeks and policy there is little chance that policy is changed. Nevertheless, the dollar slipped to a new low for the year against the Swiss franc of about CHF1.0125.

Norway and Sweden’s PMIs also disappointed, but their respective currencies are not just gaining on the dollar, but unlike sterling and the Swiss franc, are advancing over the euro. Norway’s PMI was particularly disappointing with a sub-50 reading. The 49.2 headline is the lowest of the year and compares with a 55.2 reading in July. Although the krone appears well bid, it appears vulnerable. If the euro does turn lower in North America trading today, the krone might fall further. The dollar is approaching support in the NOK6.18-NOK6.20 area. Note that local reports suggest the central bank governor may be subtly signaling a more dovish stance and that the government’s crisis committee is potentially considering a transaction tax on equities and foreign exchange. Sweden’s PMI slipped to 60.6 from 64.2 in July and expectations of a 64.0 reading. Like Switzerland, these are still quite elevated numbers. The euro has recorded new lows for the year today against the krona near SEK9.3275. This level has not been seen since mid-2008.

The BIS released its triennial foreign exchange turnover survey. It estimates that turnover stands around $4 trillion a day compared with $3.3 trillion in the previous survey. Of note, London’s share increased to 36.7% from 34.6%. The US accounts for about 18% of the turnover, followed by Japan, Singapore, Switzerland and Hong Kong. The dollar is included in about 85% of the trades, which is down from the 90% peak in 2001, but remains the dominant currency. The euro’s share rose 2% to 39%. Emerging market currencies also saw their share increase, led by Turkey and Korea. The industry has become more concentrated as the top ten banks account for 77% market share compared with 70% in the previous survey. The growth rate of the foreign exchange market has slowed considerably from 72% between 2004 and 2007 to about 20% over the past three years. High volatility may have dampened the pace of growth.

Upcoming Economic Releases

At 8:15 EST/12:15 GMT, ADP reports its private sector employment estimate. The consensus is for a 15k increase, down from 42k in July. The ISM is due out at 10:00 EST/14:00 GMT. It is expected to slow to 52.7 from 55.5. The new orders component may be more important than the headline. At the same time, July construction spending will be reported. It is expected to decline by 0.5%.. Auto sales will be reported and this may be another disappointment as anecdotal reports suggest consumers were not enticed by incentives. Poor US data may discourage risk-taking.

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Asset bubbles and leverage are kindred spirits. Just look at housing, tech stocks, and tulip bulbs. But if this is a necessary bubble condition, bonds don’t make the cut. Thanks to data provided by AMG and the Fed, we know there has been real, unleveraged buying behind the bond rally. In fact, many have failed to participate in 2010’s U.S. Treasury market’s climb. As a data point, last week Stanley Druckenmiller, a veteran hedge fund manager, expressed his frustration with missing this year’s bond rally. We surmise he has plenty of company in the hedge fund community.

Real money demand for bonds reaches beyond the Fed’s portfolio activities. Specifically, mutual fund data indicates bond performance has been fueled by long-only traditional investors. This group has been pouring money into the asset class en-mass for two years now. In the table below, we show the cumulative net inflows into mutual funds from 2009 to present. The trends show a stark contrast in asset type preference: income over growth. Consider that money funds, which pay no income, and equity funds which thrive off growth, have either lost assets or held steady.

Fixed income sectors have enjoyed robust inflows. For example, the sizable category of Taxable Bond Funds has witnessed asset growth of a massive 39% due to new-money flow. The bond market has delivered the returns. Consider that the 10-year Treasury note has posted a staggering 18% annualized return this year thanks to a 125 basis point drop in its yield and a little convexity. While the initial impetus of real money to asset allocate into bonds may have been safety and yield, it has arguably morphed into something more fundamental. As the disinflation/deflation concept has become more entrenched in the collective psyche, investors are willing to accept lower long-term nominal yields. The stellar past returns have been more accidental than anticipated. As we noted last week, it appears further disinflation is priced into the current level of U.S. nominal yields. As evidence, consider that 10-year Treasuries are trading 75 basis points rich to JGBs in real terms, a relationship that may be supporting Yen’s recent strength.

So – what will trigger a reversal in the real money flows? This seems critical to the “bond call”. Given that cash, stock, bonds and real estate are the lion’s share of most investors portfolio mix, perhaps we should posit the question differently. When will investors start buying stocks again? Here the deflation theme rings ominous: firms become price takers rather than price makers and earning and margins adjust accordingly. Another factor that may still be vivid in the memories of investors is the realized losses experienced by stocks holders. The below AMG data show, that there was heavy selling of equities at the 2009 lows. Ouch!

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Frederick Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009).

Federal Reserve Chairman Ben S. Bernanke delivered a much-anticipated speech on Friday, August 27, 2010. There was no reason to think this talk would be more or less important than his other talks except for the degree of hysteria whipped up by the media in advance. Bernanke was addressing an audience of fellow central bankers and their camp followers at an annual gathering in Jackson Hole, Wyoming. There have been memorable comments at these late summer getaways, such as, in 2005, when past-Federal Reserve Board Vice Chairman Alan Blinder claimed then-current-Federal Reserve Chairman Alan Greenspan might be the "greatest central banker who ever lived."

But Ben Bernanke said nothing new. The post-mortem analysis of the world’s most influential central banker can be reduced to four of his claims from Jackson Hole:

1. “The issue at this stage is not whether we have the tools to help support economic activity and guard against disinflation.” [Because the economy is noodling along – #4, below.]
2. “A… policy option, which has been proposed by a number of economists, would have the Committee increase its medium-term inflation goals above levels consistent with price stability.”
3. “However, such a strategy is inappropriate for the United States in current circumstances.”
4. “I expect the economy to continue to expand in the second half of this year, albeit at a relatively modest pace. Despite the weaker data seen recently, the preconditions for a pickup in growth in 2011 appear to remain in place.”

In summary, Bernanke’s strategy of inflating is “inappropriate,” given Bernanke’s stated outlook.

Bernanke’s stated outlook is wrong. On August 17, 2010, the Federal Reserve Bank of New York reported $986 billion of “severely delinquent” consumer debt, defined as 90 days overdue. On August 18, the Wall Street Journal published a survey by CareerBuilder.com. Of 4,500 white-collar workers who were asked, 9% had taken a second job in the past year and an additional 19% intended to do so in 2010. This is probably due to constrained income and shrinking access to credit (see The ‘Flations).

At some point, Bernanke’s outlook will be untenable. The Fed chairman is habitually slow to understand changing circumstances, but Dow 5,000 could do the trick.

It looks as though the U.S. Postal Service is prepared. It has listed instructions on its website to convert Priority Mail International insurance from U.S. dollars to SDRs (Special Drawing Rights). SDRs were conceived in 1969 as a possible substitute when the U.S. dollar was chasing U.S. prestige down a rat hole. It originated under the auspices of the IMF (International Monetary Fund) which defines it as “a basket of currencies, today [August 30, 2010] consisting of the euro, Japanese yen, pound sterling, and U.S. dollar.” (The value of the SDR translated into dollars is calculated by the IMF daily “except on IMF holidays and when the IMF is closed for business.” A currency that that takes a lunch break is doomed to fail.)

The U.S. dollar is still the currency that dominates international transactions, although the percentage of trade in other forms of payment has been rising for the past several years. China, Russia, and other countries have attempted to shift settlement into other currencies, including the SDR. This is understandable given how the overpopulation of U.S. dollars around the globe leaves foreign central banks with redundant dollar reserves and another housing bubble.

From the USPS website:

323 Priority Mail International Insurance

323.62 Accepting Clerk’s Responsibility

The accepting clerk must do the following:

a. Indicate on PS Form 2976-A the amount for which the parcel is insured. Write the amount in U.S. dollars in ink in the “Insured Amount (U.S.) block.”

b. Convert the U.S. dollar amount to the special drawing right (SDR) value and enter it in the SDR value block. For example:

INSURED VALUE

$100.00 (U.S.)

65.76 SDR

c. See Exhibit 323.62 for a table showing the conversion of U.S. dollar values up to $600 to SDR equivalents. To determine SDR equivalents above $600, multiply the insured amount, rounded up to the next full dollar, by the conversion factor of 0.6576.

Note: Use the following rates when converting between U.S. dollars and SDR values:

1 U.S. $ = 0.6576 SDR

1 SDR = $1.52 ($1.5206 U.S.)

The world has operated on the U.S. Dollar Standard since America defaulted on the Post-World War II Gold-Dollar Standard in 1971. Has the U.S. Dollar Standard ended? If it has not, Simple Ben’s intention to inflate the United States to prosperity will do the trick.

If “USPS Updated Postal Revision Through July 15, 2010, Section 323.62” has been discussed in the major media, it must have been in the Society pages. The website Zero Hedge carried the story last week. Whatever its chances of adoption, it certainly deserves more debate than the boring and trivial analysis of a boring and failed economist who has stated his intentions to hyperinflate for the past 30 years. Maybe a mole from the IMF infiltrated the USPS. Accentuating the trivial and ignoring imminent cataclysms is the story of our times.

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India, unlike many emerging markets, is not as reliant on exports. They account for less than 20% of the GDP. That said, the most recent data, covering last month, showed exporters increased at the slowest pace since the start of the year and Indian officials have acknowledged it might not reach its export target this year.

Growth in India was led by services (55% of India’s economy), which expanded by 9.7% and manufacturing, which expanded by almost 12.5%. Mining expanded by almost 9%. Agriculture output, which accounts for about 20% of India’s GDP, expanded by 2.8% after 0.7% expansion in Q1.

Wages in India are reportedly growing the fastest in Asia. Some economists expect wages to rise as much as 10% this year after 6.6% last year. Some of the inflation India is experiencing, however, is not a function of higher wages, but rather industrial bottlenecks. Facing shortages, for example, some auto companies have re-introduced waiting lists for customers.

The US dollar is in a large consolidative pattern against the rupee in the recent months–in the May dollar peaked near INR47.75 and a month later set a low near INR45.60. It has been confined to that range ever since. A large wedge pattern is being formed and the dollar is testing the upper end now near INR47.15. The bottom of the wedge comes in near INR46.12.

With the risk of tighter monetary policy, we are more favorably disposed to Indian equities than fixed income. India’s major equity indices are among the better performers of the large countries in the region this year–and easily the best performer among the BRICs.

Marc Chandler | Global Head of Currency Strategy

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The Usual Fare

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The current generation of policymakers seem to be like Captains of large ocean liners, out there on the high seas, bereft of either compass or adequate charts, trying hard to calm their worried passengers by telling them nothing is amiss. But the charts are there, if only they would look at them, and in the present Spanish case, unlike the old refrain, the future is ours to see, and it has a name: Germany.

For those willing and able to examine our present situation with a reasonably open mind, a comparison of the recent history of the Spanish and German economies can prove illuminating, especially since, as I will argue below, there are strong structural homologues to be observed in the evolution of the two.

This post will contain comparatively few words (what a blessing!) since I will try and let the charts themselves tell their own story, in the hope that concepts which seem to be difficult to convey verbally, may be easier to grasp visually.

Consumer Boom

The first myth I would like to debunk is that it simply is not true that the Germans are a group of "non consumers", and inveterate savers. Back in the 1990s German private consumption enjoyed a huge boom, a boom which ground itself to a halt around the year 2000. It is only since 2000 that German private consumption growth has been lacklustre, and incapable of driving the economy. (I am using a Bloomberg chart here, since I don’t have a long enough time series to hand to make my own version).

Now if we look at the same chart for Spain, we can see that private consumption growth enjoyed the same kind of "blossoming" that German consumption did between roughly 1999 and 2007.

Driven By Borrowing

But more than the phenomenon of the consumption boom in and of itself, what is interesting is what was driving it. Unsurprisingly we find the "usual suspect" – rapid increases in credit. Again, the following charts belie the idea that Germans have always been a nation of meticulous savers.

And again, the Spanish charts for mortgage increases tell a very similar (if even more exaggerated) story.

And it wasn’t only households, corporates were busy at it too. Interestingly, corporate borrowing seems to have had a brief renaissance in Germany on the back of the current crisis.

Yet again, the only area in which Spain distinguishes itself is in the magnitude of the phenomenon. Spanish corporate indebtedness is a much, much more serious problem than German corporate indebtedness ever was.

When we come to look at the last set of loan charts, I would point of two features. In the first place, total private sector debt is not that different between the two countries, despite the fact that German GDP is around twice as large as Spanish GDP.

And in the second place, look at the long tail on German year-on-year borrowing, this is the point where those with eyes to see should be able to discern something of the future which awaits Spain. Interannual lending in Spain isn’t going to climb back up again, and we should expect it to trawl around the zero percent level for many years to come, as Spain’s private sector deleverages itself.

From Current Account Deficits To Current Account Surpluses

Which brings us to the next point, the association between lending booms and current account surpluses. As we can see in the chart below, Germany was no exception to the rule here, and all through the duration of the consumption boom the country ran small current account deficits. Deficits which then became surpluses after the huge structural adjustment the country went through in the transition from being a consumer driven to being an export driven economy.

And this is the path that Spain will now surely have to follow, but just note the massive difference in scale between the two. Spain’s adjustment will need to be enormous. And how could this have happened we might like to ask ourselves? Were all the relevant drivers fast asleep, lurched over their wheels? How come no one "saw this coming"?

Given the magnitude of the correction, it is not really surprising that the IMF seem to want to hope against hope that it really won’t be necessary. As the chart below illustrates, they seem to be hoping markets will sustain the current account deficits all the way through till 2015. As can be seen, Spain is the worst case offender, and the country where the structural transformation will need to be largest. So why do the IMF continue to believe in something which is scarcely credible? It could be that they simply accept the Spanish government’s own optimistic idea that private consumption will come back to the 2% growth level again, kick started by a surge in borrowing. But a study of what happened in Germany makes that highly unlikely. Spain’s banks are having trouble enough financing themselves as things stand, are people seriously suggesting the markets will now fund another bout of additional leveraging?

And if the private sector isn’t going to do the borrowing, then who is? Since simple book-keeping tells us that having a CA deficit on the one hand implies capital flows on the other to fund it. The only conclusion I can come to – and this is what I argue in this post - is that we are assuming the government is going to continue to run a sizeable deficit, or that there will be straight fiscal transfers from other parts of the Euro Area to Spain. Otherwise the numbers simply don’t add up.

Worm Into Butterfly?

What I have been arguing so far should be relatively uncontroversial for anyone with a sound grasp of applied macro. What comes next is more of a hypothesis. As we have seen, economies seem to transit from being consumption driven to export driven, so we might like to ask ourselves, is the process merely random, or are their underlying structural dynamics at work. As I am trying to argue in the German case, the shift doesn’t seem to be a cultural one, and if Spain follows Germany down the same road then we will certainly know it isn’t.

So what could be driving all this. Well, as Claus Vistesen and I have speculated, ageing populations and the demographic transition may well have something to tell us here. Using Modigliani’s life cycle saving and borrowing idea, and the Swedish demographer Bo Malmberg’s idea of population "ages" (child, young adult, middle aged and elderly), Claus has prepared the following chart in an attempt to illustrate the process.

Of course, all of this at the moment remains at the level of hypothesis. I tend to use median population ages as a rough and ready measure of ageing, and (even though I wouldn’t want to claim any precision here) it is interesting to note that both Germany and Spain have started to transit off towards export dependence at around the 40 median age point.

Still, this is early days yet, and we will know a lot more in this regard when we see how the different countries all along Europe’s periphery perform in the years to come. Will they, as the IMF and the EU Commission seem to assume, go back to being consumption driven, or will they be condemned to follow the German path? Certainly Hungary, to take just one example, seems to look more and more as if its economy which desperately trying – but so far unable – to transform itself into yet another Germany.

Real Devaluation

The worrying thing looking at the above inter-country comparison is how much larger Spain’s correction is going to need to be than Germany’s was. As Wolfgang Munchau pointed out in the FT yesterday, Germany entered the eurozone at an uncompetitive exchange rate and embarked on a long period of (quite painful) wage moderation and deep structural reform. In fact, Germany entered the Euro with an exchange rate which was too high, give the new role exports were going to play in economic growth. The German adjustment can be clearly seen in the REER chart below, as can the very large adjustment that Spain will have to make in comparison with the German one.

When macro economists say this will be "painful" they don’t do so to be sadists, they say this since they know this is going to be hard, very hard. And doubly so when almost all those responsible for taking policy decisions at all the respective levels seem to deny that it is going to be necessary. I have advanced two suggestions (a systematic reduction of 20% in wages and prices in Spain, or a temporary exit of Germany from the Euro Zone). Since neither of these have gained any traction at all, it is reasonable to assume they are now not going to happen (at least in any orderly way). But the car is still heading full speed towards that brick wall. When it finally does crash, will the Queen of England once more say to Luis Garicano, "but tell me Luis, just why was it no one saw this coming?".

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Highlights

The Swiss franc rose to a record against the euro while the yen also continued to edge higher through the Asian session as some improved Japanese figures failed to dent the risk-off momentum. EUR/CHF dropped as low as 1.2933, and USD/CHF dropped to 1.0227, near the 8-month low of 1.0221 reached Friday. EUR/JPY hit a low of 106.25, less than a big figure off the 15-year low touched last week. USD/JPY ground down to 84.08. Japan’s industrial output unexpectedly rose in July, while retail sales, wages and housing starts all climbed more than expected. India said GDP grew 8.8% in Q2, as expected, but the fastest pace in 2 ½ years.  South Korean industrial production beat expectations and Australia released a bevy of strong data: current account, retail sales and building approvals numbers. The yen and Swiss franc led gains vs the dollar overnight, and for the month they were the only two G-10 gainers vs the greenback. EM currencies lost ground through Asian trading, with PHP, KRW and RUB leading declines. On the month, CLP and THB led the way higher, while there were losses for PLN, CZK, MXN and HUF.

Asian stocks declined as caution gripped financial markets. The MSCI Asia Pacific index fell 1.5%,wiping out yesterday’s advance and set for a 3.5% decline on the month. Japan’s Nikkei led declines in the region, plunging 3.5%, its biggest drop since June 7. There were losses in Hong Kong, Taiwan, Australia, Korea, India and Singapore. Futures on both European and US markets are trading lower.

Bonds climbed, with German bund yields falling to a record low. Japanese 10-year JGB yields dropped back below the 1% mark, down 5 basis points to 0.96%. European bonds opened sharply higher, with the Germany’s 10-year bund yield down 4bps 2.085%. US Treasuries gained, with 10- and 30-year yields down 3bps to 2.5% and 3.55% respectively.

Currency Markets

The Swiss franc rose to a record against the euro while the yen also continued higher as some improved Japanese industrial production and retail sales figures failed to dent the risk-off momentum. The Swiss franc touched a record high vs the euro, with the pair declining to 1.2934, and USD/CHF dropped to 1.0227, near the 8-month low of 1.0221 reached Friday. EUR/JPY hit a low of 106.25, less than a big figure off the 15-year low touched last week. USD/JPY ground down to 84.08. Japan’s industrial output unexpectedly rose 0.3% in July from a month earlier, after a drop of 1.1% in June. That left production up 14.8% from a year ago, more than expected. Retail trade rose 3.9% from a year ago in July, more than the 3.5% expected and up from 3.3% growth in June. Other figures showed wages grew 1.3% from a year earlier and housing starts gained 4.3%, more than twice as much as expected in July. The fact remains that the Bank of Japan’s policy response yesterday were entirely within the expectations of the market, and didn’t give a compelling reason to stop buying yen. As for intervention, it still seems unlikely as it would be a unilateral move and thus relatively ineffective. The decision to intervene is the Ministry of Finance’s and it is still obviously reluctant to follow that path.  It is not just that its experience (2003-2004) was not inspiring, but also the Swiss National Bank did not appear to enjoy any more success with its massive operation earlier this year.  American and European officials are clearly reluctant to join an intervention operation.  That said, if the Japan were to intervene in the foreign exchange market outside of its time zone, it would likely give the funds to the ECB and Fed in which they would use to execute Japan’s instructions.  This would not be the same as coordination.    Note that Kan faces a leadership challenge from Ozawa on Sept 14.  The early newspaper polls show Kan enjoying as much as a 4 to 1 lead over Ozawa who was forced to resign over a funding scandal involving aides a few months ago.

There were some strong data releases from elsewhere in Asia overnight. India said GDP climbed 8.8% in the second quarter from the same period a year ago – that’s the fastest pace of growth in 2 ½ years. It was up from 8.6% growth in the first quarter and matched economists’ expectations. The Reserve Bank of India has been making noises about the dangers of inflation, saying last week that its priority was reining in consumer prices. With economic growth steaming along at such a pace, expectations of further rate hikes will be reinforced. The central bank tightened policy last month by raising the reverse repo rate 25 bp to 5.75%, the fourth tightening move in five months, and recently predicted growth for this year at 8.5%. The next meeting is Sept 16. South Korean industrial production climbed more than expected in July, its 13^th straight monthly gain. Output rose 15.5% from a year earlier, slower than the 17.1% advance in June, but more than the 15.2% pace predicted.

Australia released a bevy of strong data overnight, dampening concerns that the slowdown in the US and Europe in recent months may weigh on growth, fears voiced by the central bank. The current account deficit contracted to the smallest since 2002 in the second quarter, while there were gains in building approvals and retail sales in July. The deficit narrowed to A$5.64bln from A$16.4 bln in the first quarter, more than expected, and the report added that exports contributed 0.4% to Q2 GDP which was a 0.9% quarterly gain. Retail sales climbed 0.7% from a month earlier, more than the 0.4% growth expected, and the highest jump in four months. Building approvals rose 2.3% from the previous month in July when analysts had forecast a decline. New Zealand building permits climbed 3.1% in July from the previous month, more than the 2% expected but down from 3.3% in June.

Upcoming Economic Releases

Asia Pacific: Thailand manufacturing, Hong Kong retail sales. Europe/EMEA: German unemployment, UK consumer credit, mortgage approvals, Italy retail sales, CPI, Spain current account, Czech money supply, Turkey trade balance, Hungary producer prices. Americas: US Consumer confidence, Chicago PMI, and S&P/Case-Shiller house prices.

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In light of recent attention on Eastern Europe, here are some thoughts on Romania. The government has been unable to sell local debt at its self-imposed cap of 7% because investors have been unwilling to finance the country at such low rates. It failed to sell any 3- and 5-year paper this month, and instead issued paper at the short end (6-, 9-, and 12-month bills). Over the past four months, the Finance Ministry rejected all bids for 3-, 5-, and 7-year paper at eight auctions. Besides issuing at the short end, Romania is hoping to sell euro-denominated debt to make up for the shortfall. It last sold foreign currency debt back in March, but that was when market sentiment on EM was much more positive. Romanian officials are mistaken if they think they can dictate what rates it can borrow at in this environment. The more auctions that fail now, the more trouble Romania will be in down the road. Indeed, one of the assumptions behind any debt sustainability framework centers around getting borrowing rates back to “normal” levels. We aren’t seeing that in the euro zone periphery, and neither are we seeing it in the weaker Eastern European credits.

EUR/RON has fallen back after spiking to a record high 4.40 in June, but given the global backdrop, we would expect this pair to creep upwards in the coming weeks. The 4.23 area represents the 50% retracement level of the big March-June rise, and is providing a strong base for the euro right now. We would buy EUR/RON at current levels around there for a move back to 4.40. We would also add that political instability is an issue that is likely to get worse. The minority government barely survived a vote of no confidence in June over plans to cut pensions and salaries, and another vote is likely to be called by the opposition this fall. Popularity of the government has plunged to all-time lows.

We noted earlier how bad debt was piling up in Hungary, and it looks the same in Romania. Central bank last week reported that loans more than 30 days overdue doubled to RON13.45 bln in July from RON5.9 bln a year earlier. Overdue foreign currency loans (mostly EUR) rose to the equivalent of RON6.4 bln from RON2.4 bln a year ago. Note that Romania’s banking sector is dominated by foreign banks, including Austria (38% of the market), Greece (17%), and France (15%). The IMF remains supportive of Romania and its USD17.1 bln Stand-By Arrangement (part of the USD26.4 bln total international aid package), and just this month approved the fifth review under the program. IMF noted that “The Romanian banking system remains well capitalized. The capital adequacy ratio at end-June was 14.3 percent and all banks had a ratio exceeding 10 percent compared to the mandatory ratio of 8 percent. Obviously, the recession adversely affects the level of non-performing loans but provisions are increasing accordingly to cushion the impact.” Still, the longer the recession lingers, the worse it’s going to get in terms of bad loans.

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Harvard Professor (and former IMF official) Kenneth Rogoff expects some Eastern European countries to face sovereign crises over next 2-3 years.  In a weekend interview, Rogoff predicted that not every country will be able to successfully consolidate their budgets, naming Ukraine, Romania, and Hungary as “potential wobblers.”  Due to close ties with Eastern Europe, he warned that the situation will create a “real stress test” for Austria.  While Rogoff is clearly talking about the sovereign picture, we note that private sector developments remain troubling as well and are likely to feed into sovereign jitters.  Earlier this month, Hungary’s largest bank said it expects the ratio of non-performing loans to rise further and sees risks in the quality of its foreign currency-denominated (mostly CHF) mortgage portfolio.  We note that CHF/HUF spiked to around 220 last week, higher than previous peaks around 218 in June 10 and 217 in March 09, and so bad loans are likely to continue rising.  The bank reported that profit dropped sharply as provisions for bad loans soared to a record high, and that loans overdue 90 days or more made up 12.4% (and rising) of the bank’s credit portfolio at the end of Q2.  The bank also warned that it would see deterioration in its loan books in Romania and Ukraine, which echo Rogoff’s remarks.  Given developments in Ireland, markets may rightly become concerned about increased government aid being needed to support the banking sector in the weak Eastern European sovereigns.

The three countries named by Rogoff are all countries that have had to go to the IMF for aid programs.  Just as the bond markets are signaling continued stresses in the euro zone periphery after a period of calm, so too do we expect a similar trend in the weaker Eastern European credits.  Bond yields and CDS prices are for now well below the crisis highs for Hungary, but if the economic outlook deteriorates as we expect, then we look for a sharp reassessment of Hungary’s risk profile.  The government certainly hasn’t given markets any reason to be confident in their capabilities, not when officials continue to flip-flop with regards to fiscal policy and the IMF program.  We remain long EUR/HUF and look for a move back to the late June/July highs around 288 and then the July high around 292.  Early June high around 290.50 is in between.

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Karl Friedrich Hieronymus, Freiherr von Münchhausen was a German baron born in Bodenwerder in the eighteenth century. Made famous by the Hollywood director Terrence Gilliam, the baron first came to public attention for his ability to recount outrageously tall tales about his adventures while fighting abroad in the Russian army. Among the astounding feats which legend attributes to him are riding cannonballs and travelling to the Moon. But perhaps his best known marvel is the story of how he managed to escape from a swamp by pulling himself out by his own hair (or by his bootstraps, depending on who tells the story). Which puts me directly in mind of the way some people are now expecting an export-dependent German economy to drag the rest of Europe – and with it the whole global train – up and out of the ditch in which it is currently sunk, simply by exporting to everybody else. Sounds just like one of those tall tales, doesn’t it. A very tall one.

Not to be misunderstood, there is no doubting the magnificent export achievement of the German economy in the second quarter of this year, just as there is no doubting the fact that it was helped considerably in attaining it by the impact of the Greek debt crisis, which as well as pushing the euro to a comparatively low level also helped the Japanese yen on-and-up towards record highs with the US dollar (the flight to safety), while the dollar itself was pushed back up to levels which were evidently not compatible with a smooth and orderly transition of the US economy back to growth, as can now be seen from the revised second quarter data, since the growth rate is down primarily because of an increase in the US trade deficit.

No Mean Feat

In fact Germany’s economy grew by a seasonally adjusted 2.2% in the second quarter (or as some point out, at almost a 9% annual rate). Now good news is always good news, but shouldn’t the very magnitude of this number in a global economy which is struggling to find its footing as it moves forward worry us just a little bit? What is the secret of this German triumph – demand elsewhere? Then where does this demand come from? Liquidity flows to Emerging Economies fuelled by low interest rates which are meant to stimulate the developed economies in which they originate? Or fiscally supported stimulus programmes in other developed economies?

Is this sustainable? Are Germany’s sharp rises and sharp falls in GDP really that desirable? For just as we may now welcome the possibility that Germany’s economy is possibly going to grow by some 3% in 2010, we should not forget that it actually fell by 4.7% in 2009, and we have no real idea at all by how much it may rise or fall in 2011, since that in fact depends on decisions which will be taken elsewhere.

The bottom line is that Germany’s economy is now totally export dependent, and as a permanent condition that is not a desirable thing, not even for the Germans themselves, since it makes their livelihood incredibly dependent on global demand, and thus on others.

French Growth More Balanced

And here we come to one of the striking features of the present situation in Europe, which is that while we have been witnessing a great deal of attention being lauded on the recent German triumph, the French economy has ever so quietly and unobserved been busily recovering at a reasonably steady rate.

In fact, if you look at the comparative performance of the two economies over the last decade (see chart below), we find something very odd indeed – at least for the current mainstream discourse – and that is that in GDP growth terms the French economy has easily outperformed its German counterpart.

Of course, you cannot make deductions about GDP per capita from looking at crude growth numbers, since the underlying population dynamics also matter. And while Germany’s population is now almost stagnant, France’s is growing steadily – indeed hypothetically we could postulate that at some distant point on the horizon France will have more inhabitants than Germany. More to the point, France’s population will be a lot younger, with important consequences for economic performance. But the key issue at this stage is that France, apart from exporting, also has vibrant domestic demand, and demand is one of the things everyone is short of right now, as we all busily rush to get ourselves out of debt by exporting.

The presence of autonomous domestic demand also has important consequences for long run economic stability. And this can clearly be seen in the present crisis. Thus, while in 2009 both economies slumped, the French one slumped by much less (-2.6%) than the German one (-4.7%). Naturally, in the first half of 2010 the German economy recovered much more rapidly than the French one – since there was far more lost ground" to recoup – and the German export sector is highly efficient (far more efficient than the French one) so as global demand recovered the German economy was one of the main beneficiaries.

Anyway, the net result of all these "ups and downs" is that both economies are now back more or less where they were at the end of 2006. This tells us two things. In the first place we still some have some distance to go before we can really begin to talk about "recovery" in any meaningful sense of the word. To be able to use this word we would at least need to surpass the output level attained in the first quarter of 2008, which was the last time, if you remember, that people were talking about Germany and Japan "decoupling" on the back of a rapid growth surge in Emerging Markets. In fact in that very quarter German growth shot up by 1.6% over the previous one (or 6.4% annualised, an earlier high point in the German trajectory). In fact as I wrote in my original analysis at the time:

So the bottom line is that the of the 1.5% increase in q-o-q GDP, nearly half (0.7% points) was accounted for by a growth in inventories, while 0.4% was accounted for by a growth in construction which was in part the result of better weather in January and February and scheduled work being advanced (although you can’t simply add these numbers since some of the construction work may well have accumulated in inventories), while the net impact of external trade slowed, and household consumption only accounted for 0.2% points. So basically it would be far from in order to announce this result as strong evidence for anything about the Germany economy at this point, other than that the economy resisted a strong slowdown in Q1. The data from Q2 should make all of this much clearer, I think, we will see what gets to happen to the inventories, and we will see what happens to construction.

By July the ZEW investor sentiment index (which could be seen as a predictor of economic activity six months forward) had fallen to a 16 year low, and I was forewarning – "what is the recession risk for the German economy?" – at a time when few others were prepared to accept the fact that a serious German recession might be on the agenda. At this point I would not be so categorical. It is evident that Germany might once more enter recession in the fourth quarter of this year, but it is far from clear that it will, since as I keep saying, to forecast what is going to happen in Germany you need to be able to see what is going to happen in the rest of the world, and this is by no means clear at this point. Here I simply want to make the point that the answer to this question is not to be found in Germany, or in anything the Germans themselves may or may not do, but in the rate of growth to be found among their key customers, many of which are now Emerging Economies. This is what export dependence means.

All The Stars In Alignment

Coming back to the present, and Q2 2010, one thing we can say about is that it saw a very interesting confluence of factors.

Effectively, if you look at the above chart, all the dials were on green during the quarter, with each of the key components – household spending, capital investment, net exports and construction – all showing growth. A good constellation of stars in alignment then. But this favourable configuration will not, of course, be permanently maintained. In the first place, if we take private consumption, German private consumption really peaked in the last quarter of 2006 (see chart below) for reasons which have little to do with the recent crisis – the German government raised VAT by 3% in January 2007, and German consumption growth, which was already quite weak, received a final from which it has never really recovered.

Of course, German consumption hasn’t always been weak. Between 1990 and 2000 it grew rapidly, but then it suddenly "maxed out" as can be seen from this Bloomberg chart.

And Germany hasn’t always run a current account deficit (that is to say, the high saving phenomenon is not simply cultural). During all those years of strong private consumption growth Germany was, in fact, running a (small) current deficit. Indeed, between 1991 and 2000 Germany did not have one single year where she produced a current account surplus.

And just what was the median age of the German population in that fateful year of 2000, when the German economy metamorphosed from being a domestic-consumption-driven current-account-deficit one to an export driven current account surplus one? Well you could have guessed it, 40, exactly the age that my rough-and-ready, back-of-the-envelope, home-made model suggests we should find a transformation, or "tipping point".

Another favourable factor in Q2 2010 was fixed capital formation, part of which is machinery and equipment (where some investment has taken place), and the other part is construction where, just as in 2008, a number of factors associated with the weather have served to produce an exceptional reading (see chart). Very bad weather in the first quarter lead to an exceptionally low reading, while there was then a stronger than normal rebound in the second quarter.

In addition both inventories and net exports were positive. Inventories here are something of the wild card, since the level of inventory building depends on the outlook for sales, so in periods of uncertainty (and none other than Jean Claude Trichet was busy saying in Jackson Hole only last week that we currently living with "a degree of uncertainty in the economic and financial sphere" is "largely unprecedented") these can be quite volatile. I had been expecting a significant increase in German inventories, but this didn’t materialise, and we had only a very timid increase. This is hard to interpret, but it could well be that in Q3 levels will be reduced if the outlook continues to deteriorate and orders don’t pick up.

Liquidity To The Right Of Us, Stimulus To The Left Of Us

Exports of goods and services rose by 8.2% during the second quarter (an annual pace of nearly 35% ) – which was of course a very impressive performance, but so impressive that it is clearly not sustainable. The most important customers for German exports in June (when they were up by an annual 28%) were the rest of the European Union (which accounted for half of the export growth – other people’s fiscal deficits and stimulus programmes), followed by Asia (which with contributed 6.9 percentage points to that 28% – or one quarter of the total – to the rise), and half of the Asian contribution came from China. The US only added 2.4 percentage points – or around one tenth – to total export growth. So Emerging Markets now clearly outweigh the Euro Area (which contributed 5 percentage points or one fifth of the growth), as Morgan Stanley’s Elga Bartsch makes plain in the chart below.

So German export growth at this point in time would seem to depend critically on liquidity flows to emerging markets, and stimulus programmes in developed economies. The liquidity flows depend on the continuation of Quantitative Easing at the Bank of Japan, the Federal Reserve and the ECB, while the stimulus programmes depend on countries not applying the fiscal austerity measures that Angela Merkel herself has been advocating. Thus would our erstwhile Baron drag us all out of that ditch into which we have all so carelessly fallen.

Enthusiasm Unbounded

Curiously, none of this does that much to dampen enthusiasm for the new momentum some feel they can perceive in the German economy. As the Financial Times put it – in an editorial entitled "Euro’s locomotive is puffing again" (strange this fascination with the age of steam engines, and toy trains, now isn’t it?):

"Germany’s sudden rediscovery of its old role as Europe’s growth locomotive brings the continent back to the future. The 2.2 per cent growth spurt is unified Germany’s best-ever performance. It was not entirely unexpected: trade figures early in the week led economists to predict good news from Berlin. But the outcome was almost a full percentage point above estimates, and helped lift the euro-wide rate".

But, as is by now well know, what the lord giveth with one hand the lord also taketh just as quickly away with the other:

"Germany’s feat is a one-off: sustained 9 per cent yearly growth rates are unheard of in rich countries. Slowdowns in China or the US may well throw cold water on exporters. Europe’s industrial production is already flatlining. And we must not forget how bad things still are: although the second quarter put German output 4.2 per cent above its low point in the crisis, it is still lower than in 2007".

Valentina Romei, in an article entitled "Economic Outlook: Indices to confirm German ascendancy" (published just before the August Flash PMI report), went rather further in proclaiming the current German "renaissance":

"Germany has outperformed the US, the world’s largest economy, in terms of growth in recent months and the trend is set to be confirmed this week. The German purchasing managers’ indices are expected by HSBC to remain at relatively high levels, while US economic growth is likely to be revised downwards".

"Economists say that the slowdown in the recovery in Asia and in the US, and the difficulties in other parts of Europe, could soon have an impact on German growth, which is largely export-driven. However, signs of improving domestic consumer confidence in Germany, and in Europe generally, portray a stable overall scenario".

Of course, the data releases did confirm the continuing high level of German activity, and the downward revision in US GDP – although as Valentina Romei meticulously fails to point out, the downward revision was due to a deterioration in the country’s net trade position, as more imports flowed in (from where, I wonder?). Curiously, the PMI data she referred to showed France’s manufacturing industry expanding more rapidly and Germany’s slowing slightly, but I still haven’t found anyone speaking of that new French ascendancy as the Gallic locomotive steams ahead, nor any similar such drivel.

Why The Obsession With The French Deficit?

But still, as I say, France’s economy is more balanced, and France is running a (smallish) trade deficit, which is arguably marginally more supportive of both European and global growth. The day the German economy runs a current account deficit again, the very same day the economy will start to fold in on itself, and that’s one robustness test it is sure to fail.

But what is so peculiar is that all we seem to hear about France is how she needs to get her deficit under control. And we are talking here of a deficit which, as I say, is helping to sustain demand for products produced elsewhere, and keep that German locomotive puffing away. And if we come to the general topic of indebtedness, neither France’s government nor her private sector are among the most seriously at risk. The French banking sector was much more prudent during the boom years, and neither French households nor French corporates are hopelessly in debt. Yet the French administration seems to be under almost perpetual attack, as the Financial Times reports:

Christine Lagarde, French finance minister, on Sunday hit back at critics of the government’s plans to meet its deficit targets, accusing markets of failing to give Paris credit for two years of reform. Speaking to the Financial Times after the government last week reduced its forecasts for growth next year from 2.5 per cent to 2 per cent, Ms Lagarde denied the new estimate remained overly optimistic.

“It is realistic and prudent,” she said, adding that even if the market consensus of 1.5 per cent growth was revised upwards, it would “not grant much credit to the reforms we have implemented and to the added flexibility in the economy”. France had been criticised by the International Monetary Fund and the European Commission for basing its pledge to cut the deficit from 8 per cent to 6 per cent of gross domestic product next year on unrealistic growth forecasts of 2.5 per cent.

Look, sometimes I have difficulty believing what I am reading here. This "criticism" coming from an IMF and and EU Commission who are more or less swallowing wholesale the most ridiculously optimistic growth forecasts from the Spanish government, who evidently also have a much higher level of deficit, and a much more serious economic situation to contend with is almost beyond belief. Is so little macroeconomics understood out there? To be explicit, I have no interest in defending either of the main French political parties, or the current state of the game in the French labour market, or even the absence of reform in the French pension system.

But why, just now, are we seeing all this pressure on Christine Lagarde, and by implication, of course, on Nicolas Sarkozy. Why is almost everything we here about what is going on in France negative, and why does no one ever value the point that, at least in terms of family friendly economic policy they are streets ahead of most other Euro Area countries. Do people imagine that this doesn’t matter, and that you can blithely go forward funding generous pension systems whatever your elderly dependency ratio?

Just one little detail. Dominique Strauss Kahn is head of the IMF, and a potential candidate for the French presidential elections due next year: there couldn’t possibly be more than meets the eye going on here, could there? (What a wicked mind I have).

To speak plainly, if we make the sort of assumptions which are being made about recovery in all other Euro Area countries, then I personally don’t find a 2.5% growth forecast for France in 2011 particularly exaggerated. Of course, if there is a global double dip, and renewed financial stress, then all bets are off. But this applies to everyone, so why single out France? Why are countries like Spain, Hungary, Latvia etc being cut so much slack in the generosity of their forecasts, and France being castigated so?

I mean, if we look at the chart below, France’s long term growth rate is quite stable, and somewhere around the 2% mark. And if we assume that ECB interest rate policy is going to remain accommodative in 2011 (a reasonable assumption when we look at the number of patients in the "intensive care" ward), then 2011 could easily see French growth slightly above par.

On the other hand Germany’s long term growth rate has been falling steadily since the early 1990s, and the ten year average in 2010 is something like 0.8% a year, which is more or less Germany’s sustainable trend growth rate at this point.

Personally, I can’t help reaching the conclusion that there is a huge bout of hypocrisy going the rounds at the moment. For example, as reported in FT Alphaville:

"The bailout of Germany’s banking sector may swell the country’s public debt rate to 90% of gross domestic product, Die Zeit weekly newspaper reported on Wednesday. The weekly based this estimate on a recent decision by Eurostat requiring Germany to include the balance sheets of public-owned bad banks — set up to help financial institutions offload toxic and non-strategic assets — into its overall debt ratio".

This situation is getting surprisingly little coverage. And of course, we could see more situations like that of WestLB and Hypo given the extent of German bank exposure to the Spanish debacle. In fact, the underlying demographic pressure on Germany’s very expensive pension and health systems constitutes a serious long term worry about a debt to GDP level which is now creeping dangerously near to the 100% threshold.

Short Memory Spans?

And people have short memories. Back in 2008, in the early days of the current economic crisis, Chancellor Angela Merkel’s bi-party cabinet pushed through a 1.1 per cent increase pensions. The increase, which included a further 2 per cent rise for 2009, had an estimated cost of €12bn by 2013 – a cost which will largely be borne by companies and younger people via higher insurance contributions.

Then in 2009, the very same cabinet adopted a permanent ban on pension cuts, effectively shielding the country’s 20 million pensioners (who might have faced old-age benefit cuts starting this year) from the effect of the economic crisis. But given the extremely low German long term birth rate, wouldn’t it have been better to shield some of those young couples who want to have children from some of the negative effects of the crisis in a way that enabled them to push the up the number of children the country has. Isn’t it better to invest in the future, than invest in the past?

Naturally the move shocked German public finance economists, who were worried that Berlin’s precipitate partial dismantling of decade-old reforms in the social security system could leave future governments facing painful choices between drastic benefit cuts or further tax and contribution increases to finance the weakened system. "We had almost fixed the pension system. We had made it demography-proof and business-cycle-proof," Bernd Raffelhüschen, professor of economics at Freiburg University, said at the time, "In fact, we had a buffer. The pension system could have gone through the crisis. Now we are back to the drawing board."

"What the government did decouple pensions from wages," according to Karl Brenke, a labour market expert at the DIW economic institute in Berlin. "This is something no government had been irresponsible enough to do for the past 30 years."

Since 2001 the value of benefits that German pensioners receive had been indexed to wages. But last year’s move broke the link and means pension payments will only ever go up, removing the mechanism that would have reduced payments if and when contributions to pension funds are reduced. The only way to compensate for this is via tax hikes (not VAT again, please!) or increased contributions, the main burden of which will fall on the countries ever less numerous younger population cohorts. Gerontocracy anyone?

In conclusion then, my intent here is not to mount some sort of "anti German" diatribe. Far from it. It is to mount a diatribe against a discourse which seems to me to be extraordinarily biased, and extraordinarily short sighted. German economy and society is facing long term issues and long term problems which it seems to me need to be addressed now, and not ignored by deflecting attention onto France. That German output levels are far more volatile than French ones, is not opinion, it is fact — fact which unfortunately is all too likely to find itself confirmed yet one more time as we approach the end of this year.

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I reviewed some of White’s remarks in my April piece The origins of the next crisis regarding the global economy and the accumulation of debt in advanced economies. The remarks he made to Bloomberg were of the same nature. In particular, White characterized the medium-term to longer-term problem in language I used a couple of days ago in Why the U.S. economy is weak, regarding the centrality of household debt.

The question for the Fed is: what should a central bank do to deal with a weak but indebted economy. White says that the Fed shouldn’t leave interest rates too low for too long. He says:

Clearly there are advantages to keeping interest rates low. We know what the rationale is. It’s an attempt to try to encourage more demand — and one would hope in particular more investment demand that might contribute to the expansion of tradable goods, etc. So, all of that is good and I don’t deny it.

The point, however, that I would make is that there is another side to very, very easy money which is over a longer horizon – okay, not tomorrow, but over a longer horizon – very low interest rates are bound to generate lower savings than you would otherwise have which is not a good thing. It allows people to borrow money to keep themselves alive – soft of an evergreening of high risk companies through the bond markets. It encourages zombie companies and zombie banks, misallocations of resources.

Now, all of these things are medium-term things and Chairman Bernanke has a clear and pressing present problem. And this I don’t deny. My only point would be that we evaluate what to do going forward, that the framework should encompass both the short-run effects of monetary policy and the medium-term effects.

So, loose monetary policy does help to increase demand. However, over the medium term, loose monetary policy lowers household savings rates and encourages the accumulation of debt and the zombiefication of industry. So, over the medium-term an ultra-low rate policy is toxic. This has certainly been the experience in Japan – and I suspect it will be no different in the US.

Higher rates now would probably help tip the U.S. back into recession. However, over the medium-term, the zero interest rate policy cannot persist as it has done in Japan. My feeling is that we are in a policy cul-de-sac right now. The "Doom Loop" of ever lower rates and ever rising household sector debt burdens and ever rising financial service leverage is at an end and that leaves little which monetary policy can do despite Chairman Bernanke’s assurances.

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