The guest commentary below was written by written by Daniel Lacalle. This piece does not necessarily reflect the opinions of Hedgeye.
The European Central Bank should be hugely concerned about two pieces of news. The euro is on the verge of parity with the US dollar and has accumulated a drop of 17% since 2021, more than 35% since 2008.
On the other hand, inflation in the eurozone reached 8.6% in June, 5% excluding the energy and food components. Inflation in more than six eurozone countries, including Spain, is already in double digits with core CPI at multi-decade highs.
Meanwhile, in Switzerland, June inflation was 3.4% with core at 1.9%. Switzerland relies on imports for gas, commodities, and supply chains as much as its neighbors, but it has not engaged in massive printing of its currency.
The euro is the greatest monetary success of the last 150 years, and it cannot be jeopardized by risking the independence of the European Central Bank. It is an elevated risk and those of us who want it to remain a reserve currency and a success are concerned.
The balance of the ECB is 69.5% of the GDP of the eurozone, when that of the Federal Reserve is 37% of the GDP of the US and the Bank of England’s is 39% of the UK GDP. However, the euro is not the world’s reserve currency.
The US Federal Reserve is the only central bank that pays attention to the global demand for US dollars and despite this, it has also made the enormous mistake of expanding money supply well above demand and, thereby, triggering inflation.
Let us not forget that prices do not go up all at once for the same amount of currency issued. One or two prices may rise for exogenous reasons, but not all rise unless the purchasing power of the currency is destroyed by printing without control. As Frank Shostak reminds, inflation is money supply growth, not prices denominated in money.
A weak euro and rising inflation are extremely worrying factors because in June 2021 the increase in broad money supply (M3) in the eurozone was 8.3% annualized, with M1 (currency in circulation and overnight deposits) increasing by 11.8%.
In other words, the increase in money supply (M3) was still 16% higher than during the so-called “Draghi bazooka”. In May 2022 it is still growing above 5.6% with GDP rebounding a mere 2.6% (consensus estimates).
Why was there no “inflation” between 2009 and 2019? First, there was. We cannot forget that when policymakers told us that “there was no inflation” the accumulated loss of purchasing power of the euro was 74% (from 1991 to 2021).
Although the annual CPI remained contained, there was enormous asset inflation as the rising supply of currency went into sovereign debt and financial assets.
Of course, housing, and non-replaceable goods and services prices skyrocketed, but nothing like 2020. The increase in money supply not only soared to exceed 12% (M3) but was mostly directed to non-productive public current spending. The eurozone and the United States flirted ever-so-slightly with Argentina’s monetary policy, and, with it, inflation skyrocketed.
In any case, the US dollar is still the world’s reserve currency, but the euro is nowhere close. According to the Bank of International Settlements, most global transactions are made in US dollars, followed – far behind – by the euro.
Additionally, the euro is the only currency of developed countries with a risk of redenomination (someone may decide to break it up). That is why it is key to defend the unequivocal mandate of the ECB: Price stability, that is, the solidity of the euro as a common currency.
The global demand for US dollars increases when the Federal Reserve raises rates, it attracts more demand towards the greenback.
However, in the eurozone, weakening the euro makes imports much more expensive and the eurozone finds itself with a record trade deficit – which is the equivalent of buying dollars and selling euros – of 16.4 billion euros.
Of course, the energy factor is relevant, but policymakers cannot use it as an excuse to destroy the purchasing power of the greatest monetary success in recent history, the euro. Commodities and imports purchased in a weaker currency make the trade deficit situation much worse. Let us not forget that the eurozone posted an exceptionally low inflation (measured as CPI) when oil and gas prices soared in different periods of 2012-2014.
The weakness of the euro should not be taken lightly. Those who repeat the fallacious mantra that a weak currency benefits exports should look at the rising cost of imports, the record trade deficit, and the slump in real wages.
A trade deficit -selling euros, buying dollars- together with governments that refuse to reduce their expenses and structural deficits -additional consumption of more new currency units- and a plan of European Next Generation funds that is going to be monetized for the most part -greater consumption of monetary reserves- can be a lethal combination if we add a central bank that maintains negative real rates -more inflationary pressure- and continues to increase money supply well above demand.
A weak euro means lower purchasing power of real wages and deposits of eurozone citizens, i.e., more poverty.
Nobody wants to work for a weak currency and the euro should not be one.
There is no advantage in defending inflationism. It impoverishes citizens, punishes the efficient sectors, and destroys confidence in the currency. Criticizing the slowness of the ECB’s actions is not anti-European. What is anti-European is inflationism, impoverishing all.
It is extremely important that the European Central Bank fulfills its mandate, which is price stability.
The ECB’s mandate is not that Spain or Italy finance themselves artificially cheap while accumulating enormous deficits and imbalances at the cost of impoverishing salaries and savings, it is price stability. What has destroyed Europe for centuries has always been inflationism.
The ECB’s mandate is not to disguise the budgetary incompetence of governments or to make excuses for high inflation, its mandate is to defend the real wages and deposits of the families of the eurozone while maintaining price stability.
It is key that the Central Bank raises rates because the problem is not a moderate increase, but the excess of debt and risk accumulated during years of negative rates, an unjustifiable monetary aberration. Interest rates are the price of risk and artificially depressing them incentivized excessive risk and debt.
It is essential that the European Central Bank stops the debt monetization madness because its mandate is not to disguise sovereign risk, but price stability. The anomaly is not bond spreads of a 100 or 300 basis points in some peripheral economies, but the lunacy of previously artificially forcing negative yields on sovereign bonds.
The anomaly is not to have spreads commensurate with the solvency and credibility of the issuer, the anomaly was accumulating up to eleven trillion euros of debt with negative yields from issuers with decreasing solvency and credit credibility.
Normalizing monetary policy does not generate “a speculative attack” when credit credibility is strong. What was a speculative attack was disguising risk and excess debt by monetizing 100% of the net issuances of sovereign borrowers.
It is essential that the European Central Bank understands that the survival of the euro depends on containing the constant increase in the consumption of monetary reserves of governments that already represent more than 50% of the GDP of the economies. It must understand the following:
Monetary policy has gone from being a tool to buy time and make structural reforms to being a tool to avoid them.
With the extremely dangerous perverse incentive to spend more without control and monetize it, impoverishing everyone, the credibility of the institution, of the currency and the transmission mechanism that allows a strong private economy are endangered, because the excess of debt is subsidized, while savings and prudent investment are penalized.
It is the unequivocal recipe for stagnation and structural worsening of an economy where the crowding-out effect of the public sector on the private sector is inadvertently encouraged through monetary policy. This leads to lower productivity, lower growth, and more debt.
Investors should not care if the stock markets and bonds suffer a correction after the excess of optimism and complacency of recent years.
Market participants should prefer that the ECB reinforces its independence, defends the currency and its citizens than scratch a couple of additional percentage points from a portfolio, because the alternative, stagflation, or outright crisis, do much more harm to more people throughout the eurozone.
One day the members of the central bank will realize that those who defend the euro and the eurozone are not those who applaud inflationism, fattening deficits, and the destruction of the currency’s purchasing power, but those of us who want the world to continue valuing the euro as a powerful global alternative. Probably when that time comes it will be too late and the alternatives will come from other currencies.
Destroying the purchasing power of currency is not a social policy. It is the most antisocial. It is impoverishing everyone. The independence of the ECB should not be in doubt, neither its respect for its unequivocal mandate.
This is a Hedgeye Guest Contributor note by economist Daniel Lacalle. He previously worked at PIMCO and was a portfolio manager at Ecofin Global Oil & Gas Fund and Citadel. Lacalle is CIO of Tressis Gestion and author of Life In The Financial Markets, The Energy World Is Flat and the most recent Escape from the Central Bank Trap. This piece does not necessarily reflect the opinions of Hedgeye.