None of this is news. What may be a surprise, however, is the fact that we are talking not about Europe, but about the UAE.
Like Europe, the UAE is a currency union with a single central bank and a core-periphery divide in which the periphery's economic extravagances have put the union and all of its economies at risk. A build-up of imbalances between the core and the periphery of both regions unraveled as indebtedness in the periphery was no longer acceptable to markets.
Euro area core-periphery dispersion driven by unwinding of imbalances... Clearly, the euro area is not unique. No comparison can be perfect, but we argue in this note that the similarities between the two regions are compelling. These similarities suggest that the diverging economic trends we are seeing between the core and the periphery of the euro area mimic the divergence in the UAE and are essentially an unwinding of economic imbalances rather than developments brought about solely by policy errors.
...which will likely continue beyond an agreement on the policy issues: In fact, even though the UAE's policy resolution was quick, the economic pain has continued as the underlying imbalances are unwound. This suggests that even if policy-makers deliver a sustainable solution to the euro area's policy issues, the economic pain is likely to continue until the imbalances are wound down. Faced with a similar problem, the economic outcomes in the UAE and Europe could well be remarkably similar.
Europe's parallels with the EM world don't stop with the UAE: In fact, many of the ‘trademark' phenomena of the EM world have seen ‘copyright violation' by DM economies:
• In severe downturns or crises, EM rates behaved more like credit spreads as external hard-currency obligations and growth slowdowns raised questions about the sovereign's ability to service its debt. The euro-denominated debt of peripheral economies and especially the advent of the PSI as well as the euro-denominated borrowing of the peripheral economies have converted peripheral euro area rates markets into EM-like credit spreads.
• Monetary policy constraints in the euro area (and in the US and the UK for that matter) now mimic those felt by central banks of highly indebted EM economies. During such times, EM central banks found that fighting inflation according to a ‘Taylor Rule' was counterproductive. First, it directly raised debt-servicing costs as interest rates rose. Second, by slowing down growth, it made investors question the sustainability of debt. Tightening policy only meant a reversal of that policy as a debt crisis threatened, creating the risk of even more inflation. The ECB's tightening campaign in 2011 matches this EM experience very closely.
There are other parallels, but these two important ones serve to illustrate the point of this note, that there is little unique about the underlying economic dilemmas the euro area faces. There is much to be learned by looking at the right parallels. The ECB's experience will no doubt chasten other central banks that would otherwise have tried to run conventional monetary policy in times of such high indebtedness, but the ECB itself could have taken a more cautious approach had it given these parallels more weight, in our view.
The core, the periphery and the imbalance: Germany and Abu Dhabi represent the core of their respective regions. Both run a persistent current account surplus, i.e., an excess of savings over investment, generated by oil in Abu Dhabi and by productivity in Germany. On the other hand, the periphery of the UAE - Dubai - like its European counterparts ran a persistent current account deficit, reflecting more spending than saving, financed by debt.
The stable, core economies make up the economic bulk of both regions, driven by the same stable, sustainable drivers that created their current account surplus. Given the lack of an intrinsic, fundamental driver of growth similar to the ones enjoyed by the core economies, peripheral economies drove their growth by increasing leverage. The leveraged boost to spending overshadowed savings and created the current account deficit in the periphery. Over time, the excess savings of the core and the excess spending of the periphery built up into a current account surplus and deficit imbalance that was bound to unwind at some point.
It's not just the unwind, it's how it's unwound: For the better part of the last 150 years, current account imbalances have eventually been unwound, usually to the detriment of the deficit countries (see Emerging Issues: Current Account Reversals, January 24, 2011). The key to this unwind is the real exchange rate. One way or another, the current account deficit country needs to become more competitive and its assets more attractive relative to the current account surplus countries. The real exchange rate does this. How? It changes the relative price in favour of the current account deficit country in one of two ways: either by making the currency of the deficit country cheaper or by lowering prices in the deficit country relative to surplus country.
Since there is no exchange rate... Unfortunately for both the euro area and the UAE, the first option for resolving imbalances is not available to them. A currency union means that there is no nominal exchange rate to allow such a quick adjustment (without a break-up of the currency union, which would be disastrous). This means that the process of making the deficit country more competitive and its assets more attractive falls on relative price adjustments in the two countries.
...prices have to adjust: So, now we face an adjustment process where the goods and asset price inflation in the peripheral/deficit countries has to underperform that of the core/surplus countries. This would be relatively less painful if the core countries were willing to allow or encourage higher inflation in their own economies. Then, even a low rate of inflation and a relatively small fall in asset prices in the peripheral economies would slowly make peripheral goods and assets more attractive.
The core is unwilling or unable to inflate... However, neither Germany nor Abu Dhabi have seen such surges in inflation relative to the periphery, partly because of the weak global economic environment and to different degrees because the core countries are averse to inflation. Thus, the onus of this inflation adjustment falls squarely on the peripheral economies. In order to become more competitive, goods and asset prices had to fall in not just relative but also absolute terms thanks to the lack of the opposite adjustment from the core economies.
...which forces the periphery to deflate: As a result, there has been significant downward pressure on goods prices, wages and asset prices in the periphery. Goods price inflation in both the UAE and Europe are noisy indicators of these pressures because of the presence of imported inflation. In a recent report, the Bank of England presented a decomposition of overall inflation into its imported and domestic contributions in which domestically generated inflation has consistently hovered around 0%. We suspect that a similar decomposition would show domestically generated inflation in the peripheral euro area countries and in Dubai moving into negative territory. Wages, like prices, are slow to adjust, but evidence of this is available from the UAE, a development that is likely to occur in the peripheral economies in order to make the labour force there more competitive.
Asset prices, however, show very clear evidence of these pressures, particularly because they are quick to adjust. Accordingly, equity prices, bond prices and house prices in the periphery of the euro area and the UAE have adjusted, and rapidly at that.
China-US: A relatively benign resolution of imbalances: Considering the rhetoric that is part and parcel of the renminbi appreciation debate, the resolution of imbalances between the US and China is actually relatively benign compared to that in the UAE or the euro area, with both the surplus and deficit taking on some of the adjustment. The resolution of imbalances in the UAE and the euro area forces the bulk of the adjustment on the current account deficit country, but the same is not true for China and the US. China, the higher productivity and current account surplus country, has actually run higher goods and asset price inflation than the US, which has allowed the US to become more competitive without compelling US inflation to move into deflationary territory or forcing asset prices lower there.
This perspective explains why the US is keen to encourage steady renminbi appreciation. Such an appreciation not only helps China lower inflation and transfer some spending power to its consumers, but it also eases the downward pressure on US inflation and keeps US asset markets on an even keel. Such a move would also have been salutary in the UAE and the euro area, except that an adjustment of the nominal exchange rate is simply not available there.
In summary, the economic issues confronting the euro area are in no way unique. The core-periphery divide in the euro area is a result of the unwinding of a fundamental imbalance and not just policy issues. Experiences from the UAE show a very similar unwinding of imbalances that continued beyond a ‘solution' to the debt crisis that engulfed Dubai. If that experience is anything to go by, an unwinding of imbalances within the euro area is likely to continue beyond a resolution of the policy issues, a resolution that is long overdue but appears to be within reach now.
There were very few surprises on the policy front. The Chancellor provided few major surprises in terms of policy as most of the measures (e.g., credit easing for SMEs, increased infrastructure investment from pension funds, pulling forward some government spending on infrastructure, policies to boost youth unemployment) had already been widely leaked to the press over the weekend. He did cap public sector pay rises at 1% per annum for two years after the current wage freeze ends next year and brought forward the timing of the increase in the pension age to 2026. Moreover, the OBR has increased its estimate of total public sector job losses from 400K to around 700K by 2017.
As expected, the OBR slashed its forecasts for future GDP growth and significantly raised its estimates of borrowing over the forecast horizon. Under the assumption that the eurozone struggles through its current difficulties, the UK's independent fiscal watchdog now expects the economy to be broadly flat through 1H12 and to improve gradually in 2H12. For next year as a whole, the economy is expected to expand by just 0.7% (Morgan Stanley forecast is 0.6%) compared to March, when it saw growth of 2.5%. In addition, it expects a GDP gain of 2.1% in 2013 compared with its earlier estimate of 2.9%. Further out, the OBR continues to forecast the economy expanding by not far shy of 3% per annum, amid stronger global growth and a firming in domestic demand. Unsurprisingly, given the current uncertainty plaguing the global economy, it believes that the probability of a much worse outcome than its central scenario outweighs the likelihood of a better outturn.
As a result of the sharp deterioration in the macro outlook, cumulative public sector borrowing (PSNB-ex) is expected to be almost £115 billion higher over the old forecast period to the end of the fiscal year 2015-16. Moreover, public sector net debt is now forecast to rise to almost 80% of GDP in 2014-15.
The OBR judges that more of the deficit is structural and less easily reduced by stronger future growth. The OBR now judges that the output gap is around 2.5% of GDP currently, compared to its March estimate that the gap would be closer to 4% over the current fiscal year. In addition, it has revised lower its estimate of the economy's near-term potential growth rate (the pace at which the economy can grow without cutting into spare capacity). It now thinks the potential growth rate will be just 1.2% in 2012, 2% in 2013 and rising to 2.3% thereafter. This compares to its previous assumption of 2.35% for 2012 and 2013, easing back to 2.1% thereafter. The cumulative effect is that it now expects the economy's potential output to be around 3.5% lower by the end of 2016. The policy implications of the OBR's updating of its thinking on the output gap and potential growth are that there is likely to exist much less spare capacity in the economy over the forecast horizon than previously thought. The upshot is that less of the fiscal deficit can be reined in by stronger growth in future years - it will need to be corrected by tighter fiscal policy.
The Chancellor remains on course to hit his fiscal targets. The Chancellor's fiscal mandate states that he must balance the cyclically adjusted current balance (current receipts - current spending), which excludes investment, by the end of a five-year rolling window. While his supplementary target states that public sector net debt must be falling as a percentage of GDP by 2015-16, the OBR judged that in the absence of any new policy tightening in the Autumn Statement, the Chancellor would have had less than a 50% chance of achieving his targets. However, Mr. Osborne unveiled additional tightening measures equal to 0.5% of GDP in 2015-16 and 0.8% of GDP in 2016-17. The overwhelming message is that fiscal austerity stretches well into the next parliament.
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