What if you invested in the next market bubble… before it became a bubble? What if you bought an asset when it was trading at fair value… before everyone and their dog bought in too?
Due to the structure of the eurozone’s monetary policy, we believe a bubble is just beginning to emerge in a relatively niche asset class in Europe.
In our last issue of Zero Hour Alert, we revealed where we think the next big bubble is set to appear, and highlighted two publicly traded vehicles we think will zoom if our thesis is correct.
I share a short snippet below…
Why the euro is [not just] an Eternal Recession Machine
By Nick Hubble
Usually, exchange rates between economies adjust for an out-of-control economic boom or bust.
The Italian lira can fall and the deutschmark can rise to enable Italy to recover economically and Germany to rein in its export and property boom. That’s why the pound fell 17% on Black Wednesday in 1992. And after the Brexit referendum. The exchange rate acts like a pressure valve.
But that can’t happen in the eurozone any more. Everyone is on the euro. So what happens when exchange rates can’t adjust?
We don’t need to theorise about that. You probably experienced Britain in the years before it abandoned the ERM – the “Eternal Recession Machine”. And then there was the 70s, when fixed exchange rates caused far worse economic chaos. The same happened in Asia in the late 90s, leading to the Asian financial crisis.
But it gets worse. Not only does the euro hinder countries’ ability to recover by preventing devaluation, it also has the same effect as a shared monetary policy: it worsens the business cycle, creating bigger ups and downs, punctuated by crashes. Economists call this effect “pro-cyclical” because it adds to the ups and downs of the business cycle instead of countering them.
The business cycle, with its booms and busts, used to be known as the trade cycle.
That’s because it was largely an ebb and flow of import and export booms. The exchange rate and monetary policy are supposed to smoothen these trade cycles by repricing imports and exports.
If an export boom gets out of hand, the currency rises, reining it in. If an import boom gets out of hand, the currency falls, reining it in. The exchange rate is counter-cyclical – it pushes the trade cycle towards rebalancing. And thereby the economy too.
But how is the shared exchange rate of the euro pro-cyclical instead?
Countries inside the eurozone that are struggling are stuck with an artificially high exchange rate, while countries that are booming don’t see their exchange rate rise. At least not as much as it would without the struggling nations holding it back.
Just as on monetary policy, everyone is left with an awkward in-between – an exchange rate that is correct for nobody. The worst of both worlds.
The European Commission estimates Italy’s export industry is three times more sensitive to the euro exchange rate than Germany’s. Which makes Italy’s position worse when the falling lira should be easing the pressure instead.
Meanwhile, Germany’s export boom continues unabated, even setting recent records. Ironically, it’s the euro’s policymakers who criticise Germany for this, despite their beloved currency causing it.
The [profitable] consequences of a shared monetary policy
The basic idea of monetary policy is to smooth the business cycle. A country with a struggling economy gets a kick-start thanks to lowered interest rates.
A country with a booming economy, high inflation, and low unemployment needs to be slowed down with higher rates to prevent bubbles, speculation and too much debt.
But what if you persistently set the wrong monetary policy? Deliberately?
Incorrect monetary policy was responsible for the financial crisis of 2008. In the US, the Federal Reserve and its former chairman Alan Greenspan copped the criticism for this. Many commentators now agree that interest rates were kept “too low for too long” in the 2000s, inflating the housing bubble with cheap debt. In other words, the central bank financed the sub-prime bubble with low interest rates.
But in Europe, the European Central Bank’s (ECB) one-size-fits-all monetary policy was never blamed for the housing bubbles that occurred in Ireland and Spain. Those countries should’ve had higher interest rates when their property markets boomed before the 2008 crash.
But Germany’s economy was the “sick man of Europe” at the time, requiring low interest rates. So the ECB split the difference and set interest rates somewhere in between.
Politicians call this a compromise. I call it the worst of both worlds. It left Europe’s struggling nations with an interest rate that was too high, and Europe’s booming economies with an interest rate that was too low.
The reverse has happened since the financial crisis.
Which is where we come to our opportunity. The ECB can’t raise rates on the struggling Italians and Greeks – the new “sick men of Europe”. So the 0% interest rate is inflating bubbles across northern Europe right now…
The other side of the coin to bubbles in the north is despair to the south, with far-reaching consequences for financial markets. More on that here.
Until next time,
Boaz Shoshan
Editor, Southbank Investment Research
Category: The End of Europe