What Happens if (or when) the Euro Zone Cracks?

Europe is still wrestling with this issue and that is not surprising given the scale of it.

In many ways it is a “Catch-22” situation (with apologies to Joseph Heller).

As the debtor nations in the Eurozone struggle to conform to the stringent fiscal constraints placed upon them to balance their public and private spending, the short term impact is that demand in the economy (and hence economic activity) declines. This cuts tax receipts and increases social welfare making even more cuts a necessity. Catch-22.

Fortunately it is not a ‘bottomless pit”.

As one famous American Economist once put it, economy’s work despite the Government’s best efforts, but in the meantime it certainly isn’t comfortable.

And the UK is not immune – and is in fact one of the basket cases.

When the recession started in 2008/2009 people started talking about “the spectre of deflation”.

At the time we said it was nonsense and so it proved to be.

But times have now changed.

The spectre is now real.

“Why?” you may ask.

Well, we have reached the point where Government spending cuts at home and in Europe are becoming painful realities not just for the “frothy minority” parts of the public sector (the special interest clubs and quangos who looked after the welfare of ever-smaller groups of vulnerable minorities) but for mainstream services.

Especially so in places such as Spain, Italy, Greece and Ireland.

There is now an increasing possibility that some re-alignment within the Eurozone will be necessary.

What does this mean?

Essentially it means that the “debt” in these countries has be “re-based”. Techno-babble I hear you say. Indeed it is.

What it means is that by some sleight-of-hand the Eurozone manages to “devalue” the “Euros” in the heavily indebted nations.

It is tricky to achieve because allegedly they are all locked together in the one currency.

How can a Euro be worth “less” in one country than in another?

Well as things stand at the moment it can’t but do not underestimate the skills of bankers and politicians.

Our view at the moment is that the Eurozone will crack – not explode.

Like an earthquake fault-line, a method will be found to re-align the nations finances so that they can begin again – and this time be more careful in how they manage their finances or risk the wrath of the mighty Bundesbank who will not let them off the hook next time round.

Once the method for allowing this re-alignment has been defined, it will have repercussions though – particularly for UK plc.

What it amounts to is an Orwellian re-badging of “defaulting on sovereign debts”.

It is what the Bank of England has done with some success since 2008 owing to its policy of “QE” (expanding the money supply to allow inflation whilst keeping interest rates close to zero so that this in turn erodes the value of the debt). No wonder Mr King is looking forward to stepping-back from the limelight.

The currency depreciates and all is well in the financial markets.

And it is all paid for by UK pensioners.

In the Eurozone, the mechanism that has been spoken about so far (though not too loudly) is the issuing of bonds by the debtor nations.

But issued in such a way that they are somehow disconnected from the Euro.

Tricky to achieve but we’ll see. I’m sure there are a few traders from the derivatives market who would be willing to have a go at it.

Once the mechanism has been found, however, the problems do not end. They actually just begin.

It will relieve some of the stresses within the Eurozone but the economies will still be flat on their backs.

The UK will struggle to do business with a Eurozone that is moribund and the UK too will continue to ‘flatline’.

That then, is what brings the spectre of UK deflation.

The Bank of England has probably now used up all its slack on QE. Expect some more to come but we must be nearing the end of that road.

With interest rates low, economic growth low, government spending unable to be expanded, and money supply expansion left impotent, companies will start to cut prices to try to attract business and achieve their sales targets. The price cuts we have seen so far will look like weekend deals.

There is tremendous productive capacity in Asia that will enable companies in the UK to cut prices and still make profits.

What stops them so far is there has been no need to do so up to now.

Will this matter? Well it well to UK-based businesses that produce mass-market products that can easily be produced elsewhere.

According to McKinsey – that amounts to about 60% of all UK industrial production.

And that is the big area of risk for the UK. If UK-based business start to come under intense pressure from abroad – as seems increasingly likely – the only place they can go to reduce their costs is reducing wage bills. Either by laying people off or cutting wages. We are not there yet but that takes us towards “depression” – not a good place to be.

Against all this backdrop the need for scenario planning, having a baseline sales projection and series of alternative scenarios mapped-out, has never been greater.

Fortunately the data sources to enable such scenarios to be run have never been better. It may not be pretty, but it should be manageable.

So our advice at the moment is to plan for the worst and build capability to quickly exploit opportunities if they arise.

Counting on a rosy future come what may is not a good basis for business planning just now.

We will see what happens.