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Friday May 13, 2005 - 19:38:34 GMT
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European Waistline Too Big For Maastricht Corset

European Waistline Too Big For Maastricht Corset

European Monetary Union is 6 1/2 years old and showing signs of stress. Instead of economic (and political) convergence, the Euro Zone is diverging economically...from growth to inflation. Economic reforms remain more dream than reality and the policy response for the Euro Zone governments has been belt loosening...easing of the Stability and Growth Pact corset to make way for the expanding waistline.

Europe and the Euro Zone's two largest economies are foundering. Germany posted a strong 1Q GDP report Thursday (+1.0% q/q). But this was mostly due to exports (couple of big months for autos) and Buba Chief Economist said soon after that German growth would flatten after the strong 1Q growth. Italy posted a second consecutive quarter of negative GDP, also on Thursday (down 0.5% q/q). In most parts of the world that counts as a recession. Growth in France in 1Q out next week should be closer to Germany, but with broader base to it including domestic consumption. Spain meanwhile has an inflation rate at 3.5% y/y (April), well above 2.0% Euro Zone ceiling. Meanwhile EU Economic and Monetary Affairs Commissioner Almunia said today after EU finance ministers and ECB reps meeting that countries who have brought unit labor costs down with reform (like Holland where 1Q GDP fell 0.1% q/q, second straight contraction) are being punished by countries who have not...ECB could not be any clearer of late that there is no scope to cut rates.

Italy in particular is vulnerable to major competitiveness disadvantages in textiles, footwear and clothing industries to China, Brazil, India and non-Japan Asia generally. While few are taking it very seriously, there are growing voices of discontent with the EMU corset as some politicians and unions are thinking about saying ciao to the euro.

The divergence dilemma also registered at the ECB in its latest monthly bulletin published Thursday (attached below is the FT summary of the ECB's discussion of divergence). But the ECB is also up against the wall on policy in the wake of the loosening of the Maastricht corset earlier this year. Fiscal policy, the undoing of most former reserve currencies, was let out of the barn in part by a de facto diminution of deficit constraints. It must now shoulder more of the load of restraint...making it even less able to respond to recession-deflation pressures.

And efforts at political union look likely to be tested later this month and early next when France and the Netherlands each hold referendums on the EU Constitution. Polls show a close vote in both countries...the no vote is in front in Holland and until recently was ahead in France (yes vote ahead 52-48% in poll published today, among decided voters...about 75% of those polled). While a no vote in either country would not kill the move toward a federal Europe, it would be a significant setback and may forever leave European integration a mainly economic phenomenon and not a political one too as has been the prime objective all along.

So with the markets selling euros and buying dollars on bullish US fundamental news, there is a growing risk that European economic and political divergence could add a big figure or two to the move down in euro/dollar.

That said I am still firm on the notion that the dollar has not bottomed. The US structural imbalances and absence of policy mix globally to address the imbalances (yuan reval one exception, but de facto window dressing for the foreseeable future), suggest a lower dollar is the only game in town to drive adjustment. The record deficits are sustainable only until they are unsustainable and that day is getting closer.

David Gilmore


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