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MONETARY POLICY


nominal wage cuts and product market reforms on the periphery is growing. Eroding real wages via rising price levels is the easier way out. Fourth, def lation on the periphery risks destabilizing fiscal accounts, since declining prices can boost debt levels relative to GDP.


THE DENOMINATOR EFFECT


Tis last point (deflation on the periphery risks destabilizing fiscal accounts) is the most worrisome at the moment. If Club Med states have to deflate, their debt trajectories risk spinning out control. Te two policy objectives of EMU crisis strategy are in contradiction, as also the OECD recently spelled out last month: intra- euro price level adjustments to restore competitiveness make fiscal targets much more difficult to achieve. Falling nominal GDP means the debt burden is rising on a shrinking base. Te ‘denominator effect’ is deadly when the public/private debt stock is high: 276pc in Italy, 300pc in Greece, 330pc in Spain and 389pc in Portugal. It is why Italy’s public debt has jumped from 119pc to 133pc GDP in just over


austerity and


two years despite a


primary


draconian budget


surplus. And when average euro- area inflation undershoots the two percent target, the conflict between intra-euro relative price adjustment and debt sustainability is more severe. Tat is why, in my opinion, intra- euro price adjustments have to be more symmetric and in the debate previously exposed from Goldman


FX


Japan’s experience in recent years shows that currency markets tend to reward high real interest rates with a stronger exchange rate


I am leaning more into the ‘this deflation is bad’ camp. A recent paper from Bruegel


(a


based think-tank) explains this view pretty well. “… a more


famous Bruxelles- symmetric


intra-euro area price adjustment should facilitate intra-euro area competitiveness adjustment. If inflation has to be 1 percentage point lower in Italy and Spain because the overall euro-area inflation rate undershoots the two percent target, the persistent primary surplus has to be higher in Italy by 1.3 percent of GDP and in Spain by 1.0 percent of GDP, according to our calculations. Consistent


with the ECB mandate, average inflation in the euro area should not be allowed to fall below the two percent target, and Germany and other euro-area countries with a strong competitive position should refain fom domestic policies that would prevent domestic inflation fom rising above two percent. Terefore, the ECB should do whatever it takes, within its mandate, to ensure that inflation does not fall below the 2 percent target.”


Unfortunately we are still far from this even if some activism from Mario Draghi, especially compared with


FX TRADER MAGAZINE January - March 2014 47


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