The Curious Case of Europe

Common currency area was dreamt up by the great economist Dr. Mundell in terms of conditional Optimum Currency Area (OCA)and he received a Nobel prize for the same. So what are the conditions on which an OCA are based? Capital & labour mobility and Fiscal flexibility in terms of a surplus nation coming to the aid of a deficit nation. Since the latter is impossible to achieve politically, it was expected that OCA would never be possible and remain a utopia. But founders of the EU led by Germany and France,hounded by the guilt of their respective histories of waging war on the Continent evolved various contraptions including but not limited to budgetary controls to launch the greatest experiment since the Leninist Bolshevik revolution of 1917.

The resulting Sub-Optimum Currency Area(SOCA) has been a major problem child spawning amongst others a Soviet Politburo like EU Council and EU Governance framework that is as bureaucratic and Stalin-like as it's famous predecessor.

This SOCA Politburo , for example, has decreed that a hitherto well to do nation(prior to joining the EU this nation was pretty well contented) of 11 million inhabitants should perish in the service of Charlemagne's fantastic vision. If this is not Stalinism , veering towards Hitlerism , then pray, what is it?

The Road to Heaven is paved with good intentions
So how did this come about? It started quite innocently as noted above bypassing all received tenets of wisdom. Politicians& bureaucrats in European capitals salivated at the prospect of extended service in the edifice of the modern Charlemagne empire. All common sense and basic ECON 101 was cast aside to hastily create a flawed structure. Nations with weak current accounts and weak fiscal positions united with those with very strong macroeconomic parameters. It doesn't require a Rocket scientist to figure out that the European Union would be as successful as the Soviet Union.

And so it is. Ladies and Gentlemen, presenting to you - The Curious case of a bungled Union-The European Union. This Union preaches austerity today at a time when suffering deflation it should be doing maximum of the opposite by utilising negative sovereign yields in many of EU nation states to borrow and spend on infrastructure, research and education.

Stalin seems to be alive and well. The Politburo did not perish with Gorbachev. The Berlin Wall never fell.

What Negative Sovereign Yields Signal to Policy Makers

Sweden's Central Bank just cut its repo rate to - 25 bps a few hours back. Switzerland, Germany, Denmark, France have followed the US bond market into negative yield territory(though today the US yields are themselves all in positive territory due to the US Fed's predilections).

So what does this imply to policy makers ? What are the action points, plans and key takeaways that a Policy maker in key deflation embroiled countries like those mentioned above need to chalk out to get their economies out of the current imbroglio?

Sadly when this question is asked , the immediate reaction is to think about Central Banks and monetary policy. But today's questions have to be answered by a totally different set of policy makers- Public economists and Law makers of various deflation stuck nations as to why they are frozen into insipidity when it is vey clear that in a deflationary environment private sector spending collapses and with negative yields supporting sovereign borrowing with beneficial fiscal spinoffs , the need of the hour is to sharply expand public investment in infrastructure,research and education. The answer is obvious-in the face of collapsing private sector demand only public sector demand can galvanize a deflating economy back to a modicum of health.

So why is this not happening? I do not know of any printable explanation. What explanation I do have is in unprintable language. Go figure.

Fighting Deflation in India Amidst Capital flow Vulnerabilities and Imminent US Fed Rate Hike

India's WPI came in yesterday at -2.06% an all time low. Crude prices certainly helped- but that does not take away the fear of deflation postponing purchasing intentions of consumers , globally and not just in India.

The Indian Government would like to have a considerably easier Monetary Policy than what the RBI is running at the moment. Political posturing aside, technically it is difficult in the face of volatile capital flows and an austerely-built FX reserve(USD 338 Bio) to cut rates when the US Fed is actually looking at hiking rates. To keep the USD/INR exchange rate stable, a potential cut of 100 bps in India's repo rate when Fed will be hiking by about 50 bps in the same duration, would require the Indian 10 year yield to move upto a level of UST 10 year + 570 bps(current spread) + 150 bps (100 bps +50 bps increase in divergence between Indian and US repo rates) = UST10 yr + 720 bps. So if the UST10 yr goes to 3% post Fed 50 bps rate hike by December end 2015, Indian 10 yr needs to be at 10.20% for the Indian Rupee to be stable. Any yield lower than 10.20% will cause the INR to depreciate. We examine 3 different scenarios assuming FX Reserves remain constant untill Dec'15.

Scenario.1 RBI cuts rates by 100 bps , and US Fed hikes rates by 50 bps by Dec'15.

On 31st Dec'15
INR10 yr yield                      USD/INR

10.20%                                       64.00
9.20%                                         67.15
8.20%                                         70.30


Scenario.2 RBI cuts rates by 50 bps , and US Fed hikes rates by 50 bps by Dec'15.

On 31st Dec'15
INR10 yr yield                       USD/INR

9.70%                                         64.00
8.70%                                         67.15
7.70%                                         70.30


Scenario.3 RBI cuts rates by 25 bps , and US Fed hikes rates by 50 bps by Dec'15.

On 31st Dec'15
INR10 yr yield                     USD/INR

9.55%                                         64.00
8.55%                                         67.15
7.55%                                         70.30

So, the lesser the rate cuts by the RBI and the lesser the rate hikes by the US Fed, stabler is the exchange rate for Indian currency. Ofcourse, there are growth and income considerations as well. But witness the exchange rate scare in 2013 when Fed taper tantrums riled India, this variable is definitely an important parameter. And the Indian 10 yr yield? In a scenario of increasing NPAs, Treasury Income is very important to allocate provisions against bad loan losses. Higher the yield, lower the Treasury Income.

So, rather than what the Indian Govt. thinks as a straight off no-brainer, reducing rates is an extremely complex optimisation program.

The Age of Deflation and Misguided Policy Responses

More QE is not the answer to Fiscal policy not taking advantage of near zero yields to borrow more and spend on infrastructure. #StepUpFiscal

QE beyond a point distorts markets and incentives that a well oiled financial system requires to function with integrity. USE of FISCAL TOOLS must be encouraged as opposed to overuse of Monetary policy.

Governments globally have allowed Central banks to pump prime economies using QE-But now the global economy requires replenishment of the slack(collapse) in private sector demand by Fiscal spending in infrastructure. Global phasing out of QE while Govts. start filling up the demand gap, latter following the former is required to take advantage of extremely low soveriegn yields.

The age of deflation can only be tackled by Govt investment in infrastructure globally filling the slack(collapse) in private sector demand.