German "Stabilität" serves euro investors well

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Investors who braved dire warnings about existential threats to the euro area have been richly rewarded. Over the last twelve months, euro area equity prices soared more than 23 percent. That leaves liquidity turbo-charged U.S. and Japanese markets far behind.

The monetary union's bond market performance during the same interval is even more impressive, given the widespread forecasts of impending disasters on its southern periphery and a new round of financial distress. Here is what happened: Yield spreads with respect to the benchmark ten-year German bond were halved in the case of Italy and Greece, and more than halved for Spain and Portugal.

That is quite remarkable because the yield on the German benchmark bond declined over that period from 1.60 percent to 1.37 percent last Friday.

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Predictably, these large capital flows favoring euro area assets have kept the single currency's trade-weighted exchange rate stable on a mild upward trend.

Can these good euro fortunes continue? I believe that is possible.

"Stabilität" is a good word

Even the Chinese -- Germany's "dream team" partners -- like it. To say nothing of some latter day Mediterranean converts, who thought that Berlin's relentless preaching about the virtues of fiscal discipline and probity would pay off by building up investor confidence was a cruel "pie in the sky."

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The German hectoring, assorted with some wrenching arm-twisting, not only produced results, it slowly passed the disciplinarian's baton back to the markets. And that is where we are now: Markets are closely scrutinizing fiscal policies and budget outcomes in a way that no euro area government would again dare test their patience.

The German-led stability pact has also institutionalized euro area budget procedures. Each member country must submit its fiscal policies for review to the EU Commission before they are presented to the country's legislature. That is a serious dent in national sovereignty, but the scrutiny of the EU Commission, euro partners and financial markets has opened up a transparent process where any fiscal transgressions would entail exorbitant costs for public finances.

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The monetary policy is in the hands of a supranational institution – the European Central Bank (ECB) – which has shown rigor and imagination in handling a hugely difficult task with limited authority in the context of an incredibly complicated legal and administrative environment.

The strength of the euro's trade-weighted value and the successful implementation of the ECB's key mandate – price stability defined as an inflation rate between 0 and 2 percent – are witnessing that the bank is doing a good job.

Slowly but surely, the ECB is also changing the euro area's political culture. By its statute, the central bank can never be a politician's hand-maiden, throwing unlimited amounts of money at any problem of electoral interest. There again, things are moving toward the German tradition where the monetary authority is a respected institution completely off limits to political fixes.

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Old habits are dying hard, though. Reading the European press I often see the nostalgia for the times when national central banks were under politicians' thumbs, doing what they were told to do. But even there, such attempts look more like the usual political game of blame shifting than an expectation that anyone would take seriously the central bank criticism.

Is euro deflation an "irrational" view?

The current IMF-inspired and promoted debate that not enough is being done to forestall the euro area "deflation" is a case in point.

The ECB has vehemently dismissed the idea of price deflation while emphasizing that it carefully monitors cost and price developments, and that it stands ready to do everything it can, within its mandate, to help the unfolding economic recovery.

True to form, Germans have been much more aggressive in squashing the deflation idea. One of the ECB's former German economists called the whole thing "irrational."

I am inclined to say "Amen."

Indeed, I am afraid that we could soon be talking about inflation rather than deflation. Here is why.

First, because most of the euro area single market is still a work-in-progress. We are far from a situation where the unhindered price arbitrage of genuinely free market forces rules supreme.

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Second, in addition to falling far short of a homogeneous market for goods and services, the euro area also has structural rigidities which prevent the smooth operation of demand and supply in labor and product markets. Some of these rigidities are part of the European welfare state, with its own concepts of social equity and justice that no serious politician would dare to dismantle completely.

Clearly, an economic system with these characteristics is more prone to upward cost and price pressures than economies exposed to unfettered competition and largely unregulated labor market practices.

I am sure that many of you will be surprised to learn that, in spite of high unemployment, unit labor costs in France and Italy last year rose 1.5 and 1.7 percent, respectively, and that wages are now picking up smartly even in Spain and Portugal. By comparison, unit labor costs in the U.S. rose only 0.8 percent in 2013, despite a strengthening labor demand and steadily falling unemployment.

Investment thoughts

I maintain my earlier view that the euro area remains an attractive investment destination. Cyclically-induced productivity gains will support the growth of corporate profits. Subdued inflation, a continuing fiscal adjustment and accommodative credit policies may also offer a limited room for further price gains in some relatively high-yielding euro bond markets.

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The ECB's reluctance to engage in extreme forms of monetary expansion of doubtful efficacy will enhance the appeal of euro assets to long-term investors. The recent easing measures seem well calibrated, but they will take time to work their way to accelerating business and consumer lending by a slowly convalescing banking system.

Electoral gains of extreme right and left political parties in EU parliamentary elections are a protest vote against high unemployment and erosions of an unaffordable welfare state. There are, however, no significant constituencies advocating exit from the euro area and/or departures from stable economic policies.

Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia.

Follow the author on Twitter @msiglobal9