France, Italy's challenge to German austerity demands causing turmoil

London

THE big question facing the shaky eurozone populace is whether the French and Italian rebellion against German austerity demands will succeed.

Such is the uncertainty that the faltering region, which has had a two-year respite from crisis, is once again causing turmoil in markets and threatening global economic recovery. It is hoped that European leaders will be open to ideas from their Asian counterparts at a two-day summit in Milan.

Former US Treasury Secretary and Harvard economist Larry Summers stressed in a recent Washington debate with German Finance Minister Wolfgang Schäuble that a change in policy to avert a Japanese-type deflationary recession is urgently needed. Mr Summers said Europe, and Germany in particular, should invest in infrastructure, which would "pay for itself" by lowering sovereign debt burdens. Mr Schäuble, however, refuted comparisons with Japan, saying Europe was a "specific" case.

"You can't compare (Europe) with Japan, nor with the US, to be very frank," he said, adding that European social spending was double that of the US and Australia and that budgets needed to be cut.

France and Italy, however, are following Mr Summers' advice by pursuing Keynesian tax cuts and spending in their latest budgets at the expense of wide deficits, despite Germany's protests.

At the same time, bankers and economists are pleading with the Germans to allow the European Central Bank (ECB) to pump more money into the system via quantitative easing (QE) to counter deflation. The debate will continue in the months ahead, but in the meantime, the following bare statistics show the extent of the Eurozone's economic crisis:

The other major concern is the volatility of markets, notably asset-price inflation, followed by asset price deflation that curbs job-creating direct business investment in factories, plant and equipment, said Brendan Brown, the author of Euro Crash and London-based head of economic research at Mitsubishi UFJ Securities International.

He frets that wide-scale fund and corporate speculative purchases of Spanish, Italian and Greek sovereign and junk European private debt in the past two years are beginning to unravel. Yields on Spanish and Italian sovereign debt, for example, tumbled from over 7 per cent in early 2012 to under 2.5 per cent and prices soared.

The market in speculative European debt, however, is relatively illiquid, he warned. Prices have already begun to fall and yields have risen.

This asset-price deflation, including the negative knock-on impact on European equities and property, threatens to aggravate the downturn, he said.

On the positive side, euro weakness is expected to spur exports in the US and Asia. Market strategists are also hoping that the German government will allow ECB head Mario Draghi to boost QE money printing.

Mr Brown cautions, however, that at best, such a move would precipitate a market rally, but the policy in the US over the past five years has had very limited impact on the real economy.