Expert view: Europe's at risk of turning Japanese

Just over four years after its launch, the euro is back to where it started, leading to a degree of misplaced pride among European politicians and a revival of misplaced attention to the US current account deficit. This is not a story of a weak dollar and a US problem; it is the story of a strong euro and a European problem.

Just over four years after its launch, the euro is back to where it started, leading to a degree of misplaced pride among European politicians and a revival of misplaced attention to the US current account deficit. This is not a story of a weak dollar and a US problem; it is the story of a strong euro and a European problem.

The usual response to a weak dollar is to talk about the "unsustainable US current account deficit", with a few comments on the hugely over-indebted US consumer thrown in for good measure. And last week, sure enough, the papers were full of statements to the effect that "foreign investors must provide [the US] with over $1bn of net capital inflows per day just to prevent the dollar from falling".

Why not say, that with $1bn a day coming in, the US economy must buy a huge amount of foreign goods and services simply to prevent the dollar from rising? Maybe the capital looking for a return comes before the spending? After all, the spending first, funding later approach led to predictions of a dollar collapse for most of the last decade.

Looking at capital flows as a driver to currencies does seem to explain the switches in currency "models" from the early 1990s, when higher interest rates were needed (remember the ERM?), to the late 1990s, when the demand was for higher growth. In the mid to late 1990s, a strong currency was seen as a sign of a strong economy; the reverse is now true.

Capital is flowing into the euro for two reasons. First, it is being brought home by European institutions with solvency problems struggling to match assets and liabilities. Second, the prospects of (relatively) high bond yields, falling inflation and no recovery in demand are attracting international investors to the European bond markets. Throw in a rising currency and hope of playing the yield curve and it's speculator heaven. If European politicians see this as a vote of confidence, they are in for a shock.

These are all the reasons investors bought Japanese bonds in the mid 1990s, so the obvious question is, could Europe be the next Japan? Even more worrying, lower short-term interest rates, the solution to Europe's problems being pushed by most advisers, risk making the problem worse. Whatever its reasons for leaving rates unchanged, the ECB has done the right thing.

In structural terms, Europe is in many ways far closer to Japan than to the US, or indeed the UK. This is, of course, extremely important as pressure mounts for the UK to join the euro. UK households have approximately $1 trillion of mortgage debt, which is, to all intents and purposes, floating-rate. Lower short rates therefore act like a tax cut, immediately freeing up disposable income. The flipside is that higher rates act like a tax increase.

By contrast the whole of the eurozone has only around $800bn in floating-rate debt. Most mortgages are fixed rate, so lower rates do not free up cash flow. And given the large amounts of savings held in cash, they actually cut household income. It's exactly the same in Japan. After years of missing the obvious reason why lower rates failed to stimulate Japan, economists are now prescribing the same medicine for Europe.

So lower rates risk slowing the euro economy while stimulating further inflows into European bonds, thus driving the euro higher. Not only will this hurt exporters but, more important, domestic companies already struggling with low demand will be vulnerable to cheap imports. And as higher bonds mean lower interest costs, this can reduce the pressure on governments to address budget problems. Let's hope it doesn't happen.

Mark Tinker is a partner at stockbroker Execution. Mark.tinker@letsxstock.com