- Europe's terms of trade are weakening the most of any major region. This is a legacy of de facto protectionist policies which have long conspired against the consumer, coupled with a new inability for European companies to charge an answering premium for their products in international markets.
International terms of trade ought to be a zero-sum game, just as all the world's trade balances ought to sum to zero. But the world's reported data never comes close to this, which is testimony to the enormous leakages from and inadequacies in the way economic data is collected and reported.
Nevertheless , movements in international terms of trade, which record how export prices move relative to import prices, are important. They matter in the short term because a sharp rise (or fall) in a country's terms of trade can result in an unexpected windfall for traders, with the accompanying effects on cashflows and profits for the economy as a whole. Long term trends matter more, though, because they record the extent to which a country's industry is able, or unable, to price their products internationally. They are, in other words, a crude measure of how much other countries want your products.
For both reasons, they form one of the core indicators I use in my quarterly effort to understand the cyclical forces and structural challenges/opportunities of major economies. Apart from the long-standing and frankly baffling fall in Japan's index (it seems incredible that corporate Japan cannot price its goods properly) the current puzzle is the underperformance of the Eurozone. By mid-2012, the Eurozone was unique in its terms of trade being more depressed even than at the height of the 2008 commodities ramp. Every other region – even Japan – has managed to make some gains since then.
So what's going wrong? Is it that the Eurozone is unable to price its exports? Or are its import prices systematically too high?
The answer is: 'both'. Notoriously, the Eurozone's 'single market' has sprouted a proliferation of regulations which quietly raised a protectionist barrier around Europe, which has allowed prices within the Eurozone to be sustained far above (30-40% above) prices for the same goods in the US. This deformation persists. But since the crisis European exporters have not been able to command similar premiums for their exports – a loss of pricing power which is also persisting.
Consider, for example, the different histories of import and export prices since 2000 by the US and Europe. On the face of it, one would expect price changes in these two economies to mirror each other. And historically, that was the case: between 1992 and 2002 the fluctuations between US import prices and EU import prices was a minor and usually self-correcting matter: it averaged 4.2% with a 4.3% standard deviation. But in the decade since starting in 2002, it has averaged 32.5% with an 11.1% standard deviation.
Since 2002, something dramatic happened to European trading prices which has left them far higher than the US. And it has persisted: latest data puts the differential at 41.3%.
How did this happen? Starting in 2000, one can track movements in Eurozone import and export prices (denominated in dollars) relative to movements in US import and export prices. (Taking 2000 as a starting point of parity is reasonable, given the track-record of near parity of movements during 1992-2002). This is what it looks like:
The pattern tells two separate stories. The first is what happened during the period of the Euro's strength, between 2002 and 2008.
- Jan 2002 to Apr 08: The Euro gained 78% vs the dollar (from a Euro buying 88 US cents in January 2002 to $1.57 in April 2008);
- Eurozone import prices rose 49.5% relative to US import prices
- Eurozone export prices rose 48.7% relative to US export prices.
In other words, roughly two thirds of the impact of the strengthening Euro was taken by those exporting to Europe, and a similar proportion of benefit was taken by exporters from Europe. Predominantly, the strengthening of the Euro benefited the world's producers at the expense of consumers – whether those consumers were inside or outside the Eurozone. This is not a matter of European prices simply 'catching up' to US prices – things simply cost more for those inside the fundamentally protective 'single market.'
(This is not just a matter of the data. I have sat in plenty of meetings with Chinese firms and asked about their pricing policy – 30% is the usual mark-up of exports to Europe relative to their base-market prices in the US. Since European producers live in dread of Chinese competition, this informal arrangement suits everyone involved . . . . except the European consumer.)
This mattered less when European producers could also pass on similar price increases to their international customers. And this is where the data tells us its second story: since 2008 European exporters have been unable to hold that relative pricing differential, even whilst the 'European premium' slapped on the price of goods exported to Europe has been maintained. The result is that Europe's international terms of trade are now worse than even at the height of the commodities boom.
Europe's deteriorating terms of trade are finally squeezing profit margins and cashflows, and, of course, weighing on the business and investment cycle. As the fall in terms of trade has accelerated since 2010, so this pressure has built.
Final observation: Radical (20-30%) price-cuts on imports into Europe could provide a significant unexpected upside to corporate cost-structures, and the stresses on consumption demand, in a post-Euro environment, provided the Euro's failure takes down the framework of the 'single market' customs/non-tariff barrier union.