Reflation toast

The SMH reports this morning that:

Europe's credit crisis could help with Australia's borrowing efforts by alerting investors to the economy's strength, says the departing head of the government's debt management agency.

Neil Hyden, who retired last week as the chief executive of the Australian Office of Finance Management, said Europe's woes had not tainted investors' views of Australian government debt.

While the need to rescue Ireland had put global markets on edge, Mr Hyden said Australia's low public debt and Asia's growth prospects were more important to Australia's

creditors. ''In a sense it makes the strength of our economy and financial system and of our securities stand out even more,'' Mr Hyden told the Herald. ''If it had any effect I would see it as positive, or certainly not negative.''

The ex-head of the AOFM has nicely captured the spirit of exceptionalism we currently regard ourselves with. There are no lessons for us in Europe, nor Ireland. The crisis can only be of benefit.

The press hardly has a mention of Europe this morning.

So is this confidence well placed? China is growing fine (indeed, combating overheating) and commodities are holding up through the crisis.

Well, no, frankly, it isn't. The reason is the euro.

First, the principle reflation mechanism for the global economy in this cycle is a falling $US. It is this that boosts the world's biggest economy through rising exports. This stabilsiing effect reassures markets that US imports will remain strong, thus keeping China strong through its currency peg. Commodity exporters benefit as Chinese strength continues its internal investment. And then there is the double benefit of the falling $US adding monetary fire to commodity prices. It's a virtuous cycle driven by the mass liquidity of low US interest rates.

A falling euro upsets this applecart. The $US rises. It's export-led recovery narrative falters. Chinese exports stall. Commodities come under the double pump of weak demand growth and rising relative pricing to the dollar.

All of these dynamics are amplified through the gigantic bets made by global finance along the reflation chain known as the 'risk trade'. If there is a shock, like a partial disintegration of the euro, this reversal will become a panic, liquidity everywhere will evaporate, and we will stand at the verge of another GFC.

The European crisis has nowhere to go for months as far as this blogger can see. Markets can see the Irish bailout is in trouble at the level of the polity and know it may fail at the New Year election. Europe is struggling to find other mechanisms to bailout the other PIGS but markets are moving too fast for them. So the euro keeps falling. And as it does, so too will equities and ultimately commodities too.