“I think more of the little kids from a school in a little village in Niger who get teaching two hours a day, sharing one chair for three of them, and who are very keen to get an education. I have them in my mind all the time. Because I think they need even more help than the people in Athens…So, you know what? As far as Athens is concerned, I also think about all those people who are trying to escape tax all the time.”
– Christine Lagarde, IMF Managing Director
I Told You So
The “I told you so” people are having a field day right now regarding the euro. They said it would never work. They said you cannot have a common currency without a fiscal and political union. Well results are what count and right now it looks like the “I told you so” people were right. The euro may or may not survive – I still believe it will survive-but either way it’s looking more like a disaster. Only the cost of dissolution seems to be holding back the euro’s demise. The so-called peripheral and core countries stay in the euro like a long married couple who now hate one another but cannot afford to get a divorce.
At this moment the only way for the euro to survive is for the European Central Bank (ECB) to print more money and for the Europe to sucker the Germans and maybe the IMF and other international softies (the Americans?) into supporting more bailouts. Except, as the above quote from the hard-hearted Christine Lagarde suggests, the softies are not quite soft enough. So Angela Merkel throws an occasional Teutonic tantrum about fiscal responsibility but in the end Mario Draghi prints.
This is a very disappointing outcome. It didn’t have to be this way. As readers of this piece know I consider the euro a magnificent example of real value added in the financial sphere. The advantages of the euro seem overwhelming to me. First, a single financial zone was created to parallel and facilitate the free trade area called the European Common Market. No more francs, lira, pesetas, deutschmarks, guilders etc., etc., etc. to confuse and complicate the lives of tourists and businessmen alike. Second, a new international reserve currency was created to give some needed competition to the almighty dollar. Third, nations, whose principal means of social intercourse in the prior century was waging war on one another, suddenly were peacefully bound together in a common currency.
A common currency by the way was really nothing new for Europe. From 1880-1914 Europe had a common currency that worked very well, viz., gold. All the major currencies of Europe were convertible into gold at a fixed price and there were no capital controls. This period was one of unparalleled human progress and low inflation. It was a period of a common currency and no fiscal union. The system worked extremely well until 1914 when it was dismembered and Europeans gave in to their historical preference for killing one another.
What Europe Should Have Done Differently
The current unhappy state of the euro was not inevitable. The concept of a single currency without fiscal and political union was not necessarily doomed. But the Europeans have persisted following practices and making faulty decisions which have grievously undermined their common currency. One must look at the underlying fundamentals and decisions.
In my opinion the Europeans have snatched defeat from the jaws of victory.
First, Europeans did not trust markets And they have paid the price. Mistrust of markets is a core theme in the Eurozone. Take one of the key concepts in the Maastricht Treaty upon which the euro is based. All the countries were supposed to maintain a deficit/GDP ratio no greater than 3 percent. Big mistake. No such meaningless and unenforceable requirement should have been placed on member countries. This ratio is not completely under governments’ control for starters and as it turned out many countries violated this rule with impunity. Big economic slowdowns cause this ratio to explode. There should have been no requirement in this regard. The requirement created both the illusion of fiscal soundness and a lack of respect for the official rules. Fiscal discipline for the individual countries should have been left to the markets. Countries running excessively loose fiscal policies should have been disciplined by higher borrowing costs and ultimately denial of market access. The acceptability of a member state default should have been the primary Maastricht weapon to ensure fiscal probity. Member countries, banks and the markets should have been left with the caveat emptor message that the member countries were on their own when it came to fiscal policy. Yes the Maastricht Treaty contains language barring bailouts. But the markets and the politicians quite correctly (unfortunately) did not take this language seriously.
Instead, European operating policy was designed to suppress the market signal, which should have been early-on higher interest rates for fiscally irresponsible countries. And the markets unfortunately accepted this suppression until it was too late. After joining the euro, the Greeks suddenly could borrow at the same rates as Germans. And so could condo buyers in Spain. Greek sovereign debt, as was the sovereign debt of all the member states, was considered a risk free asset for the purposes of bank regulation and bank capital. The markets were encouraged to assume that the risks of the two were the same. And when the markets finally woke up and decided Greece and Germany did not carry the same risk, Greece was way over its head in debt. And until far into the crisis Greece was still not allowed to default. And now so much Greek debt is held by official Vestal Virgins (like the ECB and the IMF) which are allowed to not sully themselves by being defaulted on. With Greece, Europe made a joke out of the credit default swap (CDS) which, for all its bad press, serves a useful economic market driven function.
I have written over and over how US states defaulted in the 1840s without permanent damage to the American union. But instead one bailout after another was set up for Greece and the European Central Bank began printing money. The so-called LTRO program was a complete economic disaster. Under LTRO, the ECB printed money and lent it to potentially insolvent national banks so they could buy the bonds of their potentially insolvent governments. And the bailouts themselves brought with them one giant tax raising exercise which have only made things worse.
Second, the euro is getting blamed for the sins of socialism. European countries have operated on the social democratic model by which governments assumed an ever greater role in the economy with higher taxes, higher spending and more regulation. The fatal attraction of populism has been quite evident in the European political process which has promised more and more ultimately unaffordable benefits. The governments in Europe for quite some time have been gradually devouring their economies. The bulk of the countries in Europe are headed for bankruptcy anyway and the euro is taking the blame.
The following tables (IMF data) illustrate just how great a role the governments play in the European economies. Contrast the Government Expenditure/GDP ratios of Europe vs. emerging Asia or even the semi-social democrat United States.
Third, somehow the Europeans managed to saddle themselves with a bank clearing mechanism that effectively has allowed the weaker states to pile up with impunity more debt obligations to the strong states. This of course has provided the peripheral weaker countries with another ATM machine not subject to market discipline. The European bank clearing mechanism is called TARGET 2. TARGET stands for Trans-European Automated Real-time Gross Settlement Express Transfer System. TARGET 2 is a complicated arcane subject, whose significance has only recently become appreciated by the markets. One aspect of this system is that with the creation of the ECB the domestic central banks like the German Bundesbank never really went away but still play an important secondary role in the new system. Cutting through the arcania, under TARGET 2 a citizen of say Greece can withdraw euros from Greek banks and redeposit the euros in German banks. Under TARGET 2, the ECB, and by implication the Bundesbank, winds up financing this transfer of funds. So the Germans are effectively financing the current bank run on Greek banks. At the end of April the Bundesbank reportedly had a TARGET 2 positive balance with the ECB of reportedly some 650 billion euros. This implies an offsetting negative balance of the same amount presumably from peripheral countries like Greece, Italy, Portugal and Ireland. These negative balances are not included in the usual Debt/GDP ratios computed by the IMF and other sources. Bottom line: if Greece or the other peripherals wind up leaving the euro, Germany and the ECB are left holding the TARGET 2 bag.
Fourth, the banking systems of Europe were not allowed to become integrated. Each country has its own set of national banks which have their own sets of regulators and which tend to be undiversified in terms of deposits and lending. The banks are captives of the national governments for whom financial repression, to use an old economic term repopularized by Reinhart and Rogoff, is a routine practice. The situation differs from countries like the United States or Canada which have national banks that cover the entire country. Nobody would be tempted to remove cash from Citibank New York and move it to Citibank Florida.
This is a complicated subject. But it seems to me instead of pushing for fiscal union the push should have been for Eurozone banking integration. This would have required a Eurozone bank regulator. The regulator might have to have been the ECB which is the lender of last resort for the Eurozone anyway.
What Investors Should Do Now
The situation in Europe is careening out of control. “Don’t throw good money after bad” is an old Wall Street adage. But that is exactly what Europe has done and unfortunately what Europe is likely to keep doing. My own view is that the euro will survive and that no country will leave. But I no longer say that with a high degree of certainty.
Europe has many great companies. It has an intelligent, well educated population with high levels of technical skills. Europe is the last place that should be having economic problems. Unfortunately, the addiction to socialism offsets all these assets. In 1998 Asia was rocked by crisis. Assets including equities in countries like Indonesia, Thailand and Korea became once-in-a-lifetime cheap. But these countries learned from their crises and went on to structural reforms.
Is Europe at that point where Asia was in 1998? Has Europe learned any lessons from this? I don’t think so. As mentioned, the bulk of the fiscal “reforms” introduced thus far have been tax increases. Who wants to pay even more taxes to support already swollen and intrusive governments? Will higher taxes promote economic growth? Will the Europeans abandon their fondness for socialism? I believe eventually they will. But not yet.
I read that the great Mexican entrepreneur Carlos Slim is looking to buy assets in Europe. He learned to buy in bad times from his father who bought property in Mexico during the height of the Mexican revolution. When you are buying whole companies, perhaps this is a smart decision. But for the ordinary investor in stocks, I would say waiting on the sidelines to invest in Europe is the best policy right now.
I also read about various trading ideas assuming a break-up of the euro. One is to short German bunds against periphery sovereigns since the Germans will get stiffed by the departing Greeks, Italians and Spaniards. Another is to go long the euro since it has to rise once the periphery countries are gone. I consider these trades for geniuses only and perhaps J. P. Morgan. For the rest of us mere mortals, the sidelines seem like the preferred spot.
Bernanke to the Rescue?
Europe will have a steep recession this year and there is the risk of a Lehman type situation. Europe at a minimum will pull down the GDP growth rates of countries around the world. Looking around the world, it’s hard to see sunshine anywhere. The US GDP growth rate is barely positive, China is significantly slowing down, India is sputtering and approaching another rupee crisis, and Brazil, the great South American hope, is slowing as well. The US election could be a “game changer” but it’s too early to speculate on the investment implications.
The equity markets are approaching near panic mode. But most people are afraid to go short. Bernanke and quantitative easing may be coming. Or so we have all been conditioned to expect.