This is weekly number three for Credit Writedowns Gold. The topic for the week is really unavoidable because it is all anyone talks about: Europe. Let’s be honest, Europe is a complete mess and I believe it will only get worse. The question for you is what will that mean for the real economy and investing. I am going to present my view here.
This is how I would frame the European situation:
- What is wrong in Europe?
- How would I fix it? And what will that fix mean for the real economy and markets?
- How is it likely to be fixed? And what will that particular fix mean for the real economy and markets?
So this is both an advocacy post and a forecasting post because you need to know what the alternatives are to understand how differentiated the impact will be on the real economy and markets. I will set this frame for the present situation by using current information and pulling together thoughts from prior posts.
First, what’s wrong?
Europe is in a solvency crisis
The US and the Euro zone face different problems. The genesis of the problems is the same, but the constraints are different. In both areas, excessive leverage and private sector indebtedness was used to purchase assets at inflated prices, property being the asset class of greatest importance. When asset markets corrected, they did so violently, which precipitated a credit crisis and deep economic downturn. For fear of an implosion in the financial system, governments decided to socialise a large fraction of the losses from this indebtedness by bailing out large financial institutions instead of allowing these institutions to fail.
This and the government deficits created by recession ballooned public sector debt levels. For example, Ireland now has government debt to GDP well over 100% from a relatively benign 25% mark before the crisis. In the US, Simon Johnson estimates that government debt to GDP increased 40% as a direct consequence of the financial crisis.
Now, Eurozone countries are users of currency, not creators of currency. The Eurozone setup is similar to the gold standard. Think of the euro as gold and of the euro countries as having implicitly retained their national currencies with a fixed rate to the euro aka gold.
So, when a liquidity crisis strikes as it has in the wake of the Dubai World crisis in November 2009, eurozone countries were vulnerable to bankruptcy like any other user of currency. Unless they can generate enough cash through taxation to fund government spending, they are bankrupt.
And we know there are problems here. Greece has a government debt to GDP of 160%. Italy has 120% government debt to GDP. If interest rates were to remain at current levels for an extended period, Italy would need to run a primary budget surplus (excluding interest payments) of about 5 percent of GDP, merely to keep its debt ratio constant. That’s never going to happen – and markets are on to this. The euro zone is one giant vendor financing scheme. So, if the periphery tightens fiscally, this is unlikely to significantly reduce net savings in the private sector and is therefore, likely to have a big negative impact on German exports and economic growth and drag the whole growth dynamic down across the euro zone.
Bottom line: either the ECB prints money to cover this problem or the debtors in crisis default and we have a Greater Depression. It’s as simple as that.
What would be an elegant fix then?
Europe’s policy makers aren’t fools. They see this. That’s why they have monetised debt when things got critical – and they will continue to do so. But, the European crisis solution is wholly inadequate and will eventually lead to a worsening of the macro fundamentals as austerity kills growth.
I would do it differently.
First, monetisation and QE are bad policy. Credible lenders of last resort use price, not quantity signals. If you are going to ease – and the ECB must if it is to prevent default – then ease price not quantity. All modern central banks of today operate with explicit interest rate targets, allowing the overnight rate to fluctuate within a range. These are price targets, not quantity targets. Any monopolist can only control either price or quantity, not both. And central banks want to target rates i.e. price.
Here’s how it works. The ECB announces a target – say 200 basis point spread to German bunds – and stands at the ready to defend that target via purchases and sales if the market doesn’t move to the rate. But the market does move because punters know that the ECB is not playing games. They can literally print unlimited quantities of money to make good on their policy rate commitments.
Once that target is set and defended, the liquidity crisis is null and void. Italy and any euro zone sovereign debtors willing to accede to a policy quid pro quo for this liquidity will be set for life just as the US Treasury and the UK Treasury and the Australian Treasury are. The liquidity crisis will be over.
The next concern is debt and growth. In a perfect world, you could just run this forever for all eurozone sovereign debtors. But Greece, at a minimum, is never going to be able to work its debt down below 130 or 140% of GDP for at least 10 years. It simply isn’t politically sustainable to support them at these levels. So I would put it this way: Greece has a solvency problem. The Irish banks have a solvency problem that has become the Irish government’s solvency problem. Portugal and Italy have liquidity problems that are very close to being solvency problems. Spain has a liquidity problem that becomes a solvency problem if it bails out its bankrupt banks.
Europe should set up a framework for both banks and sovereigns to determine who is insolvent. Insolvent sovereign debtors should be run through a credible resolution regime that writes down principle and interest. European bank creditors would then take substantially more credit write-downs and recapitalize or be resolved. That is the only real solution.
So Greece will default under almost all scenarios. There will never be a situation where the political will exists given the history to sustain Greece indefinitely through ECB financial repression -which is what rate caps are. On the other hand, Italy, which has a large debt problem is too big to fail. Italy will face a liquidity-induced insolvency without central bank intervention. That means:
- A credit event triggering CDO
- Italian bank run
- Spain insolvency from contagion (Portugal and Ireland have the IMF already)
- Contagion into Eastern Europe
- Euro bank insolvency from writedowns
So Italy cannot default under most reasonable scenarios. There will almost always be the political will to sustain Italy indefinitely through ECB financial repression – because the alternative is economic collapse. So I would turn to growth as the solution and try to increase tax revenue by getting back to full employment and reducing the size of the informal sectors of the economy. Germany, the Netherlands and Finland should spur internal demand, reduce taxes and run deficits in order to support the periphery until the periphery’s unemployment levels drop significantly.
What this would mean is at least a muddle through for the eurozone. Growth could actually be fairly high under this scenario. Stocks would rise from earnings and P/E growth because European P/E ratios are depressed. Corporate bonds would rise as debt distress would diminish with default rates. Government bond yields would dip in the periphery and rise somewhat in the core due to a normalising of credit spreads and of future expected ECB policy rates. This is a very bullish scenario all around. And it would spill over into trading partners in Asia and North America, providing a tailwind for those economies.
But that’s not what is likely to happen.
The Europeans will go with austerity and monetisation instead
The ECB does not have ‘permission’ to cap rates as this would be perceived as supporting national governments, something that violates the Lisbon Treaty. That’s why the ECB has concocted schemes like the Long-Term Refinancing Operation (LTRO) to end run on these rules. But, let’s be clear, the LTRO will not be effective because it is a quantity approach where a price approach is necessary. Eventually this approach will fail. Greece will default at that point if not sooner. And the haircut will be massive, greater than 75%. The potential for contagion certainly exists and the ECB is not up to containing the panic so I cannot advise piling into periphery government bonds.
Moreover, we are fighting the wrong crisis. The reason for the S&P downgrades was that Europe is trying an austerity-centric approach that is anti-growth, which risks increasing both debt and deficits. S&P even said in their message on the downgrades that an austerity-centered approach would make matters worse. Wolfgang Münchau noticed that German Chancellor Merkel and her Finance Minister Schäuble responded to this message by exhorting Europe to push through their austerity packages more quickly. Clearly they don’t get it.
So I expect the real economy in the eurozone to worsen. For example, Germany is predicting German GDP to grow 0.7% this year. It will be lower, perhaps negative. Germany, the Netherlands and Finland will be in recession with the rest of Europe and will care more about their sovereign rating and domestic economies; so all bets will be off. Finland and the Netherlands may also have burst housing bubbles to contend with.
As I said last week: Avoid peripheral sovereign debt, avoid France, Belgium and Austria. Swap euro debt for Norwegian. Avoid banks. Overweight low volatility, low beta, high dividend, stocks and high quality corporate bonds of internationally diversified companies.
Final Thoughts
Europe is headed in the wrong direction. The euro zone is already in recession. The best I see is a muddle through because the political economy will not support the solutions which will actually work. Therefore, downside risk is significant. Investors need to avoid risk, increase expected gains from fixed income sources, and construct a portfolio to hedge out volatility through insurance or market-neutral strategies.
That’s it for this week. I am hitting the send button. See you next week.