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Let's say Merkel and Draghi get the EuroZone to follow their plan--then what do the European and global economies look like next year?
12/23/2011 8:30 am EST
Okay, but I think it’s time to take Merkel and Draghi at their word. They are wedded to a plan that consists of austerity, pain, and recession—and years of it. And on the evidence there is a good chance that Merkel and Draghi can actually make their plan stick politically. The Germans are the biggest and strongest economy in the EuroZone and the German government and the Bundesbank control the cash needed for any solution.
So let’s say that Merkel and Draghi are able to execute their plan—against all opposition and against whatever personal advice you or I would offer. What then does the EuroZone and the global economy look like?
Let me sketch in the most likely scenario here. And then I’ll suggest its effects on the financial markets.
- Turmoil for years. Chancellor Merkel keeps talking about how a real fix for the euro won’t get accomplished overnight and her plan absolutely guarantees that the euro debt crisis will be with us for years and years. The plan isn’t so draconian that it consolidates the EuroZone by quickly forcing out the countries that aren’t going to finally make the cut—a plan like that would be akin to Chapter 11 bankruptcy for the euro. And it isn’t generous enough to produce any growth in the economies now struggling. In fact, as Ireland has just figured out, it is likely to subject any recovering economy to new rounds of growth-killing austerity when troubles in one part of the EuroZone or another force a recession.
- No easy decision on what countries will finally make it through to the other side—which will present a long-string of one-off struggles and concessions. The endless summits and recovery plans tend to obscure the differences between a Greece, an Ireland, an Italy, and a Spain in an effort to find a EuroZone solution. That’s simply not a very useful approach. Greece is a deeply uncompetitive economy that can’t sell enough of what it produces in goods and services on the global economy at current euro-denominated prices. Ireland, on the other hand, is a globally competitive economy that got socked first by horribly bad lending by its banks and then, second, by a terrible decision by the last government to saddle tax payers with the bill. Italy is a wealthy country with one of the world’s deepest pools of savings, an economy in need of reform, and a dysfunctional politics that can’t even produce an elected government capable of raising and collecting taxes. Spain with its relatively shallow pool of domestic savings is dependent on overseas cash flows. Yes, the Spanish real estate boom and bust have left the country with huge volumes of bad loans, but that is a problem that will get fixed either by a bad bank to hold the loans or by letting the worst of the country’s regional banks go under. (That, not surprisingly, is the policy preference of big banks such as Banco Santander (STD) and Banco Bilbao Vizcaya (BBVA) that salivate at the prospect of picking up the pieces.) But a bigger problem is the out-of-control spending at the regional level where the devolution of power from Madrid has resulted in unsustainable local budget deficits. But at least the country has an elected government that might be capable of reining in some of the excess.
- Default is still in the cards for Greece and perhaps Portugal. There’s simply no way that Greece can pay what it owes—and once the country’s leaders understand that the only thing between endless austerity and a few years of life as Europe’s Argentina is the country’s debts, then default becomes very attractive.
- Can you default and stay in the euro? How many summits will it take to work that one out? The question is so difficult to answer because the EuroZone treaties deliberately ignored the issue of how a country might leave the euro. The thought was, I think, that if there’s wasn’t a discussion of an exit mechanism, then the euro would be more likely to hold together. We are now five months down the road from the July plan for a haircut that would reduce the value of Greek bonds held by banks and other investors—and there is still no final agreement. Yep, an orderly default—or even a disorderly one—will be a piece of cake.
- The threat of a Greek default and the chaos it would bring is an immensely useful bargaining chip for countries like Ireland that don’t want to default but that would desperately like to renegotiate the terms of their debt to lower interest rates and stretch out maturities. That kind of result is tantamount to a bond haircut—less interest and longer until you can get your capital back. Ireland won’t visibly roil the markets like Greece will, but the Irish renegotiation will certainly add to investor distrust of the debt issues of any European sovereign.
- Italy is too big to fail—but will teeter on the edge of failure for years. In the Draghi-Merkel plan Italy spends years getting its budget under control by turning Italian citizens into docile tax payers (an estimated 30% of the Italian economy is now off the books) and Italian politicians into tight-fisted public servants (Italy’s 932 national legislators take home between $17,000 and 27,000 a month—and they are allowed to keep their day jobs and day-job salaries as well.) The European Central Bank may not like being on the hook for bond buying of even 20 billion euros a month (of three-year bank loans of $600 billion and counting) but I don’t see this subsidy in support of Italian government bonds being withdrawn any time soon. Germany’s Merkel and the Bundesbank may be appalled at the idea of a monetary union that transfers money from rich to poor states to keep the internal books balanced—as Alexander Hamilton engineered in the United States after the Revolution with a big transfer from wealthier southern states to indebted northern states or as the United States has done for decades in the opposite direction through its defense budget—so the EuroZone won’t implement an official transfer, but it will wind up with a de facto version. Exactly how long it takes global financial markets to catch on that the European Central Bank is committed to an endless program of bond buying that will eventually add to the money supply is a matter of conjecture. But not very much further down the road, I’d guess, given that I’ve already heard questioning of the effectiveness of the central bank’s efforts to sterilize its bond buying so it didn’t add to the money supply. The result is exactly the erosion of central bank credibility that Draghi has said he fears.
- Spain is the great mash-up of this crisis. The newly elected central government is strong enough to rein in the spending of regional governments but only if it can throw them a big bone. The most likely reward for cutting local spending on social services, construction, and other categories that keep politicians popular and in power is some kind of central assumption of some local debt through the creation of a bad bank to take this debt off the books of the regional banks that now hold so much of it. I don’t see any way around this solution. A recent attempt by Banco Santander to sell collateralized regional debt failed and regional budget deficits blow a hole in each national budget proposal to lower Spain’s budget deficit. On the other hand, the bad bank isn’t likely to be big enough to take on all the bad debt—Spain doesn’t have endless billions to throw at this problem. So some local banks will be forced under in an extension of the government’s effort to consolidate this sector. These negotiations won’t be easy—and the new government of Mariano Rajoy could in reality find itself without the leverage that I think it now enjoys—but Spain has shown more ability to deliver reform and austerity than Italy throughout this crisis. And the example of Italy gives Spain the same kind of edge that the example of Greece gives Ireland—if the thought of one country too big to fail teetering on the brink of failure is frightening; imagine two countries too big to fail threatening to do just that.
- Brother can you spare a majority? For hours after the December 9 summit, EuroZone leaders could cluck their tongues at how sad they were that the United Kingdom was the sole holdout from a new treaty of fiscal integration. A few days went by and four members of the 9 non-euro countries that had initially supported the plan began to express doubts. Politicians in euro-using Ireland and the Netherlands have asked if this treaty could be approved without a referendum. (Referenda have a tricky past in the history of the euro. Ireland, for example, rejected joining the euro in its first public vote.) And now that the summit is a whole week in the past the December 19 finance ministers’ conference call concluded with a plan to consider the treaty in effect if just nine of the 17 euro countries approved it. And this is supposed to happen by March?
- A weaker euro. All this uncertainty, the constant repetition of political and financial crisis, and the lack of an end-game strategy will all conspire to weaken the euro against the dollar and the yen.
- Higher interest rates as a result of those credit rating downgrades and the continuing erosion of the financial credibility of EuroZone governments. Higher interest rates will support the euro to a degree but not enough to make up for the worries about the fate of the currency that will drive it lower.
- Lower economic growth as a result of austerity plans and higher interest rates.
- The erosion of credibility of the European Central Bank as it is forced to pursue policies that add to the money supply and constrained from fighting inflation.
- A stronger U.S. dollar and lower U.S. interest rates than the United States deserves considering its own budget deficits and long-range fiscal difficulties. Lower interest rates, of course, mean that the U.S. debt is easier and cheaper to finance. Unfortunately that will almost certainly reduce the pressure on U.S. politicians to do something about the deficit sooner rather than later.
- Gold will get a boost from the repeated descents into confusion and crisis in the EuroZone but a stronger dollar will slow the metal’s appreciation. The volatility in the price of gold that is likely to result from the swings in sentiment about the euro will also lead some investors who have recently discovered gold as a store of value to reconsider their commitments to the precious metal.
- Slower growth in the EuroZone will result in slower global growth in general. That will have two effects—first, it will increase the attractiveness of economies and stock markets where growth exceeds the EuroZone’s low bar, and second, it will increase economic volatility as governments are tempted to repeatedly apply extra stimulus to their economies to keep growth at politically comfortable levels. Bubbles and busts aren’t going away in this scenario, I’m afraid.
- Slower growth in the EuroZone will be bad news for many European companies and their stocks, but the weaker euro will be good news for the most efficient European exporters and their stocks (in euro countries or in nations like Switzerland that have pegged their currencies to the euro.)
- The weakness of the euro and the resulting competitive advantage to euro exporters will test the hard currency resolve of the central banks of countries such as Norway and Sweden. Will either go the way of Switzerland, reducing yet further the ranks of strong currencies in the world? (That would in turn increase the attractiveness of gold.
- The troubles of the European Central Bank will empower the Federal Reserve by lowering the need for Ben Bernanke and Co. to pay attention to the hectoring voice of the central bank with the most credibility as an inflation fighter. You can decide whether liberating the Fed is a good or bad thing at a time when the U.S. has the need to reduce the burden of its own debt. If the European Central Bank is forced to tolerate 3% inflation, that could well allow the Fed to raise its own inflation bar.
I trust that’s given you something more to think about as we approach 2012—as if you didn’t have enough on your mind already. 2012 is shaping up as a very tough year for investors—and the “fix” to the euro debt crisis isn’t going to make it any easier.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Banco Bilbao Vizcaya and Banco Santander as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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