The Euro ‘Fix’ We Have to Live With
12/23/2011 8:00 am EST
You may think the current response condemns Europe to years of pain, austerity, and weak growth. And you may be right. But get used to this scenario—and discover what it means for the global economy.
Maybe you think the "solutions" to the Euro debt crisis being pursued by German Chancellor Angela Merkel and European Central Bank President Mario Draghi are totally wrong.
Maybe you can’t imagine that these two leaders seriously propose condemning the Eurozone to a year of recession, followed by more chaos and, at best, slow growth again in 2013 and 2014.
Maybe you think that Merkel and Draghi will cave in to pressure, rather than see Greece default, and rather than watch demonstrations sweep Madrid and Rome. Maybe you can’t imagine that Eurozone leaders will cling to a "fix" that has been so thoroughly rejected by bond markets.
OK. 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 the evidence suggests there is a good chance that Merkel and Draghi can make their plan stick politically. Germany has 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, do the Eurozone and the global economy look like?
Let me sketch the most likely scenario. And then I’ll suggest its effects on the financial markets and, possibly, your portfolio.
1. Turmoil for Years
Chancellor Merkel keeps talking about how a real fix for the euro won’t be accomplished overnight, and her plan absolutely guarantees that the Euro debt crisis will be with us for 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 growth in the economies that are 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.
2. No Easy Decision on Which Countries Will Make It to the Other Side
This will present a long string of one-off struggles and conclusions.
The endless summits and recovery plans tend to obscure the differences among a Greece, an Ireland, an Italy, and a Spain in an effort to find a Eurozone solution. That’s a 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 by a terrible decision by the latest government to saddle taxpayers 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 dysfunctional politics that can’t even produce an elected government capable of raising and collecting taxes. On the other hand, 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—a problem that will get fixed either by using 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 Argentaria (BBVA) that salivate at the prospect of picking up the pieces.)
But a bigger problem is 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.
3. Default Is Still in the Cards for Greece and Perhaps Portugal
There’s simply no way Greece can pay what it owes. 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, default will become very attractive.
4. Can You Default and Stay in the Eurozone?
How many summits will it take to work that one out?
The question is so difficult because the Eurozone treaties deliberately ignored the issue of how a country might leave the euro. The thought was, I think, that if there wasn’t an exit mechanism, 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.
5. The Threat of a Greek Default Is an Immensely Useful Bargaining Chip
It helps countries like Ireland that don’t want to default but 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 a longer wait before investors can get their 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 nation.
6. Italy Is Too Big to Fail, But it Will Teeter on the Edge of Failure for Years
Under the Draghi-Merkel plan, Italy would spend years getting its budget under control by turning Italian citizens into docile taxpayers (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 a month, but I don’t see this subsidy in support of Italian government bonds being withdrawn any time soon.
Yes, 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—a process similar to the way Alexander Hamilton, after the American Revolution, engineered 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.
But their disgust means only that the Eurozone won’t implement an official transfer—it will wind up with a de facto version.
Exactly how long it takes global financial markets to catch on that the ECB is committed to an endless program of bond buying that will eventually add to the money supply is a matter of conjecture.
But not 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.
7. 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. This could be done 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 proposal to lower Spain’s deficit.
On the other hand, a 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 find itself without the leverage that I think it now enjoys. But Spain has shown greater ability to deliver reform and austerity than Italy has.
And the example of Italy gives Spain the same kind of edge that the example of Greece gives Ireland. If the thought of one too-big-to-fail country teetering on the brink of failure is frightening, imagine two too-big-to-fail countries threatening to do just that.
8. 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 of the nine non-euro countries that initially supported the plan began to express doubts.
Politicians in Ireland and the Netherlands also asked if this treaty could be approved without a referendum. (Referendums have a tricky past in the history of the Eurozone. Ireland, for example, rejected joining the Eurozone in its first public vote.)
But with the summit more than a 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 Eurozone countries approved.
And this treaty is supposed to be in place by March?
And Now, The Effects of This Mess:
- A weaker euro. All the uncertainty, the constant repetition of political and financial crises, 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 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 yet is constrained from fighting inflation.
- A stronger dollar and lower 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 US debt is easier and cheaper to finance. Unfortunately, that will almost certainly reduce the pressure on US 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 commitment to it.
- 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. 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 Eurozone 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, further reducing 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 reducing 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. I leave it to you to decide whether liberating the Fed is a good or bad thing at a time when the US needs 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 all of that has given you some more to think about as we approach 2012—as if you didn’t have enough on your mind already. 2012 is shaping up to be 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, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Banco Bilbao Vizcaya Argentaria 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 here.