19 November 2010

Ireland, PIGS, QE2, the Euro and the melting pot

Today, I am going to reflect on the continuing crisis within the eurozone and the usefulness QE to spur the economy, a nice melting pot.
Greece is back behind the curtains and Ireland is on the stage under the spotlights for the continuing show of the eurozone crisis.
Summary of the previous acts
Policy makers did not want to face the harsh consequences of 20 years of easy money that led to over-indebtedness (act 1) and take the tough measures needed due to cronyism and the human nature of politicians who prefer to spend money to buy votes instead of telling voters the difficult reality of past policy mistakes. There is one reality that central bankers did not want to see is that excess liquidity leads to mal-investment, since lower returns are deemed reasonable and outright speculation becomes the norm (from individual with real real estate or stock markets - some succeeded, most failed - to CEOs who engaged in huge M&A deals to flatter their ego and grow their bank account - most created value for themselves).
The act 2 started with the financial crisis in August 2007 which reached its peak in the aftermath of Lheman’s debacle and the collapse of the real estate market. Central bank opened without any restraint the liquidity tap (should I say fire hose…) for banks 1) to get rid of junk assets (they still have quite a bit in their accounts) and 2) play the yield curve to repair their balance sheet and gain time via short term financing at no cost and investment in longer dated Government securities (you know, the famous riskless sovereign debt), making a couple of hundreds of basis points (by the way the most profitable business since you only need a couple of people to do it and you can leverage!). There is no reason to stop since Ben Bernanke QE2 is a clear signal that the FED will continue managing the yield curve to limit the cost of financing of the US Treasury whilst letting banks carry on playing the curve.
Banks (European ones in particular) poured cheap money given by central banks into government securities, without properly analyzing the inherent risks of such assets, replicating with Greece, Ireland and other PIGS (add France and Belgium), that same mistake as for CDOs and et al to gain some tens or hundreds of basis points of additional return: complacency at best...
This led to the eurozone debt crisis during H1 this year with Greece. Now, Ireland is taking the stage. In both cases, the sins lied with them, even if they are of a different nature: on one hand a cheater which did not reform itself and is totally uncompetitive and on the other hand a country that had balanced budgets and let its success running away with real estate speculation that drove its banks to the knees, hence their costly rescue and a spiraling budget deficit expected to reach 32% of GDP in 2010 despite austerity measure taken in 2009 (the first country in Europe to do so)!
This profitable yield curve play had in itself the seeds of a contradiction: why should banks lend money to a depressed real economy when they have to be more strict in their lending practice (well, financing a speculative property market is not really the same as financing the real economy, but this is an other part of the debate) and can easily make money at “no risk”.
Ant now we arrive to act 3.
Act 3
Germany had enough to pay for the sins of profligate countries; after all, and until proven differently, Germany is not a Charity. Merkel, with a reason, is fed up for Germany to become the tax payer of last resort and wants other stakeholders to pay their share of the burden: shareholders should be wiped out and bondholders (banks among the largest ones…) take a haircut. I would add, and it may be the most important act for any sustainable recovery, Boards and management should be fired (politicians too - an other story).
Large European countries, Brussels and weak eurozone countries are bullying Ireland to accept a rescue package from Europe and the IMF, while Ireland has no immediate need for funds (EUR 22 billion in their coffers). Different reason for the same objective: weak eurozone countries fear contagion and the Franco-German axis together with Brussels are targeting Ireland’s low corporate tax rate. This is the first clear of arm twisting to impose a converging taxation (upwards of course) within the eurozone. This is stupid: Ireland will be able to get out of this mess quicker than most via its competitiveness and attractiveness for foreign companies, and a low corporation tax rate is part of the solution; not the case wit Greece which has not much to show and seems however better treated than Ireland...
Between Irish and Greek bonds, you know where I would go for if I had to choose between the two. If I were Irish, I would play hard balls with the French, Germans and Brusselites to get as much as I could: this is the annoyance power since arm twisting is more or less the only language understood in Brussels, Berlin and Paris.
QE 2
The second QE decided by the FED will fail to stimulate the economy. Whilst it allowed interest rates to substantially decrease during QE 1, and therefore release pressure on many homeowners and relieve banks as well as spur the stock market, QE 2 will not add much to consumers who are either out of job with no prospect of a rapid improvement, and the wealth effect is more than dubious this time (after the crisis we are muddling thought which demonstrated that not only assets cab go down as they go up, but also collapse, who, with some sanity, is  going to borrow in order to consume on the back assets that went up thanks to the FED actions?).
QE is merely boosting asset classes, not the real economy, and attempting to inflate in order to reduce the US debt burden and debase the USD to increase export will not work, but may be temporarily - and I even have doubts (Germany have always had a revaluing currency in relative terms and continued to be the world n° 1 or n° 2 exporter; they got the products clients want: consumers want BMWs not GM cars). Playing the currency card only works if at the same time structural reforms are undertaken to become competitive on the international stage by offering the right products at the right price.
On sure thing, savers and pensioners are going to loose at this game.
I attach an interview with Jeremy Grantham, Chief Investment Officer of GMO, one of the best value investor in a generation or two, who discusses QE 2 and prospects for asset classes.