Eurozone falling chikens’ choice: internal or external devaluation?

1. An awful political background

Since the financial crisis started in 2007, 8 elections in Europe have driven incumbent parties out of business. Whether justified or not, it shows how the European population is disgruntled by a generation of politicians whose lack of courage led to the current over-indebtedness mess (N.B. voters share the responsibility by voting for the same politicians they despite now).

For a couple of years I have written that Greece could not be saved and I strongly believe that European politicians did not give a damn about Greece to solve the crisis, and were solely interested in insulating their banks from a Greek default: to succeed, (1) time needed to be garnered (hence the succession of costly bailouts) and (2) the ECB involved by buying sovereign debt from banks and extending unlimited liquidities; banks used these liquidities to buy more European sovereign debt (the 3 years EUR 1 trillion LTRO is meant (1) to provide some breezing space for deficit prone Southern European countries –France included- and (2) give a free return to banks to strengthen their balance sheet in the turn of 2-4% i.e. EUR 20-40 bn a year, a disgrace– as a side comment, none of the executives of European banks benefiting from the ECB largess should get any bonus since the profitability of banks has nothing to do with managerial acumen, and should in fact, for many of them, be bankrupt; as I have advocating for so many years banks’ executives and theirs boards should have been fired: what shareholders are waiting for?).

Greece will again go the poll in June and I do not see why results would favor a corrupt and incompetent political arena which has ruled Greece for 30 years, and all poll are giving the extreme left SIRYZA party a large lead. Despite disguised threats to the Greek electorate (80% want to remain within the EZ but with no austerity but an open check book from the Germans – they are living in Cuckoo land) from policy makers about a possible exit from the EZ (if your vote is wrong i.e. you do not abide by our integrationist rules, then it will be a disaster for you and no more money from us), the PASOK and the so-called liberals will be out of business for good, hopefully. The trick is to propose at the same time a referendum about the exit of Greece from the EZ which would end up in a rather strange situation where the majority would vote for an anti-austerity parliament and at the same time vote again the exit from the euro whilst bailouts are linked to austerity; the discussions about adding growth to austerity are fine but will not address the roots of the problem: lack of competitiveness.

After the failure of economic convergence within the EZ, we are witnessing Greece’s standard of living fast converging not with Northern Europe but with its European neighbors, Romania and Bulgaria!

For the time being, Greece got its EUR 4.2 bn rescue payment from Europe last week (add EUR 1.6 bn if the IMF disburses its part of the deal) that will cover its liquidity needs for June and probably until late July since Greece has hardly any repayment due in July.

Parliamentary elections in France, also taking place in June, will see the current Sarkozyst party (UMP) lose a considerable number of seats pending unofficial local agreements with the FN, Mrs. Le Pen populist party. The socialist party will win the elections, the question being by which margin: if their victory is large enough, after gaining control of the Senate in September 2011 for the first time under the V^th Republic, they could hold 2/3 of the congress (Senate + Parliament gathering) to modify the constitution as they wish.

Germany’s Chancellor Angela Merkel registered a strong defeat in North Rhine-Westphalia state election in May, the most populated region. However the increased lead for the SPD (the center left) does not mean that this will end the austerity imposed onto Southern Europe since it is the SPD that enshrined budget balance in the Constitution: Germans will not agree to finance ad vitam aeternam Southern Europe for the sake of “peace and the European construction”, which is the dogmatic and untrue eurocratic motto.

2. An awful economic background

Economic forecasts for 2012 and 2013 are between bad and disastrous for Club Med countries (the IMF is less confident than the EC, and private forecasters are even more pessimistic), and downward revisions will crawl along the year and next.

As the table below exemplifies, GDP will turn negative this year and more deeply so in 2013, with hardly any EU country escaping, the EZ being more affected, and within the EZ, Southern Europe the most

In the case of France, the new President, François Hollande, based his economic program on official, and as usual over-optimistic, growth forecasts of 0.7% in 2012, 1.75% in 2013 and 2% until 2016, whilst the country will be in negative territory in 2012 and 2013 at least. Add a Greek default and you get an asset that becomes a straight loss in the turn of EUR 15 bn from the first bailout already paid plus any recapitalization of the ECB.

France’s deficit will not be reduced back to the 3% Maastricht criteria in 2016 and its debt will continue on its upwards trajectory. Expect 2 notch rating downgrade within 12 months.

 Like other Europeans, the standard of living of French citizens will keep up contracting.

The key issue of low competitiveness is structural, and economic, social and tax reforms are not addressed. Policy makers have focused for too long on what they thought, incompetently or dogmatically, were liquidity issues.

3. The choice

This foolish blindness is leading to one of two tough choices: internal or external devaluation to quickly regain competitiveness.

Let’s come back to my preferred equation:

PIB = Public spending + private spending + commercial balance

The World has huge imbalances which result from demand led economies (USA for example) whose consumption is satisfied by export driven economies (China for example), and these imbalances must be corrected to go back to some economic and financial normality.

Looking at the equation, and taking into account the state of debt and budget deficits in demand driven economies in the West, they MUST shift their focus to improving their trade balance, and export driven countries MUST stimulate domestic demand.

There are two ways to improve the trade and services balance: either increase exports or reduce imports or a combination of the two.

To increase export one needs to propose goods that others want to buy by focusing on added value products (there is no way to be competitive for goods very elastic to prices) or unique goods and improve competitiveness. Wage and social costs are the items a country controls which impact productivity and no Club Med country will escape harsh austerity. Energy is also quite important and must be addressed (the USA is thriving in becoming self sufficient again in the years ahead thank to technology which allows shale oil and gas recovery – this will all also have a substantial positive impact on the US trade balance).

To reduce imports, goods must become too expensive for consumers or find the same ones locally at attractive prices. This can be achieved via custom tariff and/or other tricks or via unfavorable exchange rates.

Therefore, taking the extreme case of Greece (but it is valid for Spain, Italy, France, etc.), to rebalance the economy and improve the terms of trade, the choice is between external or internal devaluation.

External devaluation corresponds to the exit from the fixed exchange rate mechanism (the euro) where the Drachma will loose 50-70% of its new parity with the euro (or DM) leading to much higher imported goods thus lowering consumption and more importantly lowering imports; this assumes that the goods and services needed will be substituted with locally produced ones, otherwise the country will continue impoverishing itself. The terms of trade for exports will also dramatically improve, assuming Greece will produce goods other countries want to buy. For the country not to crumble under debt servicing, this will be accompanied with a debt default (restructuring, straight default, inflating the debt away, you name it). Competitive exchange rate devaluation has always been and still is an economic policy tool (see the US and China manipulating their currencies at will).

Internal devaluation is where countries have chosen austerity without currency devaluation: the only adjustable variable is real wages and social benefits which must be reduced and this must be equivalent to a currency devaluation. The terms of trade will not improve and trade imbalances will remain. Debt servicing becomes unsustainable by eating a rising portion of taxes collected. This can only work with fiscal transfers from other countries if a social collapse is to be avoided, i.e. Germany continuing paying.

Whatever the course of action followed, the standard of living of Europeans will continue to fall for years if not for a decade. However, the internal devaluation route, if followed, would end up very nastily.

I will never sufficiently outline the need for Europe to focus on innovation (strength of the US which also explains why I am more positive on the US economic prospects than the European one) and demographics, an other factor of economic growth: spending money in these areas instead of Greece et al. would have been more beneficial to European growth long term.

Source:

Capital Economics: European Economic Outlook Q2 2012

http://www.capitaleconomics.com/

A virtual interview with the WSJ and the FT - Part 4

WSJ: Earlier during this interview, you mentioned that the roots of the problem have not been properly addressed or even no at all?

M&B: Let me start by saying that I have sympathy for the Austrian school of economics but also believe that governments and central banks had to act after having closed a blind eye (or even encouraged directly or indirectly) on an irresponsible behavior (besides their even more irresponsible behavior); they however stopped short (and by a long margin) from making sure the magnitude of this crisis will not happen again (we will get other crises, but please let’s lay the ground to avoid what is avoidable) since policy makers are quick pointing the finger at scapegoats but not at themselves, and they bear their part of responsibility which is not small.

To me, the root of the problem is over-indebtedness, quasi-exclusively in the West (and mainly in the US) and Dubaï (in 2006 I was asked by a friend about investing in a real estate fund focusing 100% on Dubaï: I just told him to stay away; too many square meters built for too few buyers at the end and prices going up too far too fast), from consumers, governments (national and local) and banks; corporations were not so badly indebted.

WSJ: How did this become possible?

M&B: It became possible because of the lack of accountability and short sighting (you were better making a succession of one off deals instead of building a business). Banks magnified the problem but did not cause it: they use a favorable environment to substantially increase their Return On Equity (ROE) via leverage and proprietary trading. It is easy to directly or indirectly encourage consumers to over-consume and forget saving: true, people have been encouraged by the irresponsible behavior from banks and, overall, governments (not least in Europe). Accountability is what will ensure we learn from past mistakes:

1) Accountability from Boards of Directors: you probably noticed that just a few chairmen/CEOs were fired (and not many) whilst boards remained more or less the same. They are the one that vested chairmen/CEOs packages/bonuses, strategy, etc.

2) Accountability from regulators: after all it is the SEC that did not act on naked shorts for so long (the SEC was not worried when banks were shorting naked small and mid cap companies, resulting in outstanding shares representing over 100% of the issued capital!!).

Capital ratios were not set up by banks, but by Governments via Basle accords.

Accounting rules were no set up by banks either, but by regulators. Yes, banks lobbied: so what? Do regulators/policy makers need to follow what lobbyists say?

3) Accountability from Central Banks: 2 months after taking the helm at the FED, in 1987, Greenspan wide opened the flow of money. There was no will to seriously tighten the belt. LTCM was too big to fail? This was opening the door to the next "too big to fail".

4) Accountability from politicians: they have always been (voluntarily) dead wrong in projecting the economy and have not laid the foundation of a sustainable growth: look at (pre financial crisis) the state of public debt, budget deficits, pension disarray and health system decay/cost in the Western world.

5) Accountability from consumers: how can a consumer with some sanity borrow at 15%, 16% or 17% to buy a plasma screen or whatever consumer good, or use a credit card for the same purpose when official CPI is in the 2-3% range? How can someone borrow 100% for a house, or worse draw equity out of it. The western world, and the US in particular, have lived on steroids called over indebtedness.

6) Accountability from media: most of them are just relying information (and the more sensational, the better, whether true or not, important or not, what matters is the scoop) without investigating. Soros says something? It must be true. Greenspan says something? It must also be true. Don't question please, or mildly. The way the media reported the "success" of the G20 summit in London or Pittsburgh is shameful: as if the tax haven scapegoat (oops! depending if you are a large country or not, you are on the grey list or on the white list - Delaware, Macao, etc.) or the bankers' bonus were at the root of the crisis and solving these “identified” problems were key to lay down the foundation of a long term sustainable growth. They were just communication aimed at the man in the street (should I say the voters) and did not bring any viable and sustainable solution.

The important point is that, what we are witnessing is the brutal adjustment to this over indebtedness. The economic growth of the past 20 years was largely built on money creation by central banks and speed of velocity by commercial banks.

Did banks (and the financial sector as whole) create this background? No! They took advantage of an existing framework (in some instances they convinced regulators and policy makers to shape it in their favor) to maximize profits.

We DO NOT need more regulation but better regulation.

The previous "new paradigm" in many ways hid the relative demise of the Western world towards Emerging markets, and among them the largest: China. The economic and financial fragility of the West came to light with this crisis.

This will sooner or later result in a confrontation with the West since both sides are going to be increasingly at odd on many subjects, starting with a competition for the same limited resources to spur their growth and at least maintain (the West) / foster (emerging markets – haven’t they already emerged?) in real terms the standard of living of their populations (I unfortunately have doubts for the Western world to rebound looking 15 years forward with all the challenges we are facing - public debt and budget deficits, pensions and the health service, to name a few). This is already the case in some parts of the world ( starting with Africa - Soudan for example) spilling over into confrontation at a geopolitical level.

This crisis has revealed at least one thing for the ones who were not aware of it: this shift of power is unstoppable in the current environment. People of the West need to point the finger at the right responsibilities to make sure that, we, in the West, will be able to reshape the economic, financial and geopolitical environment to our advantage: don't be mistaken, we are not in a nice people world, but a world of domination (as it has been for a couple of thousand years and longer). there, too, there is not, and there will no be, a new paradigm: either you are on the side of the dominant or on the side of the dominated.

P.S. Wait for the next bubble to deflate, the Mother of all Bubbles: Government debt


Source:

The Economist
http://www.economist.com/user/Markets%2Band%2BBeyond/comments