Think Global: Europe again

Wayne Lochore

Once again I’ll head to where I think the most trouble is brewing, and for a while this has to be Europe.  This is not to suggest events bubbling away elsewhere are not important – they are – but it’s where the markets are focused that the greatest danger lies, because as I’ve suggested before ‘market confidence’ is the key to how long this debt waltz lasts, and it’s Europe who are on the front burner at the moment.

So did we see a solution to the ‘Greek problem’, or did we see a massive side-step that showed up the real fragility of the Eurozone?  I think it was the second because it seems no-one has put their hand in their pocket at all; they all just pulled out their ‘hymn sheet’, sung a few bars together and claimed solidarity in facing up to Greece’s needs when they turn up.  Well guess what, they have turned up – they are here and they are increasingly now!  Greece have €20 Billion to roll in April and May, so in my view Europe didn’t fall at the first hurdle, they ran around the end of it!  (That the subsequent 2nd auction was messed up and caused an immediate loss to the buyers of the 1st hasn’t helped).

While Greece at 2.5% of the Eurozone is only a tiny part of the European equation the size of their borrowings at estimated $US304 billion are far in advance of any sovereign failure in history.  Therefore their potential default is a serious problem that is prizing open the cracks in European solidarity to allow the self-interest to show through. Furthermore the focus is bringing to light all the doubtful machinations that many fringe countries went through in order to qualify for Eurozone membership in the first place.  Swaps can hide anything for a period, as we continue to find out, because they sit there like time bombs for later consumption.

Two long and recent pieces by Reggie Middleton have coloured in my understanding of the depth of European woes considerably.  I had long suspected the size of the undigested debt lump that Europe faced would be dangerous but it’s probably worse than I thought.

Largely this is due to the impact of the ‘one currency for all’ approach that the Euro itself represents.  This might work for Germany, (and clearly has comparatively), because they are less impacted by a strong Euro – their exports are more price secure and have allowed Germany to be one of 3 global majors with a positive Current Account balance. But for the Mediterranean countries a strong Euro has been a disaster – they depend on tourism and food exports and smaller manufacturing and compete with all others in the globalized world, but without a depreciating currency to make them cheap to the world.

So less profits, more borrowing, (if you want to maintain your standard of living; and people everywhere are guilty of that!)   And guess what – being a part of Europe provided debt much more cheaply than could be gained alone, so lets have heaps of that, “because as you know everything always goes up anyway”.  And that’s the story for most of southern Europe, borrowed to the eyeballs cheaply, and here’s the real kicker – now exposed to the major European banks.

So what have we here? – The members of the Euro block showing sovereign debt stress and vulnerability to funding pressures themselves AND each country’s major banks vastly exposed to ‘fringe Europe’ on their own behalf.

I’ve never thought it possible to unite former historical enemies around a set of rules and a common currency – it just seemed insufficient as a basis for the unity of Europe, where let’s face it, Wars have the habit of breaking out.  In fact Europe has generally been at war for most of history; it wasn’t just something invented in the 20th century – and what comes from that is exactly what you would expect –  by and large they hate each other (non p.c. I know) – they can’t even watch a football game without being separated throughout.  It’s not the basis for a lasting treaty; a plan which imposes a set of rules from somewhere most citizens will never visit – that in their eyes prevents them from competing with other richer neighbours for a decent crust.  Oh yeah, that’s a great idea, should last for ages.

Interestingly the analysts from Stratfor have a similar view and said this, “STRATFOR has always doubted the euro would last. Having the same currency and monetary policy for rich, technocratic, capital-intensive economies like Germany as for poor, agrarian/manufacturing economies like Spain always seemed like asking for problems. Countries like Germany tend to favor high interest rates to attract investment capital. They don’t mind a strong currency, since what they produce is so high up on the value-added scale that they can compete regardless. Countries like Spain, however, need a cheap currency, since there isn’t anything particularly value-added about most of their exports. These states must find a way to be price competitive. Their ability to grow largely depends upon getting access to cheap credit they can

direct to places the market might not appreciate.”

Stratfor’s analysis suggests that the impact of the Euro shows an average 25% improvement in German efficiency when compared to the ‘Club Med’ countries since 2000, and that larger dollops of cheaper credit has only worsened this as the decade went on.  The four southern countries – Greece, Portugal, Spain and Italy are all flirting with the prospect of default.  As Stratfor suggest the implications of this cannot be overstated. If, (as appears to have happened), the Euro has gutted Europe, and particularly the ‘Club Med’ countries, and then Germany starts to get a little forceful, (as also appears to be happening) then I suspect we’re in for a bouncy few months out of Europe.

It is clear from the German response to Greece that they are beginning to recognise their own voice, and they have the deep one in the back row with the big pockets to match.  Germany has basically gained the position in Europe by the means of financial power that they so long sought using more overt aggression. Now their major message to the less powerful is restraint and austerity – they’re definitely in the “Austrian Economic team” rather than the Keynesian colours and just how long that remains palatable to the unemployed of Europe we will see.  I’d be surprised to see a peaceful European summer.  (Moody’s the rating service (sic) is also concerned about the contagious potential of Europe under austerity).

So what are the ‘Euro-zoned’ all squabbling about? – Reggie Middleton puts it like this – “Most European sovereign nations are considerably “overbanked”.  The levered assets of the banks in many Euro-sovereign nations easily outstrip those nations’ GDP.  So when the nations’ banks get in trouble from bad banking practices (and a very large swath have), the nations themselves not only are helpless in attempting to truly save the banks……., but are put at risk themselves, for the bank is more of a sovereign entity than the country is – at least from the perspective of economic footprint.”

So here we have it – Europe’s problem in a paragraph – large swaths of Europe are not only threatened by the momentum of sovereign debt but by the far larger impact of loose lending practices by their bankers.  But don’t be thinking this is Europe’s problem alone, because it describes the situation in the US just as well, (and New Zealand too if we want to get honest).  Banks everywhere have untold billions of losses still sitting on and off balance sheet that have been sheltered by changes in Accounting rules.  Shifting them on to the sovereign balance sheet and therefore the direct cost of the public purse doesn’t make them any less toxic.  One day they will turn up, they always do.

Britain – (formerly Great Britain):

From a fiscal deficit of £6 Billion in 1997 to £167 Billion in 2010 is the measure of Britain’s progress in the first decade of the new millennium.  This is an improvement over an earlier estimate £178 Billion made in gloomier times, but whatever is the truth here with an election in the wings.  It was only 3 years ago according to the Economist that the UK was the strongest economy in Europe.  So what was the basis of recording these things 3 years ago such that the apparently strongest economy is now ranked down near Greece?  Surely this suggests some new numbers need to be collected.

It does show just how much things have changed since late 2007 – with over one half of the British banking system and 52% of GDP now ordered up by the Government it has needed every assistance that a 25% drop in the ‘trade-weighted’ Pound brings.

Marshall Auerback in a recent post explained how the UK “foolishly leveraged its growth strategy to the growth in financial services and is now paying the price for that misconceived policy, as the industry inevitably contracts and restructures as a percentage of GDP”.   (NB. Our government on the other hand is proposing an entry to the exact same industry but concentrating on the back office work.  NZ’s version of the call centre.)

Auerback also elucidates the concept that warms the hearts of Keynesians everywhere, that certainly drives the QE mechanisms in both the UK and US – In a country with a currency that is not convertible upon demand into anything other than itself (no gold “backing”, no fixed exchange rate), the government can never run out of money to spend, nor does it need to acquire money from the private sector in order to spend. This does not mean the government doesn’t face the risk of inflation, currency depreciation, or capital flight as a result of shifting private sector portfolio preferences. But the budget constraint on the government, the monopoly supplier of currency, is different than what most have been taught from classical economics, which is largely predicated on the notion of a now non-existent gold standard”

And herein lies the UK’s difference with Europe and the Euro; they have their own sovereign currency.  Undoubtedly having this also provides the mechanism for gross abuse in its ability to fashion money out of air, but I can’t imagine too many European nations who wouldn’t like these same opportunities.

All this of course is viewed wherever possible in the absence of interest rate rises, but Mr. Market doesn’t play that game – he wants a return that will compensate him for the risks about to be taken, and increasingly there appears investor reluctance, particularly at the longer end. The funding congestion that everyone can see building in 2011/12 doesn’t encourage anyone to lend long, and it shows.

We’ve seen opaque, but clearly failed, auctions in US Treasuries, and warnings of pressure building elsewhere, so it’s interesting to see what the US administration popped through the other day:

Called the $17.5 billion Hiring Incentives to Restore Employment Act (H.R. 2487), and named by the Zero Hedge site as the ‘Capital Control’s Act’ it has the following embedded in some crucial clauses:

Foreign banks not only withhold 30% of all outgoing capital flows (likely remitting the collection promptly back to the US Treasury) but also disclose the full details of non-exempt account-holders to the US and the IRS.

And should this provision be deemed illegal by a given foreign nation’s domestic laws (think Switzerland), well the foreign financial institution is required to close the account.

I wonder just what was embedded in the 2400 page Health Bill?

Wayne Lochore

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