This is really good report from JP Morgan about possible outcomes of Greece debacle. HT Zero Hedge.
It might seem odd that Greece is surfacing questions about European public debt and the sustainability of the European Union. After all, Greece is only 2% of EU GDP. But what’s in play here is an idea: can a region with very different economic and cultural characteristics form a durable monetary union? Bear Stearns was only 2% of broker-dealers and capital markets banks, but its failure set in motion the end of a different idea: that very highly leveraged entities could own risky, illiquid assets and rely on wholesale funding rather than more stable customer deposits. We must explore as investors whether the end of an idea is dawning in Europe. The point here is not to engage in idle speculation, but to consider the un-thinkable, something that has been very worthwhile to do over the last decade in markets history.
This is not the first time concerns on the Euro have surfaced. Milton Friedman and Martin Feldstein both questioned its viability years ago. In the following pages, some background, charts on the current state of affairs and some thoughts on what happens next. Irrespective of whatever subsidies may be extended to Greece, this problem will be hard to resolve. Implications for European government bonds, the Euro and equity markets are substantial.
The Euro’s predecessor: the failure of the ERM
The creation of the Euro came on the heels of a prior attempt at achieving monetary stability in Europe, the European Exchange Rate Mechanism (“ERM”). Member countries had independent central banks, but currencies had to float within pre-specified bands. The ERM virtually collapsed in 1992, since tighter monetary policy that suited Germany at the time was too painful for countries like the U.K. (which suffered from a recession and 10%+ unemployment), as well as Italy, Spain and Portugal. The bands of the ERM were widened in 1993 to the point that these currencies effectively became floating again.
The Euro is born: Der Würfel ist gefallen
Even before the ERM collapse, the idea of a more durable currency union was put in motion. Member countries would yield monetary policy decisions to a Central Bank, and adhere to tight budget deficit criteria. But according to people like Bernard Connolly (see box), the die was cast when member countries were allowed to join the Euro at possibly elevated exchange rates, despite divergent economic circumstances, productivity and income levels. As shown below, the currencies of Greece, Italy, Portugal, Spain, and Ireland (the “GIPSI” countries) fell sharply in the aftermath of the ERM failure, and then stabilized when the contours of the European Monetary Union (“EMU”) were put in place. Note how the Irish Pound and Italian Lira actually rallied during the era of Euro convergence (1996-1997).
Allowing other countries into the Euro at elevated exchange rates was seen as a win-win situation at the time, since this would increase the purchasing power of savings held by GIPSI citizens; and for Germany, as the region's industrial export power, it created a large "captive" group of wealthy consumers of German goods. [Note the similarities to the circumstances around German unification: some East German savings were converted to Deutsche marks at a rate of 1.8 M to 1 DM, vastly exceeding the real value of the East German mark. This sowed the seeds of the 1992 German inflation/ERM crisis.]
The problem with this conversion: it set the European Union on a course in which GIPSI countries would consume a lot, but not produce much, as their workers would be too expensive to hire. This would eventually prove to be a Faustian bargain for Germany, as they are now expected to mitigate the recession’s impact and subsidize debt burdens of member countries.
Were initial currency conversion rates too high? The evidence says Oui / Si / Jå / Sim / Ne
How can one tell if the initial currency conversion rates were too high? If the GIPSI countries remained competitive with Germany, then the answer would be no. However, the evidence suggests that right off the bat, the GIPSI countries started losing ground. I will spare you the economic jargon, but “real effective exchange rates” from the OECD and the EU Commission are two measures of relative competitiveness. When a line in either chart is rising, that country is losing competitiveness relative to the countries below them. The charts tell the story here.
Despite losing ground in terms of competitiveness, the GIPSI countries went on a consumption boom, fueled by lower interest rates set by the ECB, and funded by external capital4. As shown below (left), consumption took off in Italy, Spain and Portugal (Greece’s numbers are off the chart). Another look, in the chart at the right: GIPSI countries all ran sizable trade imbalances relative to Germany, highlighting the “captive consumer” connection between Germany and the GIPSI countries.
The recession hits and the party ends
The onset of the first global consumer recession in 17 years now puts Friedman/Feldstein concerns to the test. With the collapse in economic activity, GIPSI budget deficits are soaring, since governments have been forced to provide fiscal stimulus to offset sharp increases in unemployment and business failures. What makes the crisis worse is that Europe does not have a lot of ammunition; some member countries have consistently run budget deficits and debt/GDP ratios in excess of what was agreed in the EU Stability and Growth Pact. Even with all the temporary stimulus, the Eurozone looks to have grown at 0% in Q4 2009. Unlike the U.S. and Japan, European industrial production and retail sales have still not bounced from the bottom. Prompted by Greece’s challenges with rolling over its debt, concerns about broader GIPSI public debt burdens are rising, as demonstrated by the increasing cost of default protection in the CDS markets.
The Greek “adjustment”
Few market participants believe Greece will be able to carry out the fiscal adjustment it proposes. Greece plans to make one of the largest fiscal contractions on record, around 10% of GDP over 3 years, without any clear incentives or penalties for not achieving their goals, and is a country with a history of failed fiscal consolidations in the past. Strikes announced so far: tax officials, doctors, teachers, civil servants, etc. Euro area policymakers have stated that Greece won’t be expelled, won’t be allowed to default, and that the IMF won’t be invited in to help (yet). Greece is looking to borrow another EUR 50 billion in 2010, after having borrowed EUR 8 bn in January.
The United States of Europe?
Will the European Union bail out its most profligate member in Greece? It won’t be easy to explain to EU citizens. Greece revised its 2009 budget deficit to be 3x prior releases, prompting Swedish ministers to describe the data as “fraudulent”. Greece has the lowest ranking in the EU on Transparency International’s Corruption Perceptions Index, and has the largest underground “shadow” economy in the entire OECD (see chart), creating endemic problems with taxation and economic efficiency.
The crisis takes on broader implications as well: it has surfaced support for a more powerful federalist government in Europe. EU President Van Rompuy proposed giving the EU more "economic governance" powers in the aftermath of the recession, perhaps without explicit agreement from national delegations. More direct calls for a pan-European government with powers of economic enforcement, bond issuance and civilian deployment come from Guy Verhofstadt, President of ALDE (the 3rd largest group in the European Parliament) and author of “United States of Europe”.
Within Germany, the Finance Ministry appears to be against a bail-out5, while the Foreign Ministry appears to be for it. Germany will be interesting to watch: Angela Merkel is the first Chancellor born after WWII. Her predecessors (Kohl, Schmidt, Schroder) were less able to assert German nationalism; the same is not the case for Merkel and Finance Minister Schaeuble. A 2009 poll shows 70% of Germans opposed to bailing out Ireland or Greece6; they are joined by Otmar Issing (former Chief Economist at the ECB), Karl Otto Pohl (former President of the Bundesbank) and Current ECB Chief Economist Jürgen Stark.
Now what?
It looks like there will be an immediate effort by EU members to stave off contagion and a broader debt crisis, and provide some loans and debt guarantees to Greece. More details to follow next week. But as we’ve seen in the past, such solutions can be temporary if underlying structural conditions don’t change. Here’s a brief synopsis of the 5 options in play:
[1] Deflation. European currency devaluations date back to 11th century England, when they were used to raise silver to pay off raiding Viking invaders. But when a country loses its ability to devalue its currency, there’s only one option left when facing a loss of competitiveness: sharp declines in goods prices, wages and real estate. Hong Kong in 1998 is an example: the U.S. dollar anchored was so restrictive, that real estate prices fell 50% to restore some equilibrium. Can Europe handle declining wages/prices and persistently high unemployment, economically or politically? So far, there have been some austerity measures announced in Spain and Ireland. Portugal is trying, but the current government does not have a majority in Parliament.
* Ireland: Reduced public sector wages (from the highest levels in the EU), spending cuts and tax increases
* Spain: 10% replacement rate on retiring public sector workers, spending cuts, labor unions agree to 1%-2.5% wage hikes
* Portugal (proposed): public sector wage freeze, reduction of public sector employees and sales of government investments If these steps succeed, it would represent a political and economic validation of the concept of a monetary union in Europe.
[2] A large decline in the value of the Euro. A further decline could help countries like Ireland. But for the Euro to fall enough to help countries like Greece and Spain, it would have to fall much more (perhaps below parity with the U.S. dollar), since their economies are more closed (see chart on trade to GDP), and require a bigger change in the terms of trade. Such a low level on the Euro might create inflationary issues for Germany, and we all know how they feel about that.
[3] Regional subsidies. Bond guarantees are easy to provide, until they need to be funded. There are also EU infrastructure funds, bilateral country loans and IMF loans that can be provided to Greece. There are pages of EU treaties which prohibit bailouts, but in practice, they can be circumvented.
[4] Default but remain in the EMU. Countries like Greece would default and effect a Brady-bond solution: debt forgiveness combined with an austerity plan to put it back on a sustainable path. But in Europe, banks own cross-holdings in member country sovereign debt (e.g., French banks owning Greek bonds). An unpleasant outcome, economically and politically. Fun Fact: France defaulted on its debts 8 times between 1500 and 1800; Spain did it 13 times.
[5] A country leaves the EMU. A sovereign could leave, devalue by 30% and denominate its government bonds in the new currency. But legions of lawyers have analyzed the consequences for private sector companies (with assets that can be seized in other countries), and don’t know the answer. Germany could also withdraw and allow the rest of the EMU to find a sustainable currency level. It would result in a Full Employment Act for derivatives lawyers. This would be the nuclear option; unlikely.
INVESTMENT IMPLICATIONS
The European Union is a political concept 50 years in the making, and one that benefits from substantial support from many of its citizens. It would be premature in the life cycle of the EMU, now in its middle age, to succumb to a debt crisis in its periphery. The voices calling for greater European economic and political integration may win out, taking a line from Obama advisor Rahm Emanuel: “never let a serious crisis go to waste”.
However, if GIPSI public sector debt burdens are not addressed, we may be right back here later this year or next. It pays to consider the pricing of credit risk in those infrequent situations that end badly for bondholders: Argentina (2001), Russia (1998), Conseco (2002), Parmalat (2003) and the 2008-2009 crop (CIT Group, Lehman Brothers, GM, Washington Mutual, etc.). In each case, there were interim periods when stop-gaps were put in place, rescue financing from the IMF or interested governments and white knight companies was just around the corner, analysts declared the crisis over, bond prices rallied for a while, and everyone took a sigh of relief. But it was only temporary.
We wrote in December 2009 that we believed that the dollar’s decline vs. the Euro was over; that we are overweight U.S. equities vs. European equities; that we pulled in our OECD bond durations; and that we are generally taking less risk in portfolios than normal at a time of rebounding global corporate profits and manufacturing. None of these positions has changed, and are reinforced by the latest round of uncertainty coming from the European Union.
Michael Cembalest
Chief Investment Officer
JP Morgan Private Banking
What about the United States as an example of a monetary union that can survive severe recessions?
There are substantial differences between the United States as a monetary union and the EMU. There are three worth highlighting:
Higher labor mobility in the U.S. At a meeting in Spain in La Coruna in 2007, I asked a client why his idle workers would not move to Frankfurt where there were job opportunities. His reply: “Frankfurt? They would not even move to Barcelona”. Compared to Europeans, U.S. citizens are 10 times more likely to move in response to unemployment differentials, and 2 times more likely to move in response to wage differentials. [Source: “The European Immobility Puzzle and the Role of Migration Costs", Michèle Belot, University of Essex, European Commission "Employment in Europe" conference].
Borrowing constraints on U.S. States. Unlike European member states, U.S. states generally adhere to balanced budget policies. With the onset of the recession, U.S. states needed a substantial transfer from the Federal government ($180 bn) to prevent large tax hikes and spending cuts. But at least the starting point for most U.S. states is closer to balanced, unlike European member states.
Higher U.S. tolerance for regional subsidies. The U.S. is much more accustomed to the kind of regional subsidies that the EU is now debating. Fiscal transfers in the United States eliminate as much as 40 percent of a decline in regional income, while fiscal transfers between EU member states are only a tiny fraction of that amount. [Sources: Xavier Salai-Martin and Jeff Sachs, “Federal Fiscal Policy and Optimum Areas”; Barry Eichengreen, “One Money for Europe? Lessons from the U.S. Currency Union.”; and “The United States as a Monetary Union and the Euro, a Historical Perspective”, Michael D. Bordo, Cato Journal, Spring/Summer 2004].
