Market prices are what they are

Market prices are what they are, and it is an exercise in futility to argue with them; if you think they are too low, buy; if they seem too high, sell; or you can just stay away if they look too confusing.

As I am writing this note, consider this.  The French 10 year euro-bond yields 3.511% p.a. to maturity.  This bond is rated AAA.  The Brazilian 10 year dollar bond yields 3.486%, yet it is rated BBB.  Finally, the Colombian 10 year dollar bond yields 3.662% and is rated BBB-.

In other words, markets rank France just below Brazil whose credit rating is eight levels below, and only two levels above the investment grade floor.  Markets put France barely above Colombia which is rated nine levels below and barely investment grade.

Most musings by the press and economists point to France’s credit rating being lowered but remaining within the high investment grade zone (AAA to AA-).  But markets put France barely within the investment grade category; markets price in the possibility of a small loss or haircut. 

Actually, “small haircut” is an oxymoron: no country will be forced or willingly go into default simply to reduce its debts by 5% or 10%.  Rather, the small loss is actually an expected value: a given level of haircut or loss times a probability number.  So is it 30% x 2%? Or 20% x 10%?  Who knows. 

What markets are saying is that this probability number is no longer zero and that, barring strong European political will (which is so far conspicuously absent), it could be anything.

On the other hand, one could also question how strong the economies and financial systems of Brazil and Colombia would be if Europe were to spiral into chaos and the US would continue to twiddle its thumbs.  With all due respect to Brazil and Colombia, I have always thought that emerging market investment grade was another oxymoron.

So what will it be?  It is fair to say that France is no longer a AAA borrower, at least not until it makes some reforms that it has shied away from.  It is probably a AA- or an A+, three to four levels below AAA.  At the same time, I cannot rationalize buying Colombia or Brazil at current yield levels.  Would you buy buy Brazilian or Colombian bonds paying a nominal annual return of 3.5% to 3.7% if you had to hold them for 10 years, come what may?
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Unless you are convince that a Japanese-like decade of deflation is coming, I find it very difficult to buy any sovereign bond at current yields. 

Proust’s financial madeleines

There are images that are forever associated with great crises, and every time we see them, we are reminded of their context, like Proust with his madeleine.  IMF chief Michel Camdessus watching over, as Indonesian President Suharto signed a financial assistance agreement, was the most vivid image of the 1997-1998 Asian Crisis; a generation of leaders across the emerging markets swore that never again would they be caught in such an embarrassing situation, which led to the massive foreign exchange reserves accumulation of the following decade.

The shared smirk between Chancellor Merkel and President Sarkozy, as they were asked about their faith in Prime Minister Berlusconi, has become the symbol of the current European crisis.  But what will it lead to?  PM Berlusconi has been replaced by PM Monti, and Italians are no fonder of public humiliations than Indonesians were back then.

Standard & Poor’s was criticized for having taken into account politics in its decision to downgrade the US.  They were just trying to look a few years ahead, and were right to introduce this qualitative factor.  If we want to look into the future of Europe, we should consider history and culture too.

Italy is the key to a successful European project.  It was a founding member of the European Coal and Steel Community in 1951, the first step toward the constitution of a European project, and of each of its subsequent iterations (the European Economic Community, the European Community and the European Union).  Its population and its economy have been of a size comparable to those of France and (West) Germany; leaving it out would have been like trying to build a stool with two legs.

The importance of Italy was and remains also rooted in history and culture.  Culturally, Italy is the gel that makes Europe click.  For all the outward demonstrations of affection, France and Germany are strong enough to head a balanced Europe, yet too different to make a harmonious one.  Imagine a symphonic orchestra with brass, percussion, woodwind but no string section.  It could play, but somehow it would not sound right and both players and the audience would soon tire of it. 

Finally, Italy is of strategic importance to a united Europe.  It represents its the Southern flank, bordering the Mediterranean basin, and offering the major entry point for people and goods from the former Yugoslavia, and beyond, through Turkey, from Central Asia.

So Italy, for all these reasons, is an essential part of Europe; should Italy fail, so would Europe.  And my judgment is that it won’t, and this for three reasons.

First, Italy’s current problem is one of economic and financial management, not one of solvency.  Unlike Greece, Italy can grow its economy to pay its debts.  Second, the rest of the euro zone has no choice but help Italy save itself, and themselves.  Third, Italy is on the edge of the precipice, and that is the only spot where people and countries will really accept to make changes; in this instance, this meant forcing out the prime minister, voting in a non-political cabinet led by the very able Mario Monti, and giving it two years to try and turn the country around.

Total success will be very difficult, but significant progress is likely.  In this case, France will find itself under tremendous pressure.  In the early 2000s, Chancellor G. Schröder substantially improved the German economic competitiveness through a broad mix of social, labor and tax reforms.    France did not, or could not, match this, and its labor productivity is generally estimated to have lagged Germany’s by at least 30% as a result.

If Mario Monti can convince his compatriots to make substantial reforms, France will be put in a very delicate position: not on the edge of the precipice to have to make big changes, but close enough to feel the intense pain.  Furthermore, with presidential elections coming up, it is out of the question to set up a “technocratic” government, and very unlikely to expect a coalition cabinet.  With profound political divisions and powerful trade unions accustomed to call strikes whenever they want to, the new president, Nicolas Sarkozy or François Hollande, may be in a position where the austerity measures that he can get approved in Congress are very unpopular yet insufficient to reverse mounting financial pressures.

Italy is not Greece, and I do expect that it will pull out, although I don’t expect this will be a linear process.  I do expect France to have a rough 2012 and possibly 2013.  Indeed, the image that will be most closely associated by this European crisis may not be the Franco-German “smirk”; it is yet to be seen and may be most Gallic in nature.

Confidence or else

In the final scene of Le Corniaud, a classic of French movie comedies, as they ride to the police station, a gangster (played by de Funès), is explaining to the naïf who helped in his capture (played by Bourvil) how to multiply his prize money.  The naïf is doubtful and de Funès can’t help but blurt out: “Don’t you trust me? But really, don’t you trust me?”

The US, Europe and China face their own economic problems, but the common obstacle towards their recovery is the lack of trust in which their citizens hold politicians.  And of course, the greater the needed sacrifices, the more people will insist that politicians be both competent and fair-minded.

Take the Greeks.  Here they were, spending their merry and voilà, they got into the EU, no questions asked.  And not only could they keep overspending, but now they could borrow all the money they wanted almost as cheaply as Germany. Was it their fault if they took free money, or was it the fault of the markets that threw the money their way?

The problem is that markets now want Greeks to become German-like overnight.  Other European countries would give Greece more time, if they trusted it.  And the Greeks themselves would likely bite the bullet, if they trusted that the pain would be shared among all parties, rich and poor, foreign creditors and fellow European nations.   

But whom to trust to lead them?  The Panhellenic Socialist Movement (PASOK) was in power when Greece joined the euro-zone; the New Democracy succeeded it and it was on its watch that serious deficiencies in public finance accounting were recorded; finally, PASOK came back in 2009 but its current leader, George Papandreou, has seen popular support evaporate.

With responsibilities for mistakes so evenly shared, it is understandable that no party is viewed as a savior and that the Greek population seems to prefer a coalition government.  Still, even if this is what happens, the task of the new government will be extremely difficult.  More austerity looks unlikely as not politically feasible.  Increasing the “haircut” on foreign creditors wouldn’t reduce public debt that much, and if it reached 75%, the whole exercise would look more like repudiation than restructuring.  A meaningful debt reduction would necessitate the ECB, the IMF and several governments accepting to take a loss on their loans, which is possible but, in some instances, would be a first.

Even if some combination of the above were achieved, Greece would still need to grow and become more competitive.  It is regrettable than privatizations, which could both help reduce the debt and form the basis of a more competitive economy, have been deemphasized lately.  This leaves only three possibilities: cutting salaries further, introducing permanent transfer payments within the EU or devaluing the currency. 

As I noted earlier, I think that further cuts in salaries are not in the cards.  Setting up permanent transfer payments is a possibility.  After all, exports account for 1/3 of Germany’s GDP, and of these, 63% go to the EU (35% or so go to the euro zone countries).  It is clear that countries like Germany (and the Netherlands) need a healthy Europe to which they can export in euro terms; their exports outside the euro zone benefit from being denominated in euro, rather than in a stronger deutsche mark.  For the richer members, it makes sense to permanently share some of these benefits with the poorer members of the euro zone.  But again, it is unlikely to occur in the near term.  Finally, there is devaluation, i.e. exiting the euro; this would offer immediate and sizeable financial benefits provided that such a move was accompanied by very tight management of public spending and inflationary expectations.

I think that the odds are 50/50 that Greece stays within the euro zone.  Staying, in my view, would necessitate the following: (1) the ECB, the IMF and European governments taking a “haircut” on their loans; if my memory is correct, some supranational institutions took a loss on their Argentine loans a decade ago; (2) the privatization program being expanded to up to $100 billion and implemented as soon as possible, with some features akin to the Chilean capitalismo popular in order to give the Greek population a share in its upside potential; (3) the coalition government implementing the adjustment program  more effectively than its predecessors, and (4) some sort of medium to long term transfer system at the euro zone level (there again, confidence will be key, confidence by the euro zone members that Greece will deliver on its promises, confidence by the Greeks that richer euro zone members will deliver on theirs).

Unless all sides can show results, confidence will collapse and we will be left with the exit scenario.  External financial assistance will be cut; this won’t be so difficult if European banks are recapitalized and Italy mends its ways.  The Greek population will refuse to sacrifice further, will reject traditional political parties and leaders; unrest and violence will grow; parties outside the mainstream will gain influence and by the end of 2012 the possibility of a military coup will have greatly risen.  Contrary to popular opinion, military coups usually occur because a sizeable portion (at least 1/3) of the population wants it, not because some general feels like grabbing power.  This would isolate Greece politically and economically and precipitate its exit from the euro zone.

Greece may still choose to exit the euro zone in a democratic fashion if it decides that it cannot bridge the productivity gap with the core of the euro zone, or if it decides that the costs of such an effort outstrip its benefits.

What is clear is that Europe must be rethought as it is becoming fragmented.  At present, we have the 10 non-euro countries, some of which have sizeable and vibrant economies (Poland, Sweden and the UK), we have a strong core euro zone (with the likes of Germany, France, the Netherlands, Finland), we have a weak euro periphery (Portugal, Greece, Cyprus) and finally some countries which could move into any of the above categories (Italy, Spain and Ireland).

If a euro zone with 27 members is not feasible, at least for a long time, what should Europe stand for?  If its purpose is to strengthen the economies of its members, wouldn’t a free trade zone achieve that, without the need for a common currency?  If the purpose is enhanced security, what is the need for a common fiscal policy?  What is the sense of a common central bank if this bank is not the lender of last resort?  Harmonizing fiscal and monetary policies is much more demanding than it sounds when one realizes that this necessitates harmonizing social, labor and defense policies too.   

For a thousand years, France, England and Germany’s predecessors have followed a policy of triangulation to advance their interests and keep rivals in check.  In a sense, the European Union was a way to keep tabs on each other, to get not so close as to surrender sovereignty yet close enough to discourage confrontation.  It might have worked if the Union had been limited to its founding members.  It wasn’t.  The status quo will not work.  Each nation, the wiser for the experience, must now decide what it wants and what price it is willing to pay. 

I think that the current financial crisis can be contained in a relatively short period of time if confidence can be restored.  It will take years to solve it and longer still for a new Europe to emerge.