2102 revisited: the weight of culture and the risks of destabilization

In my post of last January, I quoted excerpts from a 1932 article that journalist Paul Scheffer wrote for the Berliner Tageblatt.  It painted an audience’s expectation and attitude ahead of a speech by Adolf Hitler.  What struck Scheffer was that most of these people were what he called ‘de-classed” middle-class, that is, people who had lost both their standard of living and their self-esteem, and who were waiting for a miracle.  My conclusion was that, as momentous as the impact of the current crisis had been on European economies, it would hit politics even harder.  I argued that the explosive development of social media would be a key contributing factor.  I stand by this assessment.

Subjected to an abrupt increase in unemployment, taxes and cuts in social benefits, Europeans are looking for miracles, and this situation provides fertile ground for demagogues and extremists.  In Greece, Holland and Hungary, we have seen the rise of extreme-right movements; in Spain we have seen the rise of leftwing, nationalist parties.  In France, while a moderate socialist won the presidency, there has been an unprecedented fragmentation of the political scene: splinter groups on the Left led by the likes of Mssrs. Mélanchon and Montebourg are increasingly at odds with the government as are the Greens; on the right, the UMP is splitting as it cannot decide if it should follow a centrist but unimaginative path or one of assertive populism.  In Italy, the anti-establishment party of Beppe Grillo is the second most popular political party and center parties have receded the most.  As the fortunes of Europe are unlikely to brighten any time soon, I expect an increase in centrifugal forces.

Faced with mounting pressure from the markets, most governments delayed taking corrective measures, giving the unfortunate impression that, in the end, they succumbed to outside pressure.  This in turn contributed to weakening them and the prospects for a consensual EU solution.

The need to tap outside rescue programs also contributed to reviving long standing regional frictions, witness the North-South divide in Italy, Catalonia and the Basque region in Spain and Scottish independence in the UK.

If, as I believe, the European economies do not rapidly improve, I expect that the above mentioned stresses will increase.  At first, populism is likely to rise; after all, it is easier to deflect popular anger towards the rich or large corporations (witness the 75% tax or the skirmishes with Peugeot and Arcelor-Mittal), but as these do not have bottomless pockets and are more mobile than the rest, new tactics will be needed.  The temptation for governments to intervene ever more deeply into the economy may become irresistible.  This would buy peace for a while, but it will also bring the center of gravity of politics into a no-man’s land: no longer liberal democracy, not yet illiberal democracy.  One can think of Argentina and Venezuela as the ultimate “models” for such a drift.

Pervading this debate is the unrecognized influence of culture, a major interest of mine, and something I touched upon in my post of last March.  It is an issue that most commentators avoid as they view it as politically incorrect.  That may be so, but it doesn’t mean that it is irrelevant.

Culture is the glue that keeps groups of people together and in relative harmony.  Think of the IBM or the Marine Corps cultures.  It is also what defines nations, and so, by essence, it changes very, very slowly.  Why would we still read about Tocqueville’s America or Custine’s Russia otherwise? 

In the context of the current crisis, it is worth noting that there is a longing for but not a strong European culture; rather, there is the appearance of one when dealing with other very large nations such as China or the USA.  There are however very strong national cultures in Europe; these have had a significant impact on the management of the Debt Crisis so far, and I believe they will be play a major role in determining the survivors.

A great divide has been the so-called Recovery-Through-Growth proposition, i.e., that countries should first seek accommodating monetary and fiscal policies to overcome the current crisis, postponing tax increases and spending cuts for later.  President Hollande has been its most vocal advocate.  The other side of the proposition is No-Pain-No-Gain, which is that the bitter medicine won’t taste sweeter next year and problems are best tackled early before they snowball.

It is interesting to note that France and Hungary are in the first camp while Ireland, Portugal, the UK and Germany are in the second[1].  Spain and particularly Italy are in the middle, leaning perhaps towards the latter group.  Ireland is showing progress; Portugal is still struggling but is in a much better shape than Greece.  The UK was widely criticized for choosing austerity and indeed paid the price with a slight contraction in GDP.  What is remarkable is that these countries chose to endure sacrifice – quite big in the case of Ireland and Portugal - yet their populations didn’t rebel.  They may have paid a higher price in terms of GDP loss than others, but they will come out of the crisis faster.

Italy, led by its Northerners, also took the path of some reforms, although this may not be enough to avoid debt restructuring.  There is no clear prospect for a majority government next year.  As for Spain, it finally seems to have accepted the need for its intervened banks to face reality (merger for some, assumption of losses by creditors and shareholders).  Its government is trying to take unpopular measures but it enjoys spotty popular support and it must deal with internal regional issues.  As to France, and as I noted in previous posts, it is so rich as to being able to delay the day of reckoning.  At the same time, it suffers from an ill shared with others – the weakening of its political center – as well as home-grown cultural idiosyncrasies – such as the inability to do evolution when revolution is an alternative.

To my mind, national culture had a lot to do with the choices nations have made and it will have a lot to do with the outcome(s) of the current European crisis.  This is particularly so since unemployment is expected to rise and economic activity is projected to be lackluster in 2013: national cohesion and resilience will thus be painfully tested.

In sum, while economic progress has been made in Europe, more hardship is on the way.  This in turn will put further stress on political systems which already show signs of fragmentation and polarization.  Politics rather than economics will likely determine the outcome of the current debt crisis.  So will national cultures; they help explain the choices that countries have made and they will play a major role in mapping the future outline of Europe.

 

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[1]  Germany is not (yet) in crisis but it did take some pain under Chancellor Schroeder.

Presidential aftermath

François Hollande won the 2012 presidential elections, which was not a surprise.  As I anticipated in my previous blog, the score was much tighter than expected, 51.6% to 48.4%.  Also, people who had voted for the Front National in the first round largely voted for Mr. Sarkozy in the second.

I thought that, with a good debate performance, Mr. Sarkozy could squeak by.  Unfortunately for him, while he assumed the role of the underdog, he was too often on the defensive and his overly aggressive style grated on many.  Mr. Hollande held his own, looked more composed, and in my view won.

Indeed, Mr. Sarkozy may have lost his reelection on style rather than substance.  Many would acknowledge that he did his best to undo some of the anti-competitive measures that prevented France from keeping up with the likes of Germany – the infamous 35 hour week, retirement at 60, an ever growing public sector – and he tackled some other issues – such as wearing the burka in public – that risked poisoning social relations.  But his often rough tone, cavalier treatment of his cabinet, apparent fascination with billionaires and hyperactivity gained him many detractors and won him few allies.  When he needed the votes, supporters didn’t materialize and opponents felt energized.

Obviously, other factors were at play.  First, many felt that after 17 years of center right government, there was a need for change.  Second, the incumbent was penalized for the economic crisis which happened on his watch.

What next?  As Mr. Sarkozy steps out of politics (at least for now), the political debate will focus on issues.  It will be interesting to see what Mr. Hollande proposes, but as I pointed out in the past, the actor to watch is Italy: in my view the dual leadership of France and Germany is fading, to be replaced by a troika of France, Germany and Italy.  And while Italy is sympathetic to greater emphasis on growth, it is doing the heavy lifting in the area of reforms and will not support mere deficit spending, if it were proposed.  Besides, Italy doesn’t have the financial resources to fund such an EU-wide program.

Yes, difficult times lie ahead, but failure is far from being a foregone conclusion; on the contrary, there are elements in place to produce a sounder, better balanced EU.  Markets, for the time being, sense this and are giving European politicians the benefit of the doubt.

The second shoe to drop

It is remarkable that, so far, the global crisis which started in 2007, has had very few disruptive fallouts in the political domain.  There have been two casualties so far, Prime Ministers Berlusconi and Papandreou in Italy and Greece respectively.  In both cases, traditional parties have rallied behind governments led by technocrats and have approved austerity budgets.  In the US, where it all started, the situation is even more benign:  after causing a stir and some concerns, the Tea Party has overplayed its hand and failed to organize into a potent force, and President Obama, while inspiring faint enthusiasm, may be reelected come November.

Yet this may change.  Indeed, as governments in Europe, and soon in the US, cut spending (including social benefits) and raise taxes in order to reduce public debts and balance their budgets, populations may well revolt and seek alternatives.

In particular, the perception that such sacrifices are demanded by a foreign power, such as Germany, or by faceless financial markets which have been demonized by politicians and the media, combined with the absence of tangible forthcoming benefits may well cause populations to balk, to reject further austerity and loss of purchasing power, and to become receptive to the most demagogic promises of fringe politicians.

Granted this didn’t happen in the US during the Great Depression, but it did in Europe and I would argue that the explosion of media and social electronic networks make such a threat more serious today. Although in a different context, the Arab Spring is the clearest illustration of how a movement can gather irresistible strength.

In particular, what we are witnessing today is the squeezing of the middle-class throughout the West, and such a trend is unlikely to stop any time soon.

In April 1932, the liberal journalist Paul Scheffer of the Berliner Tageblatt wrote a powerful article on Hitler and how he seduced a despondent German middle-class.  This article was reproduced in the January/February issue of Current Affairs, and I am reproducing an extract here.

Hopefully, we will avoid a similar fate. But I do expect that, while the Great Recession mostly impacted financial markets and economies initially, it will have a much larger impact on politics and government in the next few years.

Le radeau de la Méduse

This painting by Gericault, one of the most famous of the French Romantic School, depicts survivors of the shipwreck of the frigate La Méduse as they are to be rescued by the brick Argus.  The disaster was caused by incompetent leadership and resulted in over 150 deaths.  The survivors picked from the raft resorted to cannibalism to survive.

It is too soon to compare the current travails of the eurozone with those of the sailors of La Méduse, but surely it isn’t to say that a euro shipwreck looks increasingly possible.

The latest report by the IMF on Greece is sobering.  The Greek economy is weaker than anticipated, the pace of structural reforms is slower (partly as a result of bureaucratic resistance, partly as a result of poor implementation); bank deposits keep on shrinking, credit to enterprises is falling, competitiveness is marginally improving, mostly as a result of dismissals.

While large institutional bank creditors had “voluntarily” agreed to a “haircut” of 50% on their Greek public bonds, rumor has it that the government wants to apply it only to the nominal value of the debt; by offering very low interest rates and extending maturities it would increase the effective “haircut” to 75%.

Greece is in a bind as the IMF, ECB and other euro governmental credits are exempted from the “haircuts” so that private creditors bear the brunt of the restructuring.  As I wrote in a previous note, there is little difference between a 75% haircut and reneging on one’s debts.  Argentina is a good example of that, and it has been a decade since it hasn’t been able to tap international bond markets.

Furthermore, can Greece fail to pay 75% of its public debts and still belong to the eurozone?  Can Greece restructure its public debts, exchanging them for new bonds worth 25% of the originals, and still characterize the process as voluntary? The answer is no and no.

Initially, I thought that the insistence by several European heads of state that the exchange be voluntary was nothing more than pride.  Now, I wonder.  What if big European banks had been sellers of CDS (credit default swaps)[1]?  Why not?  After all, the underlying credit risk was supposed to be zero; what a better business than selling for thousands of euros protection (CDS) against a risk that was non-existent (sovereign default)? 

European banks may have sold relatively few Greek CDS, but they may have sold tons of French, Italian and Spanish CDS, and a formal default in Greece would, at the very least, force these banks to provision against the other countries’ CDS because the myth of zero-risk eurozone would disappear.  Provisioning is a euphemism for taking a (big) loss.  I did look into the exposure of BNP and other banks to European sovereign debt but these banks only disclosure their exposure in their banking books, not in their trading books, which is very unfortunate under the circumstances.

The only way for Greece not to, in effect, renege on its obligations is for the IMF, the ECB and other euro governmental creditors to share in the losses of restructuring.  If not, Greece is out of the eurozone, with all the implications it carries for the rest of the area.  Even then, it is difficult to see how Greece will improve its competitiveness and enable its economy to grow fast enough, particularly given the European austerity and deleveraging policies.  At the end of the day, I can’t see how Greece stays in the eurozone.

The other eurozone members face different but equally daunting problems.  One is the fragility of their banking system.  In the US, banks account for 1/3 of total credit and capital markets for 2/3.  In Europe, the proportions are reversed yet banks have less capital and less stable funding (their ratio of loans/deposits being well over 1.0).  In recent weeks, big European banks have announced extensive divestiture programs to strengthen their balance sheets.  This may be good at the micro level, but it is bad at the macro, leading straight to recession.  And then there is the CDS question raised above.

European governments could have forced their hands with their equivalent of a TARP program (by far the most successful US effort to stem the 2007-2008 financial crisis).  Yet they shied away, afraid of jeopardizing their credit ratings.  This was a terrible mistake.  The financial situation will not improve until banks get stronger, and sovereign ratings will drop unless forceful governmental action is taken.

The other problem is existential.  Member countries share a goal but not the means to reach it.  They want to be a powerful economic bloc but they do not want to pay the price for it but harmonizing their fiscal and social policies, and in the process relinquishing some degree of sovereignty.  They desire a common currency but refuse to let the ECB back member states private banks not to mention member state public debts.  Finally, member state populations, when asked, reject the idea of a Brussels command, yet they now have to accept one from Berlin and, yes, Brussels.

As the situation worsens and tensions rise, the survivors are warily eyeing each other; numerous meetings have shown that they are unable to reach big decisions (such as recapitalizing their banks, getting the ECB to step up to the plate) or to display real solidarity.  The sniping has started (witness the French/UK[2] war of words on credit ratings) and will get worse. 

For all of the demonstrations of coordination and harmony, it is clear that Germany is the leader of the eurozone and France is the more equal of the rest.  When de Gaulle envisioned l’Europe des Nations, he meant not to relinquish sovereignty to Brussels; today, it has been relinquished in part to Berlin.  President Sarkozy will no doubt continue to play the game until the elections; doing otherwise would mean acknowledging a reality which the French dislike. 

Afterwards, changes are inevitable.  Pulling up to Germany’s level would require huge changes in labor laws and a shrinking of the public sector which seem beyond Mssrs. Sarkozy or Hollande powers.  France can’t revert to the age-old French/English/Prussian triangulation because the UK are outside the eurozone.  Italy, under strong leadership, could offer France some of the balance it wants.  Still, Italy would not offer a real triangulation, and as a result, I think that France will wish for less European integration rather than more, for a gaullian Europe of Nations so to speak.  Ironically, in so doing it would get closer to the UK position.

Perhaps a slowly healing US and resilient BRICs will give Europe six months to a year to avoid disaster.  But the pressure will not abate, the price to pay will not drop.  In the end, a Europe of Nations is more representative of the continent’s two millennia of history than a contrived eurozone.

Germany could mitigate the strength of its new currency by preserving a mini eurozone with Austria and the Netherlands.

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[1]  This is a question that hedge fund manager David Einhorn has also been asking.

[2]   I know, the UK is not part of the eurozone.

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.