21012 in review: Greece revisited

As the year comes to a close, I feel that it is healthy to revisit the posts written so far and to assess how events have tracked our expectations and predictions.  This is the first installment of the series.

It has been our view that Greece would not be able to fulfill its commitments to the rest of EU and that the adjustments it needed to make were so great that it should and would leave the eurozone, at least temporarily, if not this year at least next.  We have also felt that the single most effective tool at its disposal to correct excessive debt loads was privatization of public assets, which it has refused to implement: of some €300 billion in privatizable public assets[1], only €50 billion were earmarked for sale, and to-date, cash proceeds to the Greek government have been €1.8 billion only. 

So far, Greece remains in the eurozone despite having spectacularly failed meeting its targets and carrying unsustainable debt loads.  Last March, the Greek government agreed to a series of targets with the Troika (European Commission, ECB, IMF), such as bringing its debt-to-GDP ratio down to 120% by 2020; despite a severe “haircut” imposed on private creditors, that ratio stood at 150% by mid-year and was budgeted to rise to 189% by 2014.  Such huge “miss” was due to both a collapsing economy and rising debts.  The budget deficit target will be missed as well.  Further adjustments include more cuts in public sector salaries, pensions and other social transfers, and of course, better tax collection.

Faced with unattainable goals, the Troika decided to fudge, increasing the 2020 debt-to-GDP goal to 124%, reducing interest rates on loans to Greece, returning realized profits on previous ECB financial aid operations and requesting Greece to buy back debt[2] (at a discount) before disbursing the next aid package.

This next disbursement of €34.4 billion is not assured yet.  It is also huge as it represents 17% of Greek GDP[3].  It is worth noting that Germany has become increasingly skeptical of the viability of the Greek rescue, and not without reason: Greece keeps missing its targets, its debts remain very high and the above mentioned budget cuts are likely to stoke further political instability and push an ever larger share of the economy underground, reducing tax revenues and distorting further the economy.

Having forced private creditors to take a €106 billion loss without putting its debt on a realistic recovery path, Greece will ask the same from its public creditors next.  Despite the IMF insistence, the eurozone has so far adamantly refused, although chancellor Merkel recently acknowledged the inevitable, sort of.  Large scale privatizations continue to appear out of the question.

The problem is that, while another round of debt haircuts appears necessary, it is not sufficient to get Greece back on track.

Nowhere in Europe has the pain been greater than in Greece:  Nominal GDP dropped 7.6% from €232.9 billion in 2008 to an estimated €215.1 billion in 2011.  It is expected to drop close to 7% this year.  Labor costs have been greatly reduced and external accounts have adjusted considerably, although in large part because of low internal demand: the trade deficit[4] for the first nine months of 2012 was €10.1 billion compared to €18.6 billion in 2009 and €32.7 billion in 2008.

For the period 2009-2012, the Greek GDP will have fallen as much as that of Chile did in the early 1980s, yet the comparison stops there.  Chile carried out profound structural economic reforms during its depression years while Greece hasn’t.  Unless Greece invests massively to become more productive and to shift its output towards greater value added products, unless it shrinks its public sector, unless it designs a tax system that is efficient without being confiscatory, the above adjustments will prove to have been cyclical rather than structural.  So far, the situation is grim: for example, total investment as a percentage of GDP has gone from 23.7% in 2008 to 14.5% in 2011 and is likely to drop further this year.

At this stage, the odds of Greece remaining in the eurozone are slim although less dismal than they were last March.  To remain, it is necessary that Greece get a large debt reduction, but it is not sufficient.  Besides reforms it also needs the European Union, which absorbs over 62% of its exports, to recover too.

So far, it seems to me that Greece’s condition has gone from desperate to critical; perhaps there is room for further improvement.  The eurozone countries are starting to acknowledge that they can’t fully collect their loans to Greece.  They have yet to decide which avenue is best for them: granting a large haircut as the final boost to a recovering country and fellow eurozone member, or cutting their losses to a country exiting the eurozone.

I remain in the camp of the skeptics.

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[1]  As per former ECB Board member J. Stark.

[2]  Essentially directed at the new bonds which Greece issued as part of its private debt restructuring.

[3]  Source: UBS.

[4]  Excluding oil products which are not included in the official time series.

Nelson at Trafalgar

On October 21^st, 1805, HMS Victory, Admiral Nelson’s flagship, sent out to its fleet the most famous naval message in history: “England expects that everyman will do its duty”.  Unfortunately for us French they did, and we lost the battle of Trafalgar.

The British navy was better trained and, at that time, enjoyed better command.  Nelson’s fleet was also under unified command while its adversary was a mix of French and Spanish task forces.  Nevertheless, the French and Spanish ships had huge firepower, and the British knew that they had to go all out to win.

Suppose however, that Nelson’s message had been different, such as:

-          “I know some of you men haven’t slept well these last few days.  Those who want to take the day off are excused from combat”, or

-          “Officers, because you receive a higher pay, I expect you to fight real hard.  As for you men, you can duck any time you feel like it”, or

-          “I have decided that one man on each battery will act as an observer in order to spot areas warranting future improvement”, or

-          “I have a plan to win this one without suffering any casualty”.

With less than an all out effort from all of his crews, Nelson could very well have lost the battle, and for sure British casualties would have been far higher.  Instead, he won everlasting fame, yet his example seems to have been lost of most future politicians.

Consider the cases of France and the US, where enormous adjustments must be made to correct structural economic and financial imbalances that threaten the future of these countries;  one would think that their political leaders would call for an all out effort, where every man and woman would be expected to contribute to national revival.  Not really.

What we have seen instead is a reluctance to acknowledge the gravity of the challenge and the inevitability of sacrifices and hardship in order to prevail.  We have also seen an effort to divide society, between rich and poor, young and old, entrepreneurs and salaried workers. 

 There is no question that the rich will need to pay more taxes, but there is also no question that almost half of the active population can’t continue paying no income taxes.  As Prime Minister Monti declared early in his mandate, the burden needs to be fairly shared among all.  Politicians should stress solidarity and fairness, not privilege or clientelism.  It is human nature that if Peter is asked to make an effort from which Paul is exempted, Peter will look for every way to wiggle out. 

We are at a time of crisis; the economies of most of the world are unstable, growth is negative to anemic, debts are ballooning while money is printed with abandon; trust in politicians, and therefore implicitly in democracy, is at an all time low; in the eyes of many, capitalism has failed to provide progress and stability for all (even when its critics have had a hand in its excesses).  Put it another way, we are in a state of unstable equilibrium the consequences of which could be very dire.  As at Trafalgar, it is time for a call, expressed succinctly and clearly, for each one of us to take our fair share of pain and to do our best to pull the country through.

Reply to George Soros' June 26 FT article

In his Financial Times article of June 26 (How to shift Germany out of its cant do mode, June 26), George Soros explained that avoiding a euro meltdown was just a matter for Spain and Italy to agree to structural reforms in return for which Germany would agree to a mutualisation of a “significant portion of their outstanding stock of debt”, such German agreement having been withheld so far mostly because of domestic politics.  This remains to be seen.

In Italy, Prime Minister Monti has been keen to push through reforms, yet has found great resistance from a variety of Italian vested interests.  In Spain, reining in the discretionary powers of provincial governments has proven difficult.  Although they were not mentioned by Mr. Soros, Greece has done very little to reform its bloated public sector while France has rejected the German economic model.

Structural reforms on the scale that is needed take years to be debated, approved and finally implemented.  And this is when populations are not dead set against them.  Therefore, a debt mutualisation today would have to rely on promises (couched in the form of laws which can be later amended) which will become reality, at best, over a much long time-frame.

There is a say that if you owe little, it is your problem, but if you owe a lot it becomes your creditor’s problem.  As a creditor, Germany is fast approaching this point of no return.  Given that hundreds of billions of debt are in the balance, it is very doubtful that the threat of fines or penalties would sway delinquent countries or compensate Germany for the financial burden it would assume.

A larger issue is whether such reforms would be successful in securing the place of the weaker countries alongside Germany in the eurozone over the long-term.  I would love to swim a relay with Lochte, Phelps and Adrian, but, however hard I train, our team wouldn’t make the Olympic cut.

Finally, it remains to be seen whether Europeans truly want a federal system, one where pensions will be determined in Brussels and be based on the German system, or where the size of national public sectors will be shrunk to converge with that of the best performing countries.

In my view, Germany will not accept an early mutualisation of European debts for the above reasons.  Nor will Austria, Finland and the Netherlands.  If push comes to shove, they may consider exiting the euro; yes, the strong deutsche mark would make German exports less competitive, but it would also make the repayment of euro-denominated debts a bargain.

Rather than forcing a decision that won’t be accepted and will resolve little, it might be better to focus on what can be preserved: a Europe of 27 countries where the weakest will be helped to the extent they help themselves.  One option suggested by the economist Richard Koo would be to ensure that a large portion of new sovereign debts be issued to domestic investors and remain in their hands; this may raise the financing cost but in return it would ensure greater financial stability.  It would also preserve greater strategic flexibility. 

Another would be to accelerate privatizations in Italy, Spain and Greece.  Vast resources could be freed in the process which would help reduce the size of sovereign debts.  Greece has over €300 billion in public assets which could be sold; it committed to sell €50 billion; so far it has sold a minute fraction of the latter number.  If a country declines to sell public assets, why should its euro partners guarantee its debts?  Why should the IMF and financial markets agree to a rescheduling, or even a restructuring? 

Other measures to foster growth and employment include reforming labor laws.  Yes this takes time, but then all reforms do.  There is no shortcut.  Some will argue that markets won’t wait.  Perhaps.  But historynshows that markets tend to look ahead, and it is likely that a credible reform program will elicit a favorable reaction in the form of greater investor interest and creditor cooperation.

In the end, some more countries may have to reschedule or restructure their sovereign debts.  But contrary to what is often written, this does not signify the death knell of economies; only the absence of coherent policies and the capricious application of laws do.  One only has to look at the example of Chile in the 1980s when it received no international financial aid yet engineered the longest lasting economic recovery in Latin America.  Indeed, even though debt-to-equity terms were more onerous than in neighboring countries, investor interest was much higher.  Or take Brazil under the leadership of F. H. Cardoso, first as minister of finance and then as president.

Debt mutualisation, as Mr. Soros advocates, sounds great and stirs the right emotional cords of generosity, European solidarity and immediate relief.  In my opinion though, it is unrealistic and insufficient.

Contrary to what European politicians would want us to believe, this is not the first time that countries, large and small, have had to face debt and spending difficulties.  The ways out are well known and they work.  But they are not quick or painless.

I could have been a contender!

Bummer, they cut me, I’m off the team.  It was a blast while it lasted though.  Imagine, on the same 4x100 free relay with Michael Phelps, Ryan Lochte and Nathan Adrian!  I thought it was a long shot, a good joke really, but no, I got to be part of the team and practice with these guys in Colorado Springs for almost a week before I got the word, you’re out.

It all started on a whim; I sent to the powers that be a photo of a CTS scoreboard with my name on it and my time for the 100, 48”60.  I guess they were real impressed because they sent me an email, backed by a written invitation via Fedex, to come up.  Sure, I looked older - actually I could have been the grandfather of any of my team mates - and as muscular as Popeye before he gulps down his spinach, but hey, 48”60!

I did explain that I needed to use flippers for kicking sets because it helped build up lactic acid faster and therefore was more challenging;  I also avoided racing sets because of a tender rotator cuff.  I got some strange looks, but in the end, they let me do my stuff.  The food was great, I really liked my Ralph Lauren USA sweatsuit, and being with the guys was a blast.

I guess the fun could have gone on for a while longer had we not been dragged to a charity event to race a strong local team of Boys 10 and Under, and lost.  Michael stormed out of the pool, Ryan had a good laugh and Adrian’s eyes rolled back into their sockets.  The coaches were not amused and got real unpleasant: 

-          “What the heck were you doing out there, looking for clams!  And what’s your name again?”

-          “Euh, well …. I can explain but no need to blow a fuse …”

So I did explain; the CTS photo was real enough, except that I had photoshopped it a bit; you see, the actual time was 1’08”46, and no, it wasn’t a long course meter time but a short course yard one.  Anyway, there were pissed and I thought it was unfair because they were all of a sudden nitpicking everything when they had welcome me as one of the boys, as a real contender.

That’s why I do feel great sympathy for the Greeks, I mean, they photoshopped some stats and reports and the like, but it was all in good fun and the Europeans should have realized it from the start, and now the poor Greeks are the butt of unseemly sarcasm and threats of expulsion.  Christine Lagarde of the IMF is even demanding that they pay their taxes!

But you know, there is life after the Eurozone just like there is after Colorado Springs.  Greece is no more competitive within the EU than I was in the pool.  When you “restructure” your privately held sovereign debt and your creditors take an 81%[1] loss, and you still can’t carry your remaining debt, you don’t really belong in the same club as the AA and AAA rated members.  More importantly, you need a break, a devaluation, to adjust your costs, otherwise, you starve yourself to death and/or you have a revolution on your hands.  During the Asian crisis, the Russian ruble devalued 333%, from 6 to 26 to the dollar, making exports of goods very competitive, and while inflation shot up in the fourth quarter of 1998 and the first quarter of 1999, it then slowed down considerably.

While Greece should exit the Eurozone, it doesn’t need to leave the European Union.  Some may argue that Greece should stay within the Eurozone and carry out the reforms needed to regain competitiveness.  The problem is that these reforms, politically and socially, would take years to be implemented (more time than financial markets would allow), and success would not be assured.  Even then, given its demography, economic structure and size, Greece can’t rely solely on cost cuts to be competitive with the likes of Germany, Holland and France; so it still needs a one-time large devaluation to close the gap, and perhaps a continuing one to stay within range.  Either way, it would be a hard slog, and it may be that Greece chooses to follow a different path, of less stress and slower growth.

A good relay must be made up of swimmers of comparable caliber who also get along well together.  The same goes for a political and economic federation of countries.  People point out to the example of the USA at the end of the 18^th century as a possible model for the Eurozone.  I would say that the (voting) Americans of that time had more much more in common than the EU today:  they were Anglo-Saxon, spoke English and had left Europe to found a new country common values.  The Europeans of today are far more diverse, don’t speak the same language and don’t (yet) want to be governed by bureaucrats from Brussels.

Perhaps a smaller eurozone will survive, with the necessary fiscal and political integration. This may not be the best outcome, as it may not respond to popular aspirations and would codify a two or three-speed EU.  A better solution may be a Europe of Nations, as envisaged by de Gaulle back in the 1960s, but one accepting enough fiscal and monetary coordination so as to facilitate a system of floating currencies whose exchange rates will be confined to a wide band that will accommodate some differences in policies and economic cycles; an improved “snake in the tunnel” of the 1970s if you wish (it is interesting to note that, in the end, only Germany, the Benelux and Denmark stayed in the tunnel).

Step up …get set …

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[1]  It was estimated at 75% initially, but since then, Greek yields have skyrocketed.

Well, punk, do you feel lucky today?

The negotiations for a second bailout of Greece are going to the wire.  Indeed, the goal line seems to be reset further back as some EU countries are wondering whether a Greek default would be less costly than the funds they are supposed to come up with to avoid it.

In retrospect, both the IMF and the Eurozone probably rushed into the first bailout, and the question now is whether they would be throwing good money after bad.

Initially, the ECB committed €45 billion and the IMF together with EU countries and other institutions another €65 billion. In total, €74 billion were disbursed.

What is under consideration now is another €93.7 billion from the EFSF to be applied as follows: €30 billion to help Greece finance part of the private debt restructuring/buyback; €35 billion to help Greece finance the buyback of ECB financing; €5.7 billion to help Greece pay accrued interest; and €23 billion to recapitalize Greek banks.  Net net, the IMF/ECB/EU exposure to Greece would rise to €132.7 billion.

As the clock is about to strike midnight, the wealthier European countries seem to feel like the “punk”, wondering if he should take a chance and reach for his gun, or back off should Dirty Harry have one more bullet in his Magnum .357. “Well, […], do you feel lucky today?”

The key variable in this equation is Italy.  Back in the summer of 2011, markets put Italy and Greece in the same bag, and given the size of the former, a default by the latter would indeed have been very dangerous.  But Italy under Mario Monti has engineered a remarkable reform program, and so far, traditional political parties have cooperated thanks to the Premier’s diplomatic skills (to wit, his handling of the relations with Silvio Berlusconi). 

Spain, the next weakest link, has shown determination in cleaning up its banking system.  Finally, the ECB has hosed the European banks with hundreds of billions of euros, offering three year funding against a relaxed set of eligible collateral.

Confidence in Italy and Spain has increased, bank funding markedly improved.  Do we feel lucky today?  Do we want to face electors and tell them they are on the hook for €100 billion to Greece and counting?  If only we could be sure that Greece would make it.  Alas, that looks very difficult.

Greece would still be highly indebted, and whatever productivity gains it has made look unsustainable.

So far, Greece is experiencing a vicious circle with collapsing demand, investment, employment and tax receipts.  As a result, the fiscal deficit is still growing and the population is revolting.  As I wrote last January in this blog, the risks of political instability are rising in countries under economic stress.  So, further tightening looks counterproductive.

The more serious issues are structural, and therefore do not have short-term solutions.  According to a study published by Natixis, Greek hourly productivity in the manufacturing sector is good, but the value added produced by the manufacturing sector (as a % of GDP) is 40% that of Italy, 30% that of Germany and 26% that of Finland: the manufacturing sector is too small and doesn’t produce enough high value added goods. 

The service sector and particularly the bloated public sector are the real issues.  Yet Greece has done very little to improve this, in particular by going slow on privatizations.  To date, only a few billion euros of publicly-held assets have been sold; this compares with a €50 billion goal and a total base of €300 billion as estimated by former ECB board member Jurgen Stark.

So Greece looks unlikely to be able to grow any time soon.  This makes structural reforms very difficult: privatizations usually result in substantial job cuts, unless the output can be largely increased at a profit.  Think of oil, metals and the like that are sold in US dollars yet produced in devalued local currencies.  This looks unrealistic for Greece; it doesn’t produce these goods and it is in the eurozone.  As to tourism, where the country has both an existing infrastructure and great sites, competing with the likes of Turkey or even Dalmatia looks difficult.

As if it were not enough, ingrained habits, such as skirting the law, operating on a cash basis, avoiding taxes (be they on real estate, income or sales) will be even more difficult to reverse.  They may have had a rational and justifiable basis some time ago, but to the extent they have been absorbed by the culture, they will be that much harder to abandon.

All things considered, the most rational course of action for Greece is to exit the eurozone.  Then, it could follow either one of two models: Russia in 1999 which greatly benefitted from a devaluation of the ruble, political stability and positive economic policies, or Argentina in 2001 which veered to the left and proceeded to distort economic incentives to the point that inflation sky-rocketed, energy surpluses disappeared and the agro-industry declined.

It is also the most rational course for the rest of the eurozone.  Advancing another net €60 billion would achieve little except a short respite, would ratchet up tensions and in the end, destabilize both debtor and creditor countries.

Such a decision would probably cause volatility in the markets, but that could be countered by having the ECB stand behind the sovereign debt of the remaining eurozone members, and by having the latter to commit to better economic policies.

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.

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.