Watership up

In the 1970s British novel, Watership Down, a band of rabbits led by one Hazel escaped destruction and went on looking for a new place to live.  In the course of their odyssey, they come across a warren of well fed but depressive rabbits; these resplendent animals feed on mouth-watering lettuce planted by the local farmer, except that this farmer also sets up snare wires in his field to catch them, one by one.

Unable to resist the lettuce yet afraid of the wires, the epicurean leporids try to convince Hazel’s band to stay in order to lower their own chances of strangulation.  Showing both fortitude and wisdom, Hazel and his friends move on.

Moving on to Europe in 2016.

Last week, the human inhabitants of Britain voted to exit the European warren in search of a better life.

Unlike the rabbits, the British people don’t enjoy the support of a seer and his conviction that they will succeed.  But like the rabbits, I think that they made the right choice.  Europeans should take this opportunity to change course as well.

Originally set up as a customs union, the EEC included six founding members.  With the passing of General de Gaulle, the key opponent to federalism disappeared and the European institutions went on increasing their areas of competence.  By 1973 Denmark, Ireland and the UK had joined in. 

The 1980s set the seeds for real dissent by further enlarging membership (Greece, Spain, Portugal) and further increasing the powers of the European Parliament[1]. 

The 1990s brought the Treaty of Maastricht with expansion into foreign policy, criminal justice, the military, and of course financial matters with the creation of the euro.  The euro was a rushed job[2] and a highly political compromise: Germany was wary of the euro but eager to absorb East Germany; France was wary of German expansion but eager to adopt the euro.  And three new countries joined the European Union.  The Treaty of Amsterdam further built Brussels bureaucracy, to the point of making many of the new regulations unworkable.

The 2000s brought in twelve more members, such as the Baltics, Bulgaria, Cyprus and Malta but also created more conflicts between national and EU areas of competence.  The seemingly unchecked reach of Brussels in a 27 country union with GDP per capita ranging from $50,900 to $7,700[3] encountered growing resistance among the core countries.

In retrospect, it is amazing that such a transformative integration process as the EU was conceived and implemented with almost no popular consultation or approval.  Indeed, after the Dutch and French popular rejections of 2005, the EU Constitution was recast under the 2007 Treaty of Lisbon so as to avoid future popular referendums![4]

Suffering from a legitimacy deficit, the EU was at risk if its members faced serious difficulties, and this is what has happened with: 1) poor macro-economics in the aftermath of the 2008 global crisis, 2) recurring acts of Islamic terrorism, and 3) uncontrolled immigration from the Middle East.  Worse, being part of the Union didn’t seem to help.

I for one am fairly optimistic for the UK:

-The British Isles haven’t drifted towards the freezing Artic,

- The commercial, industrial, financial and touristic ties built with the EU countries over the last three decades are not going to disappear any time soon as they are mutually beneficial,

- The UK and London have always been open to the world; this culture, the skills and the soft infrastructure developed over the centuries will endure and should facilitate an international revival free from the cumbersome shackles of Brussels.

For the remaining 27 EU members, Breixit is also an opportunity to reform the Union.  Indeed, former President Giscard d’Estaing, of no-referendum fame, declared yesterday that the EU needed more democracy, less bureaucracy and more differentiation between big and small countries.

The EU is often made fun for silly rules such as the curvature of bananas, and why not?  But more serious rules stand in the way, such as those preventing Italy today from recapitalizing its ailing banks.

Prestige aside, the euro zone has disappointed.  Instead of bringing about stronger finances, it has incentivized its members to take advantage of lower interest rates to load up on debts.  Rich countries like Germany are now indirectly supporting the weak fiscal policies of others while the weakest ones, unable to devalue, must squeeze their workers to the point of endangering social stability.

Returning power to the states, limiting bureaucratic creep by cutting down the number of commissions and agencies, mandating sunset provisions in new regulations, tying national voting power to population and GDP size should count among the steps towards establishing a better union of so many members.

The UK has been the catalyst for change.  It is messy, jarring, worrying, yet necessary for survival.  Following in the steps of Hazel, Fiver and Bigwig, Britain is on the move again, and who knows, it may decide to join a reformed European Union?

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[1]  Starting to cause the first serious frictions with a number of member countries, Ireland having to amend its Constitution to accommodate this power increase.

[2]  Common currency without fiscal integration or even harmonization as the so-called convergence criteria were soon disregarded by the major countries.

[3]  Austria and Bulgaria.  Luxembourg is excluded.

[4]   Former President Giscard d’Estaing candidly confessed to that in an op-ed in Le Monde on 10/29/07.

A flash in the sky

65 million years ago, the dinosaurs ruled the earth. No other specie could compete in diversity, dominance nor offer surer prospects for more of the same for eons to come. And then, suddenly, they were gone. A catastrophic event, perhaps a large asteroid crashing into the sea off the coast of Yucatan. The world would never be the same after that.

For decades, macroeconomic management in western economies was carried out through the competing and complementary efforts of business practitioners (mostly ex-bankers) and economists. The final arbitrages were made by elected politicians.

This balance of influences served us well. “New” ideas were thoroughly debated between theoreticians and practitioners, with the most toxic ones being filtered out. This didn’t prevent preeminent economists like Paul Volcker or bankers like Robert Rubin from making key positive contributions to the economy.

But then came the financial crisis of 2008 and the ensuing Great Recession, and the banker specie became extinct, figuratively speaking.  (Investment) bankers[1] had been playing with fire, resorting to dizzying debt leverage, funding huge quantities of dodgy mortgage loans with overnight funding, betting on derivatives without properly hedging themselves, and the list goes on.

In truth, bankers were not the only ones responsible for the crisis, but they were the richest, they were politically tone deaf and they were the ones standing among the ruins. Politicians were equally despised, but since they couldn't be fired, knew how to quickly blame somebody else, and fake compassion by writing new regulations and imposing huge fines on bank shareholders to atone for the sins of bank executives, they survived.

The economists were neither rich nor elected, and they had two hands (“on the one hand…on the other hand..”). And so the new era of the homo economicus began.

Unchecked, unchallenged, economists rose to the status of doers, saviors, and seers. They were empowered to carry out real life experiments on a massive scale and test their theories in the real world.

The last act of the banker/economist tandem (Paulson/Bernanke) of opening the liquidity spigot and forcing a massive recapitalization of the banking sector was appropriate at the time.

But subsequent and continuing experiments in printing huge amounts of money, forcing interest rates down to zero and even below, and in having central banks buy hundreds of billions of shaky sovereign and corporate bonds have hardly been conducive to inspiring confidence.

Under such altered financial states, home owners may see their equity go up (because of rock bottom capitalization rates), but they also see their investment income collapse to a trickle.  Not likely to encourage splurging.

Working people, if they pay attention, worry that their pension plans are way behind in building up the kind of retirement assets they will need later in life.  In all, some five trillion dollars in public and private US pension plans are affected.  It is even worse in Europe.

While governments have taken tens of trillions in new debt, they expect their national currencies to weaken just enough to facilitate exports but not enough to trigger capital flight.  Good luck with that.  And whose currency is appreciating to soak all these exports?

The current economists’ bold plans remind me of the Collor Plan in Brazil, back in the early 1990s.  One of its key measures to crush inflation was to drastically reduce demand by freezing financial assets.  All of a sudden, households couldn’t touch their investment accounts, could only withdraw US$600 from their savings accounts and up to 20% of their interest-bearing checking accounts!  That monetary freeze was to last six months!  And ultimately the frozen money would only have limited use.

Debasing the currency, targeting private savings, encouraging excessive risk taking may help balancing some equations on paper, but they destroy confidence, and without confidence there is no economic growth.

In fairness to economists, bickering politicians had left monetary policy as the avenue of last resort. But the adepts of the Dismal Science didn’t need much encouragement.

And now these sorcerer’s apprentices must undo their clever constructs, like Disney eponymous character.  I may be wrong, but the reign of the economists is unlikely to challenge that of the dinosaurs.

---

[1]  By and large, the most egregious excesses were committed b investment bankers, but some commercial bankers joined the fray.

“Why can’t Greece be more like us?”

Why can't a woman be more like a man?
Men are so honest, so thoroughly square;
Eternally noble, historically fair;
Who, when you win, will always give your back a pat.
Why can't a woman be like that?...

Henry:
Well, why can't a woman be like us?[1]

So the first steps in the third bail out of Greece were taken last weekend.  The terms of this new deal are hard and grating on the Greeks, but the perspective of lending up to €90 billion to a country which has caused private creditors to lose €105 billion in 2012, and which will likely need tens of billions of debt forgiveness from eurozone members should also be grating on European taxpayers.

Above all, there is little trust that, this time around, Greece will change its economic model to fit in the eurozone, relying instead on the reluctance of other members to pull the plug. The Greeks already went through a lot of pain, yet they have nothing to show for it.  PM Tsipras declared that he didn’t believe in the reforms which were demanded of Greece. 

Chancellor Merkel could be forgiven if asked, “Why can’t Greece be more like us?”

Contrary to most commentaries, the main problem of Greece is not the excessive burden of its public debt but its lack of economic competitiveness.  As explained in a previous post, its debts mature over 30 years, interest rate thereon is very low and payment thereof is partly deferred; that is not much of a burden.  Besides, Greece has had a primary budget deficit, that is a deficit before taking into account the payment of interest on its debts.

This time around, the euro safety net has grown so tenuous that either Greece accepts to make big changes now, or it is forced to leave.  Even then, absent changes, it would experience a painful drop in living standards.

The needed changes are huge, the government is ideologically opposed to them, the Greek population is no more enthusiastic, and time is short.  Yet Greece could find examples of small countries within the eurozone which successfully reformed their economies, and did so with far less outside financial assistance and in a relatively short period of time. 

I am talking of the Baltic States: Estonia, Latvia and Lithuania.  Having won their independence from the USSR, these countries switched from a centrally planned soviet economic system to one open to the rest of the world.

What is remarkable however is that the bulk of the reforms took only five years (1992-1997)!

The essential policies that allowed the “Baltic Miracle”, with some variation in emphasis and timing, can be summarized as follows:

·        Anchoring the currencies either via a peg[2] (Latvia, Lithuania) or a currency board[3] (Estonia), to control inflation;

·        Reforming and simplifying the tax system with a combination of lower - sometimes single flat - income tax rates for individuals and corporations[4] and of VAT taxes.  This, combined with prudent public spending helped bring budget balance close to equilibrium[5];

·        Liberalizing prices and markets, and in the case of Estonia, opening up its economy to imports by eliminating tariffs and quotas[6];

·        Privatizating state enterprises to reduce the overwhelming size of inefficient public sectors, make the transition to free markets difficult to reverse, and bring fresh capital into the economy.  In Estonia, privatization was carried out via international tenders to choose a core/majority investor for a given company and then via the voucher system to attract minority shareholders.  Lithuania used the voucher system.  On average, over the 1993-1997 period, annual government revenues from privatizations averaged of 3.4% of GDP.

·        Reforming the pension systems, between 2001 and 2004 with a combination of (1) a solidarity scheme based on Social Security contributions, (2) mandatory personal funded retirement accounts, and (3) discretionary personal retirements accounts.

Critics will point out that the Baltic States’ economies shrunk more that the rest of Europe’s in 2009.  They did.  Clearly they had allowed bubbles to grow, and they were constrained by their strict monetary systems[7].  But that doesn’t take anything away from the remarkable and successful efforts undertaken in the 1990s, before some complacency crept in.

Furthermore, one should note that the Baltics also responded positively to the 2009 crisis by pushing forward deeper reforms in their pension systems and keeping a lid on their budgets. 

By 2014, Estonia, Latvia and Lithuania’s budget balances were +0.6%, -1.4% and -0.7% respectively.  This compares favorably with France (-4%), Greece (-3.5%), Italy (-3%), Portugal (-4.5%) and Spain (-5.8%) for example[8].

Today, the Baltics enjoy faster economic growth, far lower debt levels and healthier employment than Greece.

In conclusion, small democratic countries can and indeed have made profound reforms in their economies, with great success.  The key ingredients were:

1.     Facing an even greater danger (Russia for the Baltics, implosion for Greece?),

2.     Having the support of their population,
3.     Ensuring that their governments and technocrats believed in free-markets,
4.     Applying shock therapy and speed.

Greece has #1.  It lacks #2 and #3, but it is its choice whether to change or not.  Smaller, worse off European countries did.  And in Athens, economic advisers from  Tallinn will be more welcome than those from Frankfurt.

---

[1]   My Fair Lady – An Hymn to Him.

[2]  Latvia pegged its currency to the SDR while Lithuania pegged his to the US dollar.

[3]  Here the anchor was the German Deutsche Mark.

[4]  In 2000 the Estonian system was modified to tax corporations only on their distributed profits (as Chile did in the 1980s).  Lithuania adopted an income tax abatement on reinvested corporate profits.

[5]  Except for the period 2010-2012 where the deficit grew to around 9%.  However the same policies greatly helped bring the budget deficits to around zero in 2014.

[6]  In subsequent years, Estonia negotiated bilateral agreements and joined the EU which watered down this policy a bit.

[7]  Estonia joined the eurozone in 2011, Latvia in 2014 and Lithuania in 2015.

[8]  Source: Eurostat.

Welcome to Thunderdome!

You remember the movie[1], Thunderdome with its ghoulish MC and his famous opening line: “Two men enter, one man leave!”

Well, Thunderdome just moved North, except that we are no longer talking about Max and Master Blaster, but Greece and Germany.

For the last few months, the new Greek government, elected on an anti-austerity platform, has showed no interest in abiding by the existing multilateral agreement under which private creditors were bought out at a massive loss (≈77%) to them, or negotiating a new reform program with the other eurozone countries, the IMF and the ECB.

Instead, the basic Greek game plan has been to play chicken, betting that the prospects of a Greek default would scare the other Eurozone members into caving in, while periodically demanding WWII reparations from Germany and flying its prime minister to Russia.

The Greeks have some excuses, for while Finance Minister Schauble has taken a clear and firm line, his French counterpart has kept zigzagging, one day asking them to come up with serious proposals and the next insisting that Greece couldn’t leave the currency union.

The result, so far, is that Greece is expected to default on its IMF loan repayment today, its banking system is essentially shut down and confidence in its government (as measured by money flows) is at its lowest level among locals and foreigners.  Much worse, by now Greece’s economy has shrunk even more than Chile’s did in the early 1980s, yet it has nothing to show for it while by 1986, Chile enjoyed a nationalized but functioning banking system, a sustainable private pension program, globally competitive non-traditional export industries, a balanced budget and foreign debt reduction programs which met their objectives and attracted new investments.  Its GDP also grew by 6%.  And unlike Greece, Chile had not received any multilateral financial assistance in solving its financial crisis.

The new Greek government has planned a referendum for July 7^th, yet has lacked the honesty to set the choice right for voters: it is not between economic austerity and flexibility, but between staying within the eurozone and leaving it. 

Greece’s “intellectual” allies decry the imposition of reforms and spending cuts, yet Greece has already gone through the pain for no benefit.  The UK, with its much criticized austerity policies, is doing better than most of continental Europe for two reasons: a) its austerity policies were devised so that everyone carried his fair share and b) capital is not blind and will go where it has a chance to prosper.

Another bugaboo is the excessive burden of the Greek debt: creditors should (again) take a loss to make it bearable.  But what is the real burden if interest rates are rock-bottom, interest payments are partly deferred[2], and principal repayments extend 30 to 50 years in the future[3]?  Besides, Greece has a primary budget deficit, that is before even paying interest on its debts.

At this stage, it is difficult to predict what will happen in the next weeks and months.  Perhaps another lifeline will be cast to Greece. 

But all parties realize that by getting in deeper, creditors are becoming hostages to their debtor.  Private creditors took a whopping 77% loss just three years ago!  The new sovereign creditors are on the hook for close to €250 billion, of which France alone gathers it is owned over €42 billion.  Already, in the last go around, Finland demanded collateral to back its bilateral loan while Cyprus, Slovakia, Ireland, Portugal and Spain stepped out of the EFSF.  Greece has already asked for a haircut from its eurozone partners, while providing scant details as how it will repay the rest.

More fundamentally, even if a new Greek government were to adopt better economic policies and the population were to agree to drastic changes in such areas as taxation, pensions, public sector employment, privatizations, etc. it remains to be seen if Greece can really share the same currency with the likes of Germany, unless it is to receive permanent subsidies.

Can a country, whose holders of its sovereign debt lose 77% of their investment, really be part of the second most important reserve currency system in the world?

Bound to the euro currency, it can only regain productivity the very hard way: by cutting wages. Likewise, the euro linkage hampers its tourism industry (18% of GDP[4]) as it competes with the likes of Croatia, North Africa and Turkey.

As the core economies of the eurozone regain their health, the gap with Greece will grow.  As explained above, the debt burden is NOT the essential problem of Greece.  Rather, it is its lack of competitiveness.  Not sharing the same currency with the stronger economies is politically and economically the only way out, even if it is unpalatable in the short run.  Recurring eurozone wealth transfers are a no go. 

In the short term, Greece may not want to leave.  If it stays, I expect Germany and others to leave, eventually.

Welcome to Thunderdome! “Two countries enter, one country leave!”

---

[1]   Mad Max Beyond Thunderdome.

[2]   Up to 2022, interest on €34.6 billion of EFSF facilities is capitalized and then paid over the 2023-2042 period.

 [3]   €142 billion owed to the Eurozone countries via the European Financial Stability Facility (EFSF) mature between 2023 and 2053 and carry interest at the rate of about 1.5% p.a. The IMF loans amount to €25 billion and carry interest at rates varying between 3% p.a. and 4% p.a.; €7 billion are due this month and the rest at intervals until 2024.  Another €95 billion represent traded sovereign bonds which were already subjected to a 77% haircut.  Furthermore, of these €95 billion, the ECB holds €27 billion.  However, the ECB bought these bonds at below market prices and has agreed to repay that discount to Greece.  Finally, there are €53 billion of bilateral loans from other Eurozone countries which carry interest at a rate of 3 month Euribor + 0.5%p.a. for an all-in rate barely above 0.5% p.a. (the spread was repeatedly reduced from an original level of 3% p.a.).

[4]   The importance of tourism is understated by this percentage given the very high contribution of the public sector to GDP.

El almirante Padilla meets Captain Bligh

“Now don’t mistake me.  I'm not advising cruelty or brutality with no purpose.  My point is that cruelty with purpose is no cruelty – it’s efficiency.  Then a man will never disobey once he’s watched his mate’s backbone laid bare”. (Mutiny on the Bounty, 1962)

Until last week, Cyprus’travails looked like those of El Tite Socarras, who had been put out of the smuggling business by an overactive Colombian Navy.  By Sunday, Captain Bligh of the Royal Navy came to mind.

The weekend negotiations with the European authorities and the IMF were bruising for Cyprus, and its economic future is uncertain.  That goes for the eurozone too. 

On the positive side, the debt restructuring focused on the banks in trouble, mainly Laiki, and reverted to financial orthodoxy: insured deposits would be protected, recapitalization (of Bank of Cyprus) would involve a debt-to-equity process where losses would be assumed by shareholders, bondholders and uninsured depositors, in that order.  Laiki would be split into a good bank and a bad bank, with the former being merged into Bank of Cyprus.

Less positive was the assumption of the ECB funding of Laiki by BOC and the lack of estimates as to the extent of the losses uninsured depositors would suffer in both banks.  Laiki’s will likely lose most of their money while BOC’s may lose anywhere between 20% and 50%.

Very negative was the evisceration of the Cypriot economy.  Post crisis, its main industry, offshore banking and financial services, has been destroyed.  And it is pretty clear that this was done on purpose.  Yes, the Cypriot banking sector was hypertrophied, but isn’t Luxembourg in the same situation?  Or Switzerland?  And while it was prudent to reduce its size, did this have to be achieved overnight?

While it was legal to force uninsured depositors to take losses after junior creditors and shareholders have been wiped out, in the case of Cyprus it smacked of retribution, and of example setting Captain Bligh-style.  After all, while the Cyprus restructuring rolled on, Spain announced that the recapitalization of Bankia - which called for wiping out common shareholders, haircuts of  43% for holders of preferred shares and of 15%-40% for subordinated bondholders - would leave all depositors unscathed.

Indeed, the public flogging of Cyprus at the mast was so harsh that no country which might fear a similar fate in the future raised its voice in defense of the island.  The eurozone lives for another day, but the atmosphere on board ship is now more Bounty than Club Med.

Understandably, no country wants to quit the euro now for fear of suffering a rapid financial meltdown.  But what is the price for continued membership? 

The elaborate Euro charter, institutional design and numerous Brussels staff have been superseded by German directives; that is understandable since Germany is asked to bankroll everybody else, but is that really the European project that members had in mind?  For that matter, did Germany expect to be besieged with demands for money by its fellow Europeans when it co-founded the eurozone?

With no way to devalue their currencies, Eurozone members experiencing financial difficulties are forced to rely solely on cost cuts, which are politically difficult to enact and socially destabilizing.  A more palatable solution would be a reliance on some currency devaluation, some inflation and some fiscal/cost adjustment.  This has been the way most countries, from the Latin Americans in the 1980s to Russia in the 1990s, overcame their crises.

Mired in economic stagnation and hampered by a banking system which remains undercapitalized, Europe is gradually tackling its debt problems but is doing so on an ad hoc basis and in an increasingly destabilizing way: massive financial resources of the Union are being used up, and distressed countries are required to make adjustments which are deeper and faster than would otherwise be advisable.

Finally, it remains to be seen if smaller countries can attain and maintain the same degree of productivity as the best in class while abiding by the same EU rules: could Singapore be what it is if it were a eurozone and EU member?

For the time being, Cyprus is in the eurozone, but I wonder: longer term, wouldn’t it be better off leaving it, reverting to the lira and setting up an off-shore dollar banking zone?

El almirante Padilla, euro version

There are few musical genres that are more enchanting than the vallenatos, particularly those composed by Rafael Escalona and interpreted by Carlos Vives.  Escalona’s songs deal with everyday life in the Carribean coastal region of Colombia which stretches from Cartagena to the Guajira peninsula.  One of my favorites is El Almirante Padilla in which Escalona laments the prospects of Tite Socarras, whose contraband business has been ruined by the intervention of the Colombian Navy and who may now be forced into a new, conventional, and dull professional life.
 

Y ahora padonde irá, y ahora padonde irá?
A ganarse la vida el Tite Socarras
Y ahora padonde irá, y ahora padonde irá?
A ganarse la vida sin contrabandear
 

Change came just as suddenly to Cyprus, long accustomed to serving as a regional hub for shipping, trading and financial services.  Cyprus, planted in the middle of the Eastern Mediterranean sea, governed over centuries by various invaders, had lately morphed into the most important offshore center for Russian investments.  An EU member, it was a more reputable tax haven for corporations than more exotic venues.  It also offered a low tax refuge for thousand of European individuals, particularly British retirees.
 

In sum, its business model grated on big European authorities as much as Socarras’ contraband grated on regional authorities, and while Brussels didn’t send a frigate to deal with the irritant, the end result was the same.
 

Pobre Tite, pobre Tite...
La armada le salió lista
Hombe! que ahora esta muy triste
Lo ha perdido todo por contrabandista
 

But high living Cyprus was not in default – although it had lost access to international debt markets – and while some of its banks were essentially bust, the majority wasn’t.  Ironically, its demise was caused not by real estate speculation or other home-made disaster, but by its banks’ excessive exposure to Greece.
 

Under such circumstances, for Brussels to force its government – and for the latter to agree - to freeze bank deposits and confiscate part of them, including those that were supposedly government guaranteed is incomprehensible; not to work on a plan with Russia which is the biggest contributor to the economy of Cyprus and has the most to lose is mystifying; to force on depositors a levy equivalent to 30% of Cyprus GDP is very difficult to justify; that the Cyprus government opted to target depositors rather than bank creditors and shareholders is mind-boggling.
 

It is clear to me that the EU wanted to do away with Cyprus as a tax haven; it is extraordinary that the government of Cyprus didn’t think it was committing economic and financial suicide.  But if Cyprus’ business is ruined, its tormentors’ is also severely damaged. 
 

Yes, the economy of Cyprus is unbalanced, with a financial sector many times the size of the GDP; but is it very different from that of Hong Kong, or for that matter that of Luxembourg? 
 

Yes, when people take business risks they should be ready to pay for their mistakes; but should they now expect the EU to arbitrarily change fundamental financial rules in areas such as: government deposit insurance, the order in which losses are allocated to creditors, applying quasi bankruptcy rules in the absence of same?
 

Yes, membership to an economic and financial union carries with it obligations, but should member countries and private economic agents expect a degree of assistance and solidarity in times of crisis or that stronger members will muscle in to extract deep competitive benefits as the price for a modicum of help?
 

Don’t get me wrong, Cyprus and its banks got themselves into trouble, but they were no more guilty than Ireland, Spain, Portugal, Italy and, perhaps, France tomorrow.  Unlike others, they were too small to resist the pressure (the only exception being Ireland on the topic of corporate income tax).  
 

The latest Cyprus crisis is a reminder that the eurozone problems are a long way from being solved.  It also shows that the future of the eurozone, in its current composition, is very bleak: there is too much disparity in economic size and strength, which makes policy harmonization quasi impossible; cultural differences are too wide; finally, the eurozone is the ultimate Rorschach test: some see in it the solution to political weaknesses, others see in it an economic multiplier, a few seek enhanced geopolitical security.  In the end, whatever they want from it, no member is willing to surrender economic and financial sovereignty to a common center.
 

The eurozone may well survive this latest challenge, but in no way should investors assume that this union is comforted.  Rather, I expect each member country to more closely look after its on interests - minimizing the allocation of resources to common strategies in order to safeguard its own future – and to look for potential fellow travelers so as to enhance its security and negotiating position in case of future troubles.
 

Unos pierden porque juegan
Escalona enamorando
Pero el Tite, pobrecito
Lo ha perdido todo por el contrabando.

 

On a wing and a prayer

One of the most spectacular stages in certifying a jetliner is the wing load test.  Powerful hydraulic pistons subject the wing to ever increasing loads, bending it further upward.  Typically, it should break when the load is about 150% of its maximum expected value in flight.

Contrary to movie lore, where bolts start bursting and spars breaking, one after the other until the climatic end, the break in a wing load test is quite sudden, unpredictable with any degree of precision to the casual observer.  Yes, he will notice that stress is building as is the likelihood of a break, but the behavior of the wing at 151% will anticipate none of its destructive explosion at 152%.

Stress in society and politics tends to follow a similar pattern. In societies or countries experiencing very high financial or emotional stress, the observer can readily notice abnormal behaviors and worrisome signals, but nevertheless may conclude that train service will be more or less on time, that politicians will keep assembling and voting and people will follow more or less their usual routine.  Until, all of a sudden mayhem breaks out.

It is my belief that we are, so to speak, on a wing and a prayer in many parts of the world, certainly in Europe, and to some extent and sometimes for different reasons, in Latin America.  The extremely difficult question is whether the stress load is at 120%, 130% or 149%.

One country of concern to the investor, or should I say speculator, is Argentina.  Its economy continues to experience rising stress, its politics are poisonous and every day life is marred by the lack of security.  After the expropriation of Repsol, I decided to buy shares in YPF and Telecom Argentina (TEO) as they were very cheap and I expected the government to have to gradually return to more orthodox economic and financial policies to reach its development goals.  I also felt that international justice, while slow, was closing in.

I had thought that we were at 145% or so on the stress scale, but I now think while we may only be at 125%-130%, without an effective opposition we could go to 160% in a hurry.  Besides, the prices of these stocks had risen by 50% or so since we had bought them.  I decided to sell all of my YPF stocks and keep my TEO for the time being. 

The government seems unlikely to mend its ways and pressure to do so has not yet reached breaking point; its latest declaration in the US Appeals Court that it would not abide by its ruling if ordered to pay its debts may or may not be a ploy.  Furthermore, YPF seems to find it very difficult to implement the kind of joint ventures it needs to exploit its shale oil resources:  Exxon is MIA, Bridas may be a go but Chevron is mired in legal complications from an Ecuadorian lawsuit, and YPF’s CEO is seen courting second tier E&Ps around the globe. Even if these JVs start to operate, there is still a lot of risk attached to government meddling, as can be seen with Petrobras in Brazil.

Stress is building elsewhere too.  In Europe, with no currency devaluation possible and weak domestic and export markets, the fiscal adjustment must be borne by the population in the form of lower wages and benefits, a shrinking public sector and heavier taxation.  So far, there has been no statesman in a major country with the ability to push through any combination of these policies.  Monti tried and was bumped out; Hollande didn’t even try; Rajoy may do better than his two peers because of national cultural differences, but the jury is still out.

Are we at 110%, 120%, 130% in Western Europe?  Again, tough to say.  My guess is we are over 100% which really means that we are somewhat beyond the maximum “normal” stress level.  I think that stress is bound to rise for two reasons: either governments do too little and lose control over their autonomy or they try to do the right thing and will trigger massive pushback from pressure groups and maybe the population at large.  I still like companies in basic sectors which are effectively restructuring, such as retailers Carrefour in France and Tesco in the UK.  I also see strong restructuring talent at Vivendi (France).

As for the US, I am embarrassed by Washington, but I take solace in two factors: we are below 100% and there is a broader realization in the population that we need to cut government spending just like households cut their own.  The debate, in my view, will be how to devise a program that will be viewed as allocating the sacrifices fairly.

What is unclear is the margin of safety that we have as investors.  The actions of the Fed continue to distort all asset values, from real estate to bonds and stocks.  Traditional benchmarks such as p/e multiples, bond yields and the like imply that bonds are expensive and stocks are reasonably priced.  But with a slow growing economy and corporate profits at an historically high level, it doesn’t take much imagination to see stock prices falling 10% or even 20%.  So the important question is, should this happen, would the stocks that I hold still be attractively valued based on long-term fundamentals?  And since we are in a “what if” frame of mind, how about a Warren Buffett test that I find compelling:  would I hold the same stocks if I knew that their shares would not be publicly traded for the next three to five years?