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?

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.

May 29, 2024

The police presence was heavy as usual, but the oppressive, volatile atmosphere that had cast a pall over the Champs Elysées, and indeed the whole city in previous weeks, had lifted.  Instead, an air of expectancy mixed with curiosity had gradually set among the assembled multitude.  But the police prefect was taking no chance, as dozens of armored transports and riot control vehicles were massed, out of sight, on the rue de Ponthieu and Avenue Kleber.

 “I wonder if he will bring his kids” wondered a thin man in a bright yellow Tshirt.  “Carla will not let him!” shot back his neighbor, “Besides, they don’t speak French so they wouldn’t understand what’s going on” added another.  “Well, is he coming or what, we’ve been waiting since four o’clock!” complained a neatly dressed middle aged woman.

HE had been waiting for an even longer time, twelve years to be exact.  He had lost the 2012 elections more than his adversary had won them.  The French had rejected an hyperactive President in favor of a calmer, blander alternative; they had turned their back on “a certain idea of France” and voted in favor of a more comfortable, traditional vision that had much in common with that of an ostrich in imminent danger.  In truth, HE had not helped his case: during most of his term, his unbound energy notwithstanding, he had rarely given a sense of what his governing priorities were or should be, and during the presidential campaign, he had shied away from focusing on the challenges and policy choices that faced the nation.

Hated by many, radioactive to his fellow UMP members, Nicolas Sarkozy had accepted a fellowship at the Hoover Institution of Stanford University.  Within a few years, he had added a teaching position at the university’s Political Science Department and become involved with Stanford’s famed Business School.  In 2018, the IPO of  Uwin, in which he had invested $200,000, made him the first billionaire ex-President.  He was half way through his traversée du desert[1].  Now a very wealthy man, and the symbol of the modern politician who reinvented himself successfully if unconventionally, Nicolas Sarkozy would spend another six years trying to reenter the French political scene. 

Far from the Californian shores, France was not doing so well.  Neither the new president nor the French felt like paring the budget.  Having promised his electors economic growth rather than public spending cuts, President Hollande found it difficult to backtrack, even when faced with a budget deficit bigger than expected.  Taxes on the rich were raised yet they brought in but a fraction of the needed revenues.  So fiscal policy was relaxed, deficit targets were postponed and pressure mounted on the ECB and Northern Europe to provide additional deficit financing.

Had France been isolated, it may have been forced to face the music, but it was not alone; Spain and Italy were in the same situation, having to push through austerity measures which were increasingly unpopular and politically explosive. 

On the other hand, Germany, already facing slowing economic growth and the fallout from China’s recession, was growing more and more concerned that its financial commitments vis-à-vis the eurozone were becoming so large as to be internally destabilizing.  Netherlands, Finland and Austria were on the same page, and in any case too small to shoulder a greater eurozone assistance program.

This all came to a head at the Antwerp conference of 2014.  The new Spanish prime minister, who had just spent two weeks battling with the regional governments of Catalonia, Andalusia and Murcia, announced that he was neither in a position to accept more outside supervision from the troika nor to pay the sovereign debt as scheduled.  His Italian homologue noted that his new coalition in Congress wished to revisit some of the reforms voted under the Mario Monti government and that, in any case, the Spanish crisis made it impossible for Italy to access the financial markets on sustainable terms.  France for its part had been under a three weeks general strike which had escaped the control of the two dominant unions, the CGT and the CFDT, and leftwing splinter parties under the leadership of Jean-Luc Mélenchon were calling for the nationalization of half of the companies in the CAC 40 index.  President Hollande had to decide which way to go.  In the end, he calculated that he couldn’t win over the strikers or the opposing political parties because they would never accept the necessary remedies which, in any case, he didn’t himself fully embrace.  He also felt that the country was far richer than generally acknowledged and could take care of its own financial problems if these were, at least partially, reduced.

On October 15, 2014 in Antwerp, Germany, Finland, Austria and the Netherlands formed the New Eurozone, anchored by the Euromark(€Mk).  Central banks’ balances with the ECB were to be settled via new 10 year ECB bonds.  Given the instant 30% appreciation of the €Mk vs. the €, Germany took an immediate mark-to-market loss of some €200 billion on its ECB credits.  On the other hand, it also showed a comparable gain on its outstanding sovereign debt for the opposite reason.  The top French, Italian and Spanish banks were nationalized.

In the months and year that followed this historical event, it became clear that Anwerp solved only in small part an economic problem, but was even less successful dealing with political challenges.

The German economy took a hit, but not as hard as some had feared.  The €Mk proved a serious headwind to exports and corporate profits, as German exporters cut their margins to the bone to preserve market share.  Imports by France, which represented 19% of total, plunged.  On the other hand, parts and other imports from France, Northern Italy and Spain rose.  Corporate efficiency campaigns went into high gear to mitigate the pricing headwind of a strong currency.  Endowed with a super strong €Mk, German companies accelerated new capital investments in Asia, Mexico and the US.  By the end of 2017, the German economy had regained it mojo, and the timely Chinese recovery proved an added bonus.

In France, the competitive boost gained from a weaker euro was transitory.  It weakened the case for deeper reforms.  It depressed consumption and therefore tax revenues.  Faced with a diminished purchasing power and depreciated savings, the population soon became restless and clamored for “a new deal”.  But faced with high borrowing costs, the government had limited resources.  So, in 2015, new taxes were levied on those who profited from the devaluation, mainly exporters and international firms.  Next, private savings were channeled to finance what amounted to general budgetary shortfalls.  As this was not sufficient, the government reached farther for new sources of funding.  In 2017, “Social Solidarity Financing Programs”, or PROFINSS, were started whereby public assets, services or institutions were used to collateralize new public debt issues.

The state of affairs was not very different in Italy and Spain.  In particular, social and political unrest had become pervasive in Spain where the central government was still faced with a volatile conflict with the regions.  For the first time in recent memory, Italy was faced with its own kind of regional strife, as Northern Italy was in open conflict with Rome.

With stagnant economies and restive populations, these three countries pressed the ECB to increase its emission of money, trying to compensate some of the adverse effects of this policy with export incentives and targeted compensatory schemes.  By 2020, most French salaries included indexation provisions and inflation had risen to 7% p.a.  At the same time, price controls had been expanded, so that the official consumer price index was widely viewed as understating inflation by several hundred points.

As we have seen the Antwerp conference and its aftermath had brought France little relief.  The 2017 presidential elections were hotly contested but the right lost handily, divided as it had always had been.  President Hollande also lost, to his minister Arnaud Montebourg.  The new president was viewed as more charismatic and “progressive” yet not as extreme as Mélenchon. Yet Mélenchon and his Left Party scored big at the legislative elections and assured their participation in the new government.  Also scoring big was the National Front of Marine Le Pen with the support of some refugees from the UMP.

By the time the 2022 elections came around, the world economy had mostly recovered from its slump of a decade before.  China was in the midst of its Domestic Frontier program aimed at accelerating the development of its Western provinces.  Mexico had become the latest emerging markets star and the leader of a revitalized Latin American free trade group which included Chile, Peru, Colombia and a reborn Venezuela whose oil production had reached 4 million barrels per day thanks to the historic opening of its energy sector to private companies.   The US too was on the mend, having flirted twice with disaster but finally built a block of moderates from both parties in the House.

Southern Europe lagged behind.  In France, the 2022 had brought a new president, former Socialist Party Secretary Martine Aubry in the same role of conciliator as that thrown upon Montebourg five years earlier.  The opposition was led by Marine Le Pen as the leader of the Union pour un Movement Républicain-UMR, the result of the fusion of the UMP and the National Front.

By then, the Socialists and the UMR parties had hardened their positions, as each firmly believed that it could impose its views, bloc the other and win over the support of the population thanks to massive demonstrations or other spectacular action.  Crime had become a major social issue and how to combat it was a key political battle ground; the CGT and CFDT unions backed the government while the police unions supported the more vigorous policies advocated by the opposition.  Over the next two years, the policy stalemate continued and pressure built.

In 2024, with little economic growth, continued capital flight and persistent inflation despite administrative price controls, the government took the fateful decision to nationalize what it called the Six Strategic Pillars of the economy: Electricité de France, France Telecom, Lafarge, Renault, Suez and Total.  The government had expected that this move would not be overly disruptive; after all, the Paris stock market had been in a state of torpor for years, all six stocks traded at already depressed levels and state intervention in their affairs was already pervasive.

Market and popular reaction was however wholly unexpected.  While many had not minded the state controlling prices and browbeating wealthy executives, they were now aghast that the attack was directed at their own property.  Also, while stock prices had been depressed for a long time, dividend yields were attractive as they approximated official inflation levels.  Finally, the nationalization raid had come out of the blue and nobody knew what else was in the offing.  On the far left, politicians were up in arm when the prime minister announced that compensation would be paid “based” on market prices; why should taxpayers money be used to reward those who had unjustly profited at the expense of the working class?  Institutional investors, for their part, wondered whether they should wait or just dump all their holdings.

On that day of May 21, 2024 the already depressed CAC 40 dropped by 27% before trading was halted.  International suppliers made it clear that they would suspend all non-essential dealing with the Six Pillars until further notice.  S&P, Moody’s and Fitch downgraded the Six’s credit ratings by five notches triggering sharp drops in their bond prices.  French sovereign and other top corporate bonds swooned in unison.

On the morning of the 22^nd, the Paris Stock Exchange didn’t open for trading and a €4 billion OAT issue was cancelled.  By noon, when trading finally opened, the CAC 40 fell another 11% whereupon the exchange was closed for the day.  Sporadic runs by depositors on branches of BNP, Crédit Agricole and Société Générale were reported in Lille, Strasbourg and Grenoble.

By the 23^rd, the UMR had called on the government to explain its ill advised nationalization in Congress, with supporters and detractors engaging in shooting matches and government members occasionally ducking for cover as projectiles of various shape and weight flew across the Chamber.  Outside, civilians, union members, and employees of the Six were picketing, milling around and waiting for something to happen.

On the 26^th, two things became crystal clear: (1) the government was going to fall, and (2) the UMR had zero chance to replace it.

And so, on the 29^th of May, 2024, at approximately 6 pm, Nicolas Sarkozy, former president (2007-2012), former fellow of the Hoover Institution, venture capitalist extraordinaire, walked up the length of the Champs Elysées, accompanied by his wife Carla and his two daughters, and by the clamor of half a million French.  His hair was grey and his cheeks were rounder, but years of surfing in California had helped him stay in shape, and he effortlessly glided up the famed avenue. 

The government had resigned; President Aubry had asked Nicolas Sarkozy to form a new one.  She had also agreed to resign within three months so that new elections could be called.  Already, brand new banners, white and blue background with “France Avenir” in bold red letters, were fluttering in the breeze, portends of campaign soon to be launched.

The above is just an exercise in political fiction, although it attempts to find a realistic base in history and economic realities.  But it is only that.  Alternative scenario could have been proposed which would have a chance of happening.  The point of this fable is not to guess what the future will be like.  It is to illustrate as vividly as possible the fact that the latest debt and European crises have had severe economic consequences, yet relatively mild political ones. 

In our view, the next few years are likely to bring about political upheaval on a scale comparable with the economic upheaval we have been through so far.

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[1]  Literally, crossing of the desert.

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.

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.