austerity, debt crisis, ECB, economics, euro, European Central Bank, eurozone, germany, greece, ireland, italy, Keynesian, maastricht treaty, monetarism, monetary policy, nationalism, PIIGS, populism, portugal, sovereign debt, spain, United States
The Euro has practically been destined for failure since its inception. In essence, the Euro is a 17-nation currency peg that lacks any sort of flexibility to adjust for real economic movements. It strips away the independence from each nation within by eliminating any form of monetary policy, meaning that each individual nation has no ability to shift its money supply due to economic events.
This would not necessarily be disastrous if there were other mechanisms in place to account for it. After all, the American states of Texas and Ohio both lack independent monetary policy, as well. The main difference, however, is that American “states” are not governed as sovereign nations. They gave up that sovereignty in 1789 when the US abandoned the Articles of Confederation in favor of the US Constitution. Moreover, American banks don’t primarily rely on financing from the state of Virginia or the state of New Jersey. They rely on it from the United States federal government and it is regulated by the US Federal Reserve. Whereas, banks in Spain rely on financing from the Spanish government. Yet, Spain’s currency is controlled a completely separate entity: the European Central Bank.
Unfortunately, this has been a recipe for disaster. In many ways, it’s almost like a reversion to the gold standard, in that nations that need to increase money supply can not. Except, it may even be worse, since gold is at least a commodity that can be bought and sold. Whereas, if you’re Spain, your currency is actually pegged to other currencies that don’t even exist any more. Moreover, moving the peg requires all the other Eurozone nations to agree to measures that allow this to occur. So, there is no way out and a nation like Spain can get stuck in a deflationary spiral.
While I am a value and distressed equity investor, I have almost completely stayed away from the Eurozone due to my concerns with the overall macroeconomic picture. However, I wanted to share many of the thoughts I’ve had on the problems, the solutions, and the future of the Eurozone:
(1) First things first — let’s acknowledge that the Eurozone crisis will end ugly. I originally had some faint optimism that Eurozone policymakers might realize what is necessary to make the Eurozone work, but all signs point to this not being the case. Instead, we’re seeing an increase in populism, nationalism, and radicalism across the Eurozone. This is a frightening trend. Desperation can sometimes yield accidental solutions, but it can also yield monstrosities such as the Soviet Union.
(2) If Greece and/or Ireland leaves the Euro and restructures their debts, the German banks are in deep trouble. Therefore, the German banks would prefer for the German government to keep Greece and Ireland on life support. This is also why Germany desperately wants Greece to stay in the Eurozone; because the German government might suddenly find itself propping up its own banks.
(3) The other alternative is that Germany semi-permanently starts paying for Greece and Ireland’s government obligations. While the Euro dramatically helps boost German exports via artificially weakening their currency, eventually, the German government is going to rack up quite a debt if it continues to subsidize the PIIGS. This alternative, while unappealing, might be better than allowing Greece, Ireland, and others to default actually — but it’s unlikely that the German populace will support this or go along.
(4) The idea that Germany has been responsible and prudent, while the PIIGS have been reckless spendthrifts is complete rubbish (with the noted exception of Greece). Four years ago, Spain, Portugal, and Ireland had low government debt and showed all signs of being more fiscally responsible than the vast majority of states across the world. It wasn’t reckless spending that ruined them; it was the financial crisis. The problem is that you can’t fund government oligations with 20% unemployment (as in Spain) or with zombie banks (as in Ireland). And you can’t dramatically cut government spending when you have 20% unemployment and zombie banks; lest you make the crisis even worse. Hence, it’s a giant catch-22.
(5) If you live in the US, you should be thanking God (or the deity or non-deity or your choice) every day that your nation has independent monetary policy. Spain and Portugal would probably be OK if they had that. However, being stuck in the Eurozone will likely doom them without significant reforms or an eventual exit. Of course, the worst thing that could possibly happen to the US is that some nitwits re-enact the gold standard and essentially put the United States in a similar predicament as Spain.
(6) Another solution to this mess would be to start financing all government debt through the ECB. Part of the problem is that the Eurozone not only artificially boosts exports for the stronger nations; but it also artificially lowers interest rates. It does the complete reverse for the PIIGS. However, once again, Germany has steadfastly opposed debt financings through the ECB … even though it’s the most logical solution and the solution that is also least likely to cause disaster.
(7) The Eurozone should also implement current account surplus tax that redistributed money from current account surplus nations to current account deficit nations. This is necessary because the Euro artificially redistributes wealth from the weaker economic nations (the PIIGS) to the stronger nations (Germany, Austria, Netherlands, Finland). This will also never happen, but it makes sense economically.
(8) One of the purposes of the Eurozone was to tie together the European nations closer and to avoid the issues of the first half of the 20th Century with rampant nationalism and economic protectionism. Instead, the Euro has, ironically enough, re-ignited European nationalism.
(9) Spain, Portugal, Ireland, Greece, and Italy would all be better off if they left the Eurozone entirely. The political status quo in each nation, however, is unwilling to consider this solution. Don’t be too surprised if you see alternative parties that slowly start to push towards a Eurozone exit, in the same way that political changes were the impetus for ending the gold standard in the Great Depression.
(10) However, the idea that the PIIGS leaving the Eurozone would save it might be flawed. Rather, a PIIGS exit is more likely to give the Eurozone a temporary stay of execution. The flaws of the currency union are significant enough so that the exact same issues will manifest themselves again at some future date.
(11) I would not invest in Germany right now. In some ways, it’s the most vulnerable Eurozone nation. The market is already pricing in a lot of distress in the PIIGS, but Germany is considered relatively “safe”. This is a dangerous assumption. Germany is very vulnerable to the changes that will inevitably occur over the next few years.
(12) In a worst case scenario where the Eurozone dissolved, the German banks would be in deep trouble due to debt restructurings in Greece and Ireland. Moreover, the Deutsche Mark would dramatically strengthen, thereby killing German exports. Right now, Germany’s economy is held up by an artificially weak Euro (from the perspective of Germany’s natural currency) and artificially low interest rates. Any interruption in that could change things for the Germans.
(13) I’d be terrified to invest in most Eurozone banks. The only Eurozone investments I have considered are telecom companies and big international firms (e.g. Siemens). Only a few banks might be worthwhile.
(14) Banco Santander is my one and only Eurozone investment right now. Even Santander is not immune, but they hold about 30 billion in Spanish government debt securities with around 80 billion in equity. Their capital levels are significantly higher than most Eurozone banks and they have much greater diversification, with a huge Latin American presence, as well as a US and UK presence. I’m betting that Santander can survive the worst-case Eurozone scenario, but I could be wrong. I would not make this bet with any other Eurozone bank. Even with Santander, I’m limiting my bet to a smaller chunk of my portfolio.
(15) The thing that makes the Eurozone situation so difficult to invest for is that no one really knows what’s going to happen in the end. The ultimate outcome will be driven by a combination of political considerations and economic realities and it’s difficult to predict where the two will meet. The Euro, itself, could be saved if the Eurozone nations eventually decide it’s in their interest to change the mechanisms behind it. If not, the Eurozone will either dissolve, a few nations will split off from it, or it could just become a big zombie for an extended period of time.
(16) If I had to wager, I’d bet that within the next five years, at least two nations will leave the Eurozone. But this is a shot in the dark, given the potential number of outcomes. My main reason for believing this will occur is that I see virtually no desire to cooperate amongst Eurozone nations. There have been virtually no indications that any nation is willing to sacrifice sovereignty in order to make the Euro work. Or in other words, there’s been no “Constitution moment” as there was in the US in the 1780’s. What seems more likely is that eventually, some populist movement in particular nations push the government to end austerity policies and exit the Eurozone.
(17) It’s worth noting that austerity is only making things worse. The PIIGS have artificially overvalued currencies because the Euro includes stronger economic nations like Germany, Austria, and Finland. This means that assets in the PIIGS are artificially overpriced in relation to their intrinsic value. This, in turn, means there are downward market price pressures until equilibrium prices are hit. Only problem is that deflationary pressures tend to harm debtors enormously, which in turns, harms the banks once the debtors can’t service the debt.
How does austerity solve this problem? With higher taxes and lower government spending. Higher taxes mean that intrinsic value of assets will fall. Lower government spending means that assets produce lesser cash flows, and hence this also decreases the intrinsic value of the assets. So austerity tries to solve the issue of artificially overpriced assets by beating down the intrinsic values further, and hence, making the assets even more artificially overpriced. This creates even greater deflationary pressures and in turn, makes things even worse than before. Austerity would actually work better during an economic boom than during a bust, but it’s almost always enacted during the latter, rather than the former.
That’s all for now. Based on all of this, I am personally limiting my exposure to Eurozone investments to a very minimal amount. Until the underlying issues are resolved, investing in many Eurozone companies may be like investing in the US in 1930. Even my bet on Santander is based on my belief that they have enough geographic diversification and high enough capital levels to absorb future losses inside the Eurozone.