John Paulson, the President of hedge fund Paulson & Co, is now shorting German bunds. Paulson became famous for his shorts relating to the subprime mortgage crisis in 2008, but has struggled in recent years, with big bets on financials and what one might call “junk stocks.” Yet, this short bet on the German bunds has a chance to succeed in a big way; the only real question to me is one of timing.
Price distortions and trade imbalances created by the Euro are the real problem in Europe. It’s no coincidence that nations like Poland, Norway, and the Czech Republic have been amongst Europe’s best performing economies over the past decade. While these three economies are at different stages of progression, the one commonality is that none are pegged to the Euro.
By making the German currency artificially weak, the Euro has created a situation where Germany has perpetually loose monetary policy and lower-priced exports. Conversely, by making the Spanish and Portuguese currencies artificially strong, those two nations have perpetually strong monetary policies and crippled export industries.
These distortions coalesce to create a net destruction of wealth in the eurozone. The situation is inherently unstable and can only be solved by either fiscal integration or dissolution of the eurozone. Regardless of the solution, the result for German bunds should be the same: a fall in price.
To understand why German bunds must fall, it’s important to understand why the prices are so high (and the yields so low) to begin with. The Euro’s trade distortions have helped create a mirage of prosperity around Germany, which has led many to view German bunds as a “safe haven” in the same sense as US Treasuries. However, there are major differences between the US Dollar and the Euro.
The question of “what is a currency?” is at the heart of the Euro’s struggles. Is the Euro the currency of Spain simply because it’s proclaimed to be so?
Instead, I would argue that Spain has a “natural currency” and by virtue of its sovereignty, that currency cannot be the same as the currency of Germany, France, and Italy. Spain’s “natural currency” may have ceased to exist legally, but economically, this “natural currency” is actually pegged to the Euro.
Once you begin to view the eurozone as a series of currency pegs between “natural currencies”, the distortions become clearer. Under this prism, we can also begin to think of the Euro more as a “basket of currencies” similar to a Special Drawing Right, rather than a true “currency”.
Market Corrections in Sovereign Currencies
At its most basic level, a currency represents the value of all the “Real Assets” of a nation. When the Euro was created, all of the national currencies were pegged at their market values to the Euro. Yet, economies evolve over time and the value of the “Real Assets” in each nation has changed. This means that the value of “the natural currencies” has shifted, as well; yet the Euro basket remains the same. Since the eurozone nations continue to be sovereign entities with no fiscal integration, this is problematic.
In a sovereign nation that issued its own currency, movements could be corrected by market mechanisms. For example, let’s assume that the US has “Real Assets” of 100 and there are 100 US Dollars. This is not a completely realistic, because it’s unlikely that we’d need currency to represent every single asset in a nation, but let’s assume we do in order to make our example simpler to understand. So if we have 100 Real Assets and 100 US Dollar, then that means that 1 US Dollar represents 1 Real Asset.
Now let’s say that an entire US city is destroyed (but no currency is destroyed), resulting in a fall of Real Assets to 90. The Dollar would need to weaken in order to correct this disparity. Each Dollar should now only be worth 0.9 Real Assets. If the Dollar were not allowed to weaken for any reason, the US would have to sell its exports at inflated prices, making them less attractive; so it’s actually quite vital that the Dollar depreciate in this scenario, as it allows the market to hit its natural equilibrium state.
How the Eurozone is Different
The eurozone is not quite like the United States.
Let’s simplify things a bit and imagine that the eurozone is a 10 nation union; each nation has 100 Real Assets, and 100 Euros to represent it. So the overall eurozone starts with 1,000 Real Assets and 1,000 Euros.
Let’s run the same scenario we did with the US on Spain. Spain is now down to 90 Real Assets. Yet, the number of Real Assets in the entire eurozone only fell to 990. Since we still have 1,000 Euros that means that 1 Euro represents 0.99 Real Assets.
Compare that to our US scenario and notice what happened. Spain did not receive the full benefit of the market correction such as the US did with its sovereign currency. Instead, it only received 1/10 of the benefit, while the other 9/10 was redistributed to the other nine nations in the currency union.
Since Spain only received 1/10 of the benefit from the currency correction, Spain’s exports are now priced artificially high, which results in a lower national income. This also makes it more difficult for Spain to service its debt, particularly since its debt is in an “external currency” in a real economic sense.
Market observers see this and begin to demand a higher yield on Spanish debt due to the higher risk. These higher costs of borrowing then force the government to cut spending. But cutting government spending results in lower cash flows (and hence, lower value) for all assets, putting more downward pressure on prices and income.
The result: the currency must weaken some more. But once again, Spain is only able to receive 1/10 of the benefit in our example. In essence, Spain is trapped in a deflationary spiral. Its economy cannot correct, because it must continue to redistribute the benefits of a weaker currency to the other eurozone member nations.
Why German Bunds Must Fall
The reason why German bunds must fall relates to all of this. In our example with Spain, note that Germany maintained its same “Real Asset” level of 100, implying a “natural currency” value of 1 to 1. Yet, one Euro now represents 0.99 Real Assets. Since Germany is pegged to the Euro, it is able to sell its exports at artificially cheap prices in this scenario.
This results in higher income for Germany, which lowers the risk to its lenders (at least on paper). Lower risk means lower yields (and higher prices) for debt. In short, Germany receives a double benefit. The Euro is a redistributionary currency in this sense. By artificially strengthening the Spanish currency, Spain’s has high-priced exports which result in lower income, which then results in greater insolvency risks, and higher debt costs. Conversely, by artificially weakening the German currency, Germany has low-priced exports, greater income, lower insolvency risks, and lower debt costs.
Germany is the clear winner, but there’s one big problem: Germany’s gains are contingent on nations like Spain, Greece, and Portugal perpetually losing wealth. Those nations can only go on for so long before they become completely insolvent. This becomes a problem for Germany, because it can only keep its economic machine running by finding a way to allow these weaker nations to stay alive, while also using the currency distortions to redistribute more wealth to its own citizens. It’s not a sustainable situation.
Let’s also explore another theme. If each nation has its own “natural currency”, then each nation should have its own monetary policy. But since each nation is forced to the middle by the collective currency, instead we see a situation where Germany should have higher interest rates, but deflationary currents in other parts of the eurozone keep those rates suppressed. Meanwhile, Portugal and Spain should have lower interest rates, but the Euro keeps those rates artificially high.
There are two major permanent solutions to the crisis, but there are many variations of these two solutions. The first solution is fiscal integration. The second is dissolution. And Germany’s trouble is that it doesn’t matter which one it picks, it will cause natural economic forces to rear their ugly head.
Fiscal integration could be achieved by a few different mechanisms, but the most commonly mentioned one is the Eurobond. Instead of each nation issuing its own currencies, Eurobonds would be used to finance debt. This means interest rates would shift towards a “middle point”, in the same way the value of the Euro does. Notice that this helps Spain, Portugal, and Italy finance their debts since they will be able to obtain lower market interest rates. On the other end of the spectrum, it results in Germany having higher interest rates.
What would that mean for Germany? For starters, it would mean tighter effective monetary policy that would likely result in a contraction in its exports. It’s not completely clear to me what would happen to the old German bunds, but one way or another; German interest rates would increase, resulting in a lower value.
The other obvious solution would be to kick Spain, Portugal, and Greece out of the eurozone. That’s problematic for Germany, as well. Remember, Germany’s export gains and higher income are the result of being able to peg its “natural currency” to a weaker basket of currencies (the Euro). This basket would strengthen once Spain, Portugal, and Greece are gone, resulting in reduced exports for Germany, lower income, and a higher relative debt load. Since interest rates are held artificially low by the deflation of the troubled nations, it stands to reason that German bunds would get hit here, as well.
If Germany loses out either way, what does that leave? Mainly the solution that Germany has preferred thus far: kicking the can down the road. But remember, that solution requires that Germany constantly take its own resources and redistribute them back to Spain, Portugal, Greece, etc. Eventually, Germany finds its own debt load rising and investors begin to see that it, in fact, has significant risks, as well. This results in lower prices and higher yields for German bunds, as well.
Overall, I see Germany as being in a lose-lose-lose situation right now and German bunds are much riskier than the market believes.
Fiscal Integration Not That Appealing
Even if Germany is in a lose-lose, we can still argue over what the best solution for the overall union. I’ve mentioned that fiscal integration and dissolution are the two major permanent solutions. Cullen Roche of Pragmatic Capitalism, has argued for awhile that a fiscal union is the best outcome; as has famous hedge fund investor George Soros.
My views differ a bit from Roche and Soros. While fiscal integration would solve some of the obvious economic distortions created by the eurozone, it would also likely lead to German political dominance over the union, which would be highly detrimental to nations like Spain, Portugal, and Ireland.
While the United States is generally viewed as a successful model, I’d argue this isn’t completely true. The US really only became a fully successful nation after the Great Depression when it abandoned the mercantilistic trade policies that had kept the Southern states in poverty. The Southern US only began to catch up with the North in the second half of the 20th Century. So it’s true that many Northern states achieved great success in the 19th Century, but almost the entire South (and other more rural areas of the country) suffered as a result.
This is not to imply that a German dominated eurozone would result in tariffs, but it would not be surprising if German interests dominated the union and enacted policies that would benefit themselves at the expense of nations like Portugal and Spain. So fiscal integration might result in an economic solution to the crisis, but would also likely result in greater long-term poverty for places like Spain, Ireland, and Portugal, as they are unable to meet their own needs as effectively as they could with complete sovereignty.
Unfortunately, while Germany will probably gain most of the benefits, this still does not mean that German bunds would be a good bet – at least not at current levels, because fiscal integration would still result in German interest rates rising in the short-term.
Shorting German bunds (BUNL) could very well work out for Paulson. Timing is the only real issue. How much longer can Germany continue to drag the crisis on, before having to take decisive action? It’s possible this charade could last a few more years.
Yet, even if it does, maybe a German bund short is not that dangerous. Recent sells have been at record low yields. While yields could possibly fall a bit more, the losses would be somewhat limited by the fact that prices are already near the floor. Meanwhile, the upside scenario is that the German bund yields skyrocket either after the eurozone kicks out a few members, or Germany is forced to “bail out” Spain.
What This Means for Eurozone Investing
If Greece, Spain, or Portugal exit the eurozone, there will be major opportunities. A best case scenario would be total eurozone dissolution, in which case, I’d start looking at some relatively cheap European companies, such as France Telecom (FTE) and Telefonica (TEF).
At the same time, I’d keep away from eurozone investing completely until it’s clear that there’s some solution to the crisis. It will not resolve itself and it is not “cyclical” in nature. This is a structural problem that will continue to destroy wealth inside the eurozone until a permanent solution is found.