The Fate of the Euro, and Euro Investors

By John L. Chapman, Ph.D.        June 17, 2012       Washington, D.C.

The world economy is truly suspended on a knife’s edge at the moment, as events in Europe push toward a settlement after years of reckoning postponement.  Global stock markets, led by undervalued U.S. equities, would soar in the event of credible commitment to fiscal discipline and reasonably-apportioned recognition of losses.  Alas, that is unlikely for a while longer at least, and it is hard not to like a stronger dollar vis-à-vis the euro in the next few years.

When Mario Draghi was studying economics in M.I.T.’s vaunted department under the tutelage of Nobel Prize winners Franco Modigliani and Robert Solow during the misery of the 1970s sclerotic-growth era of stagflation, he could not have imagined that one day he was to stand astride the European continent in a storm now showing itself to be far more intransigent than that era’s investment-dulling global monetary instability.  Nor could he have appreciated the irony in later meeting his fellow M.I.T. alums from the same era, Ben Bernanke and the Bank of England’s Mervyn King, on the same stage, 35 years hence.

But old-school habits die hard, and the one thing in common all three men cling to is an inner-core belief in the sanctity of the Keynesian paradigm, especially as it relates to policy activism– albeit expressed  after Keynes – embodied in the Phillips Curve.  The brainchild and work of the LSE economist A.W. Phillips, the central idea posited by the Phillips Curve is that there is an inverse relationship between monetary shocks and, ultimately, unemployment.  Its adherents are predisposed therefore to monetary policy activism, thinking that it can jump-start real variables.  That’s worth remembering in the current moment, with a vote in Greece, banking woes in Spain, new debt threats in Ireland and Italy, and a continent mired in recession and averaging 0% growth; indeed Mr. Draghi, who is supposedly bound by one sole mandate at the European Central Bank – price stability across the Eurozone in which inflation is not to exceed 2% per year – is most assuredly soon to be swept up in events that may overtake him.

A Brief Recounting of the Path That Led Us Here          

How have we come to such a place, where global investors are on a collective hair-trigger, awaiting a vote in Greece between what might be considered a standard Leftist, high-tax, pro-redistributive party (New Democracy) and a more virulent group of socialists (Coalition of the Radical Left, or “Syriza”), both of whom profess a desire to pursue policies to remain in the Eurozone, and both of whom have hinted at the need to “restructure” the prior-agreed bailout measures calling for more fiscal discipline? (Indeed, the only appreciable difference between the two we have been able to discern is the relative degree of emotional intensity between the two parties, with respect to their dislike of “German-imposed austerity”.)

In fact, the past history here is as simple as it is forgotten, but needs to be recounted so as to apprehend the logic of what must follow.  While the problem of European monetary integration had long been studied, and put forth by optimum currency area proponents such as economist Robert Mundell (the intellectual “father of the Euro”), it is nonetheless true that the single-currency Eurozone is first and foremost a political creation, crafted by EU bureaucrats and managed in Brussels – and not, therefore, an economic outcome generated by a market process.  This is in fact critical to understand, because by definition it was always therefore going to be subject to the machinations and manipulations of the political class, and hence less stable, than outcomes generated in free markets.

Launched in 1999, the European Central Bank demanded that Eurozone members (now up to 17 sovereign nations) adhere to the fiscal guidelines of the Maastricht Treaty, in which no nation was to run an annual budget deficit greater than 3% of GDP, or achieve national debt levels greater than 60% of GDP.  In turn, the ECB was to pursue one policy target of low inflation (<2%).  This was of course correct as far as policy intent to stabilize the currency, but there were no enforcement mechanisms put in place to ensure compliance (and, as we now know, at least in the case of Greece the Eurozone “application” documentation was false).

It was the lack of enforcement mechanisms that would thus encourage political manipulation by the several countries in the Eurozone that in turn led Milton Friedman, as far back as 1998, to predict its likely demise.  Mr. Friedman felt certain that the welfare states of Europe would over-run their fiscal obligations (and indeed, even Germany has gone beyond 3% budget deficits, let alone the weaker peripheral economies), leading to the need to adjust relative bilateral relationships in trade, costs, inflation and output levels.  But since such adjustments could not be borne by freely-floating exchange rates, there would be adjustments in real variables, most prominently in the recalcitrant countries whose incomes would need to fall as costs and interest rates rose.  Mr. Friedman further reasoned that such costs, in the form of a lower standard of living, would not easily be borne by the weak or profligate economies in the Eurozone, and hence absent the ability to adjust relative currency values, they would seek to exit the currency area, likely after default. 

In essence, Friedman’s ruminations are exactly what have come to pass, only in far more virulent fashion than he might have imagined.

What Now, for the Euro and for Investors?

As George Mason University’s Lawrence White reminds us, had the ECB “stuck to its guns” regarding the maintenance of a strong currency, it would have refused to monetize the debt of the recalcitrant governments (the “PIIGS”) in the Eurozone, but this would have been a problem for those governments, not for the Euro itself.  By participating in the multilateral push to backstop first Greece and then Spain and, to a lesser extent, Ireland, Italy, and Portugal (other parties include the IMF, the European Financial Stability Facility [EFSF] and its permanent counterpart, the European Stability Mechanism [ESM], and ultimately, we fear, the Federal Reserve), the ECB is indeed creating a problem for the euro itself.  In fact the ultimate break-up of the entire currency union is now more, not less, likely: a default of a recalcitrant Greece in the face of a stern ECB would have had salutary effects on all the other profligate governments as well as, ultimately, Greece itself in the future.

It is further important to point out that the multiple bail-out rounds and continual infusions of capital to insolvent banks, or loans to profligate and indebted governments, only tend to postpone the “day of reckoning”, as has happened here.  The age-old distinction in classical banking between liquidity and solvency often gets obfuscated in the modern era, particularly by modern elites who have a vested interest in “socializing” what should be the private losses of individual firms, or in broadening taxpayer burdens imposed by fiscally imprudent governments.

For Greece itself, the future is grim. Now mired in its fifth year of recession an third full year of its debt crisis, with falling incomes and 22% unemployment, the country has lurched into a downward spiral that promises years of pain no matter what happens in near term voting.  The years of growth propelled by a phony equivalence of Greece’s creditworthiness to that of Germany are now long over.  As such, we do not place too much importance on near-term political shifts there (though we still fear very short term market gyrations beginning this week): we still expect the music to stop at some point and Greece to leave the Eurozone.  To the degree this is true it is of course preferable that it be sooner rather than later as the costs of the exit increase with time.

For the rest of the Eurozone, years of torpor appear to be in the making. A Greek default may stiffen spines, and lead to some sort of arrangement heretofore unreachable by the affected parties: to wit, the German government agrees to lead a debt-workout and bank-recapitalization consortium that includes the IMF (and hence the U.S. tax-payer) and ECB as well as the extant European taxpayer-backed rescue facilities, all of whom agree to work with a chastened Spain, Portugal, and others in debt reduction and loan work-outs.  The sovereign debts and bad paper of the banks would be covered (via fiscal coordination in terms of eurobond issuance) in return for new fiscal strictures – again, all driven by (seemingly) a newly chastened political leadership in Europe.

This of course is not a certainty: the German government may throw in the towel, even after Greece leaves the Eurozone) and reclaim the Deutsche Mark, or to a lesser degree, agree to maintain the euro with its “northern” faction of more stable fiscal governments (e.g., Finland, Austria, the Netherlands), and leave the “southern” governments to their fate, with each country worrying about its own banking system. 

In either eventuality, we do not see how the euro maintains its current value against the dollar (having traded down from the mid-$1.40s to $1.26), at least in the short to intermediate term.  Indeed, one outcome of the votes and meetings of political elites in the next few weeks (G20 in Mexico June 18-19, and then the EU summit June 28-29) may be to reinforce how feckless they all are, leading to the realization that the disastrous unemployment situation in the PIIGS countries (all 15-25%, with youth unemployment rates between 30-50%, and 11% across the Eurozone), coupled with falling incomes and increasing debt levels, can only end in a falling euro, perhaps dramatically so.

Investors should therefore tread carefully across Europe, looking for high—quality growth stories in individual companies, or in the debt of the stronger sovereigns, if a play on deflation – not an unwise move in the near term – is desired.

For U.S. investors, the situation is mixed: U.S. companies have had months to prepare for the Greek exit and associated turmoil, so direct exposure is limited.  But at a broad level, little thought is given to the fact that Fed swap lines with the ECB and other central banks, supplying dollars in exchange for euros, are not riskless, in this environment.  Further, the ongoing torpor in Europe, which threatens more Leftist governments in a political backlash against necessary corrective declines in living standards in recalcitrant nations, hangs over U.S. and indeed global investment.  The wide range of possible outcomes in Europe – how, for example, will Spain ever get solved if the Spanish cannot cut the Gordian knot that currently intermixes gargantuan unemployment rates and declining incomes with the need to reduce fiscal deficits – is matched in mirror fashion by that in the United States: this is manifested in gold that is still above $1600 and held by inflation-phobes alongside a ten year Treasury note that has traded recently at 1.46%, and is snapped up by equally fearful deflation-phobes.

Missing from the mix is any real movement toward pro-growth policies that would induce saving, investment, and a much-needed global recapitalization.  In the United States, the November election is, more than anything else, central to some resolution for investors.  But let us end on a hopeful note: there is a plausible path to a brighter tomorrow which would imply the re-equitization of national economies today.  Put simply, the choice facing the Europeans – led in its decisions by Germany – is for greater fiscal coordination (as stated above, likely in the form of German acquiescence to a backstop program for the continent and its $2 trillion in bad loans post-Greece departure, when Germany may have greater leverage in how things are structured in countries like Spain) or an end to monetary union, ultimately.  If a small miracle happened that led to such fiscal prudence by chastened Eurozone actors, and this were coupled with new pro-growth policies in the United States next year, equities would rally yet here in 2012 around the globe, and growth prospects would be brighter.

We concede this is a big “if”, but the answers begin to arrive this week.  For the U.S., we do look for policy shifts that will move equities eventually.  But the ride between now and then is sure to be a bumpy one given the ongoing drama – and real-life Greek tragedy – played out at the moment before our very eyes.   

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, John Chapman can be reached at john.chapman@4kb.d43.myftpupload.com. The views expressed here are solely those of the author, and do not necessarily reflect that of colleagues at Alhambra Partners or any of its affiliates.

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