By John L. Chapman, Ph.D.     June 27, 2012    Washington, D.C.

Ahead of the European Council’s meeting this week, which will solve absolutely nothing in the Eurozone other than assuage the rather massive egos of the likes of the new French premier, the level of nervous chatter about a serious global recession borne of a Eurozone meltdown has increased.  But scarce is the pundit or essayist who brings concrete facts – or better said, specific details – about the Eurozone’s many economic challenges to his analysis, and this itself has become a great challenge for both policymakers and investors alike.

To say that Spanish banks are overleveraged and undercapitalized, that Greek aggregate demand does not match up with new fiscal budget targets, or that Euro-periphery bank failures will engender a contagion leading to global recession thanks to collapsing bank balance sheets and concomitant reductions in commercial activity around the world are all statements as startling as they are interesting.  And while they may even be true, the lack of details behind the “facts” that are moving markets now is positively stunning.  If nothing else they recall for us the wise aphorism of Keynes’ teacher, A.C. Pigou, who once famously observed that “…[t]he error of optimism dies in the crisis, but in dying it gives birth to an error of pessimism. This new error is born not an infant, but a giant.”

One legitimate problem, of course, for both investors and policymakers is the opacity of the Eurozone banking system, which mirrors the challenges U.S. investors have had in recent years in wrestling with the valuation of illiquid mortgage-backed securities.  Valuing a firm, of course, starts with valuing its individual assets and liabilities.

Compounding the problem is the emotional response elicited from investors in the wake of platitudes of general concern and fear: investment and entrepreneurial energies are stifled, leading to a downturn via self-fulfilling prophecy.  And in turn, policymakers effectively panic, answering the call to “Do Something”;  their actions may be late if not counter to what response would be most ameliorative, and of course are often aimed at the wrong target (since the “correct” target is buried in the opacity of the economic data).

In researching the Eurozone this week for investing strategy insights, we returned to our long-held belief that macro perspectives can inform micro analytic-based decision-making. And hence in this spirit we have advice for investors and policymakers alike.

 

 

How the Tools of National Income Accounting Can Aid Investors and Policymakers

Following all the proposals for various reforms in Europe, now focused on fiscal harmonization and German underwriting of area-wide “Eurobonds”, we are left shaking our heads in wonderment at the continued “Kabuki dance” of naked emperors there. We’d invite the pundits to dust off their ancient copy of Dornbusch & Fischer and re-read the chapter on national income accounting.  All freshmen economics students learn about the inexorable laws of basic macro-accounting identities, which actually illuminate the Eurozone’s troubles at the moment:

[1]   GDP = C + I + G + NX,    where NX = X – M, and

where GDP is the nation’s gross domestic product or total output represented by aggregating all spending; C is consumption spending; I is business investment spending; G is government spending, and NX is spending on net exports, or, total spending on exports (X) less total spending on imports (M).   (In other words, if spending on imports exceeds the spending on exports, total spending on domestic output is diminished, from a national accounting perspective.)

Further:

[2]   GDP = C + S + T,

Where C is, again, consumption spending, S is total saving, and T represents all tax payments. 

Note that [1] and [2] are equivalent; substituting (X – M) for NX, we see this as

[3]  C + I + G + (X – M) = GDP = C + S + T.

In other words, total economy-wide spending as expressed in macro-aggregates that include business and government institutions is equal to the flow of total income to individuals, which they in turn use in one of three ways: consume current goods, save for future consumption, or pay current taxes (Note: most macroeconomics texts describe these two equations as “sources” and “uses” of spending and income, respectively, that equilibrate at an economy-wide level).

From these are derived the classic interesting and policy-relevant identities, as follows:

After subtracting C from both sides of [3], we derive

[4]  I + G + (X – M)  = S + T.

Rearranging, we have

[5]  (X – M)  = (S + T) – (I + G),    or

[6]  (X – M) + (I + G) – (S + T) = 0, which is equivalent to

(X – M) + I + G – S – T = 0, and again rearranging, becomes

(X – M) + I – S + G – T = 0, which, after grouping and then multiplying all positive-signed expressions by 1, transcribes to

[7]   (X – M) + (I – S) + (G – T) = 0.

Expression [7] is a classic identity in macroeconomics, comprised of three expressions signifying dollar (or, ultimately, resource) flows, whose rich policy implications cannot be ignored or annulled, by Greece, Spain or, for that matter, the United States:

  • (X – M) is an expression of the balance of trade.  If it is > 0, then a nation is running a trade surplus.  A negative sum connotes a trade deficit in goods and services.
  • (I – S) describes the relationship between investment and the aggregate saving to fund it.  If I > S, then a nation must borrow from abroad (or, receive inflows on its capital account due to foreign direct investment) to fund its capital-forming activities.
  • (G – T) is an expression describing the government’s fisc and specifically, degree of budgetary balance.  If G > T, the nation is running a fiscal budget deficit, which must be covered by borrowing, either from abroad, or domestically, in which case citizens’ savings levels must increase.
  • (Note that the above three differences describe the foreign trade, investment, and government sectors, respectively, in terms of their dollar flows between transactors; a fourth relation, domestic consumption, would be shown as (C – C), which is trivially zero.)

In recalling this canonical trilateral relationship of macroeconomic policy, what strikes us is how useful it is in broadly considering investment alternatives, when all are considered together, as well as policy choices and implications.  And also, unfortunately, how misunderstood this tool is, often by practicing economists.

For example, Frederic Bastiat, Milton Friedman, and others are surely correct when they argue that trade accounting is largely irrelevant and, when focused on driving exports, is misguided.  As Bastiat pointed out, a country running a perpetual trade deficit (where X < M) must per force be receiving capital inflows from abroad – that is to say, investment that surely creates jobs and wealth.  This in fact happened all throughout the 19th century, when the U.S. ran perpetual trade deficits but literally built out the continent thanks in great measure to British (and Dutch, etc.) investment capital.

More recently the formula for U.S. growth has been somewhat different.  Like the 19th century, (X – M) has been negative for more than three decades as the U.S. has once again built-up big trade and current account deficits. But unlike the prior era, where there were negligible amounts of government spending and taxation, recent decades in the U.S. have also entailed large fiscal deficits, where there has been a positive relationship for (G –T), and thus the moniker of “twin” (budget and trade) deficits.  By definition, the inflow of foreign savings has made (I – S) less than zero to cover these deficits and balance out the macroeconomic identity.

Both formulas have generally been salutary for economic growth and job creation in the U.S.; in the 19th century the U.S. economy grew well north of 4% annually, according to the empirical work of Christina Romer and others, and beginning in 1983 generated a great prosperity here that ran more or less for 25 years.

The implications from this for policymakers are indeed interesting.  For one thing, in theory, a country could run a permanent, perpetual fiscal budget deficit, and perhaps have it accompanied by a permanent trade deficit, too, if it made up the difference via some level of higher exports and/or, more likely, receiving perpetual saving inflows from abroad.  There are also, self-evidently, multiple routes to prosperity among the three variables, as evinced by the United States in the two different eras.

While empirically indiscernible, though, there is surely in practice an “optimal” level of difference for all three of the macro-accounting identity’s relationships.  For example, and to see how this macro-theorizing can apply to investment analysis, consider Greece. During the Euro-era, Greece has run perpetual trade deficits and fiscal budget deficits, too, in its own mini-version of a twin problem.  On net the country has had to rely on an importation of foreign savings – that is, external holders of Greek debt – to balance out the accounts.  But any country can only rely on foreign sources of funding so long as its creditors believe in its continued creditworthiness.  When that faith is lost, default is on the horizon, as is the case now in the Eurozone.  And hence in spite of the “theory” alluded to above, the practical reality is that the inter-relationships among the variables denoting saving, investing, spending, taxing, importing, and exporting must be internally sustainable, that is to say, believable to trading partners and international creditors or investors.

So far in this analysis we have not mentioned exchange rates, but adding this dimension to the discussion does not materially affect our conclusions.  In the case of the 19th century gold standard or today’s Eurozone, fixed exchange rates prevail, meaning adjustments to these macro-variable relationships must all be axiomatically done with real shifts in magnitude, as described above.  Floating exchange rates afford the benefit of “flexibility” in adjustment, and thus, for example, vis-à-vis its Eurozone trading partners, Greece’s chronic budget and trade deficits would lead, ceteris paribus, to a depreciating currency that would lead to improved exports, a lower real government debt burden, and perhaps “forced savings” where the domestic consumers in Greece were priced out of international markets.  But the identity’s three-part equilibration would still obtain.

What are the Implications of Our Foregoing Analysis?

We have learned the following:

(1)  Countries would be in a permanent and perpetual state of stability if all three differences equaled zero “internally”, by themselves.  That is to say, if internal savings levels covered all investment, if tax levels were sufficient to cover all government spending, and if exports were sufficient to pay for all imports, macroeconomic disturbances would be minimized if not effectively eliminated, due to the economy’s structural balance.  But in the real world, this case never obtains.  The challenge for policymakers is to see to it that any imbalances do not become chronic; for investors, the magnitude of the differences within the accounting identity’s three relationships can provide clues as to any opportunities to pursue, or avoid.

(2)  Greece is going to default, formally, on its debt – per the above, that is axiomatic.  Extending new loans – that is, increasing the “S” in the macro-identity to paper over continuing budget and trade gaps – is a fool’s errand given how out of control the fiscal deficit is.

But herein lies a thesis for a solid investment opportunity.  Given what we know of the future play-out there, any Greek company which sells a quality product or set of services to trading partners who reside in countries with appreciating currencies relative to that in Greece (whether in the Euro or not) will do very well – indefinitely.  For example, Greek-flagged shipping enterprises or tourist/resort properties will unambiguously prosper in a relative sense in the years ahead.

(3)  The question of staying in or leaving the Eurozone is actually separate from the certainty of debt default.  In theory, if Greece could make a credible commitment to fundamental structural reforms, it could stay in the Eurozone, continuing to capture the benefits of a common currency (in the language of Equation [7] above, a newly-chastened Greece would lower “G”, increase “X”, and have greater levels of “I” balanced by the requisite “S”).

But the foregoing analysis leads us to believe, more than we had previously realized, that the political union of a “United States of Europe,” which was the driving idea behind the Euro, is and always was a chimera. Because in fact, the monetary union comes with too great a degree of moral hazard, as seen in the “abuse of privilege” that was permitted to the periphery countries.  And those countries with sound, or in this context, balanced fiscal, trade and capital investment policies will no longer subsidize the recalcitrants.

Hence the Eurozone is going to break apart, though it is impossible to tell whether in whole or in part, and when this will happen.  Because these macro-imbalances are so severe, however, it seems axiomatic to us that the Euro will depreciate in value to a considerable degree, in what should be no more than a few years, along the way to some final devolution.

(4)  For countries like Spain, the necessary pain to be endured is a rebalancing based on lowered government spending and write-down of investments in private portfolios.  Who “takes these hits” and in what degrees of apportionment remain to be seen, but for a country with 25% unemployment already, this is of course a catastrophe.  Further, no level of investor scrutiny from across the Atlantic Ocean would seem enough to ensure a decent chance for a safe return in such an environment, and civil unrest moving from Greece to a country like Spain cannot at all be ruled out.

(5)   Perhaps worst of all, because of the cacophonous haggling involved in any forum involving 17 sovereign nations with massively divergent interests, the likelihood is that Europe will be a drag on the global economy – not to mention its own impoverished citizens, for years to come.  This will stem in the main from multilateral refusal to absorb the inherent losses within the Eurozone’s economy, that is to say, to “kick the can further down the road” in the blind hope that others somehow come to take necessary write-downs.

The best thing that could happen for the Eurozone therefore is a recovering global economy, led by a resurgent United States that assists in the needed structural re-balancing in Europe, and makes the inexorable choices easier to bear.   This is true for Japan as well where, for example, big government deficits and a continued focus on export-driven growth (until very recently), have portended a long-duration investment gap that has meant very low productivity and improvement in living standards.  For Japan, increasing private-sector investment coupled with lowered government spending levels and higher imports (coupled with a gently falling yen) will have the beneficial effect of raising material living standards there while at the same time re-balancing the Japanese economy in order to make it more stable as an international trading partner.

More broadly, the basic macroeconomic identity gives lie to the thesis so popular at the moment, that any decreased level of government spending implies “austerity”.  Seen in a broader macroeconomic framework, decreases in government spending free up resources to allow for a pick-up in private-sector investment, or perhaps improvements to exports.  In the long run, the very best policy mix in terms of inciting growth is to have a minimal-sized government sector alongside strong investment, and a high level of imports that serves a growing and vibrant consumer demand. Until such rebalancing occurs on a global scale, investment will truly be an art, and not a science, in which case idiosyncratic situations will be the order of the day for any alpha returns, especially where overseas diversification is involved.

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.

Click here to sign up for our free weekly e-newsletter.