By John Mauldin
"If we want
everything to stay as it is, everything will have to change."
– from The
Leopard by Giuseppe Tomasi di Lamedusa
"The crisis
takes a much longer time coming than you think, and then it happens much faster
than you would have thought, and that's sort of exactly the Mexican story. It
took forever and then it took a night."
– Rudiger
Dornbusch
Europe's leaders are committed to keeping both the euro and the eurozone as
it is. But for it to do so, everything must change, as the wonderful quote from
the 1958 Italian novel suggests. This is no easy task, as no one wants a change
that will impact them negatively; and there is no change that will allow things
to stay the same that does not impact all severely, as we will see.
The choices we
make today are constrained by the choices we made in the past, and the choices
we make in the future will be limited by the choices we make today. Europe
chose to create a free trade
zone, and then some of the countries proceeded to lock themselves into the gold standard of a single currency, relinquishing the ability to adjust any imbalances in their economies by changes in the prices of their own currencies.
zone, and then some of the countries proceeded to lock themselves into the gold standard of a single currency, relinquishing the ability to adjust any imbalances in their economies by changes in the prices of their own currencies.
Interest rates for the southern tier of Europe dropped to levels never
available to them before, and those countries responded by borrowing
ever-increasing amounts of money to finance current spending. Then came the
credit crisis, and budgets simply ballooned out of control, and debts began to
get to levels that made the bond markets ask for ever-higher rates, as concerns
about sovereign defaults began to rise.
This problem was compounded by the fact that European banking institutions
were allowed to leverage their purchases of sovereign debt by 30 or 40 to 1
their actual capital. That means even a default by a small country has
potentially big ramifications. As it became clear that Greece was in trouble,
European leaders at first thought that if Greece was given some time, it could
get its budget deficit under control and then once again gain access to the
bond market.
In the summer of last year, after dithering through some 40-odd summits, it
began to dawn on European leaders that it was not a short-term liquidity crisis
they had on their hands but a solvency crisis. A fact that numerous
commentators had been pointing out to them for quite some time. And as Greece
began shake and bake its way to "austerity," the very act of cutting
deficits pushed the country into recession, which lowered tax revenues and
increased expenses, putting the elusive goal of a balanced budget even further
off. We should quickly note that this is not just a Greek problem. Spain's
"draconian" cuts have meant that its 6% deficit target for the year
has this week been raised to a more likely 8%, making it harder to get back to
even.
For country after country, this is the Endgame. It is the end of the Debt
Supercycle. Debt has grown to the size that it cannot be sustained. The market
will not lend any more money on terms that can be afforded, and any efforts to
cut spending and raise taxes will result in an even worse economy, in various
degrees of recession, with falling revenues and rising costs.
Europe has three main problems.
1. A growing
number of its countries are insolvent or close to it. It is increasingly likely
that the only way forward is for defaults of some type, to lessen the burden of
debt to a level where it can be dealt with and that will allow the countries
the possibility of growth, which is the only real answer to the problems they
face.
2. Because of
growing fears of multiple defaults (just Greece would be bad enough!) most of
the banks in Europe are seen to be insolvent and in need of hundreds of
billions of euros of new capital. The interbank market in Europe is in a
shambles, and banks park their cash with the ECB, at a lower rate of return, as
that is the only institution they trust. They clearly do not trust each other.
As an aside, I heard from many sources while I was Hong Kong and Singapore,
meeting with readers and friends, that European banks (especially French) are
cutting back on their trade lending, which is making normal commerce more
difficult. Didn't we just go through that in 2008?
3. The real problem
in Europe is the massive trade imbalances between the peripheral countries and
the so-called core countries. Without the ability to adjust currencies, those
trade imbalances will render any debt solution moot, as a country cannot
balance its budget while it runs a trade deficit and its citizens and
businesses also deleverage. I have written about this arithmetic problem on
numerous occasions. There must be balance or there must be a mechanism to
achieve balance.
One cannot solve one problem without solving all three. Either they all get
done or none truly get done. You can kick the can down the road by solving
problems 1 and 2, but problem 3 will put you shortly back to square one.
Europe is now trying to address problems 1 and 2. They are talking about a
"new treaty" that will require austerity of a real kind, although I
understand that Germany has put in a clause that gives it some extra time to
achieve its own balanced budget. And the ECB is
dispensing euros through the back door to banks, in exchange for anything resembling collateral. Not directly of course, as that is prohibited, but the same thing is being accomplished, despite objections in some quarters, mostly German.
dispensing euros through the back door to banks, in exchange for anything resembling collateral. Not directly of course, as that is prohibited, but the same thing is being accomplished, despite objections in some quarters, mostly German.
It was late in September of 1998. I was flying from New York to Bermuda to
speak at a hedge fund conference, and found myself upgraded at the last minute,
back in the day when I did not fly that much, so I was feeling rather happy. As
the door closed, a patrician-looking gentleman stepped in and came and sat next
to me, immediately picking up a file and burrowing into it. I had a book and
the Wall Street Journal, so I was content to read.
As soon as we took off, he asked for a scotch. He proceeded, over the next
hour, to wage a very aggressive war on the diminishing cache of scotch bottles
stored on board. (No, it was not Art Cashin. He doesn't fly.) It was an arduous
campaign, but he was fully committed to winning.
He glanced over to my Journal and noted some headline
about the crisis that had occurred the previous week. I had been following the
extreme market volatility with interest, but this was in the first decade of
the internet, so most of what you came by you still read in print or heard on
the phone.
"They don't really know how close we came," he shuddered, his
eyes showing the first signs of emotion – and fear – I had seen from him. That
piqued my interest, and I engaged him, though without touching his precious
hoard of scotch. I settled for a nice chardonnay. It turned out he was the
second-ranking executive at one of the three largest banks in the country. He
had been at the table in the NY Fed boardroom when 14 banks were forced to put
in $3.625 billion to keep Long Term Capital from collapsing, with only Bear
Stearns declining (one of the reasons they had no friends ten years later). The
NY Fed president had essentially called all the heads of the banks, told them
to be in the room, not to send proxies, and to bring their checkbooks. There
was subsequently a lot of criticism of the Fed, but they did what a central
bank is supposed to do in times like that: they made the children play nice in
the sandbox. They were the only entity that could force the various monster-ego
players to even sit in the same room with each other.
"No one will ever really know," he said again. But of course,
soon everyone did, as Roger Lowenstein wrote the must-read real-life thriller When
Genius Failed.
"We walked to the edge of the abyss, and we looked over." He
proceeded to regale me with the stories of the negotiations, as the immensity
of what would happen if they allowed the collapse dawned on the group one by
one. They all had exposure to LTCM but did not realize the extent of it until
it was too late. Looking back, it might have looked something like the credit
crisis of 2008 if they had not acted, except it would have happened much
faster.
I can tell you that no one in that room wanted to write a $300-million
check. It was not good for their careers. Interestingly, after two years the
fund was liquidated and the banks got back their capital plus a small profit.
Now, the bankers and leaders of Europe are getting ready to walk to the
edge of the Abyss. It will be a long way down, and look like the 7th level
of Dante's Inferno.
Their first real look will come in the next few weeks, as Greece is
negotiating aggressively with its lenders as to how much of a haircut they will
receive and what sort of guarantees Greece will provide on the remaining debt
(they are balking at putting the new bonds in a legal jurisdiction that will
have some real bite if they default again, which they will). They are also
negotiating with Europe about how much additional real austerity they will have
to endure in order to be allowed to take on more debt. If they walk away and
there is an uncoordinated default, it will guarantee chaos. Bank collateral
will collapse and credit default swaps will be triggered, including many sold
by European banks that are already essentially insolvent.
The legal euphemism here is that if debtors "voluntarily" accept
a 50% haircut, then no credit default swap protections will be triggered on
those positions. But not all parties want to voluntarily take that loss (or an
even greater one). If they are forced to do so, then the credit default swaps
they bought come into effect. Greece can legislatively force them to take the
haircut, but CDS contracts are written in such a way that that action would be
seen as a loss, triggering the CDS insurance. The governments involved want everyone
to accept, so there is no crisis. The funds simply want as much money as they
can get back, and many are playing a very hard-nosed game.
Can the holdouts be enticed with sweeteners that not all may get? Maybe
different collateral? Or shorter terms, or …?
The sad thing is that a 50% cut of the private lenders only gets Greece
back to what will soon be 120% debt-to-GDP, from the current 170% and rising.
120% (which I consider optimistic) is just another, lesser form of insolvency,
as Italy now understands. And if Italy is under pressure at 120%, then it is
almost a given that the market would see Greece as still insolvent.
There is at least one unintended consequence arising from the Greek
settlement negotiations. Private investors thought they were buying a bond that
was "pari passu," or equal with all other Greek sovereign debt. It
now turns out they were buying junior, second-tier, subordinated debt.
Something like a second mortgage on a home. You will take the first loss, so
you then charge accordingly. But it now seems that the ECB, the IMF, and
European public institutions are "more equal" than the private
parties and will not have to share in the losses. The private lenders have
found out they were taking subordinated risks while only getting senior-rate
returns.
It the public lenders were involved in the haircuts, then maybe it would
only have to be a 30% haircut, or if it was 50% it would be enough to maybe get
Greece to the point where it might have a chance; and the remainder of the debt
would be in better shape, rather than this just being the negotiations for the
first haircut, with more to follow.
Every private lender in Europe now recognizes they are taking more risk
when they invest in a sovereign debt instrument. This will have the effect of
pushing rates up in the private market, like they have very recently climbed
for Portugal (more on Portugal later).
Europe faces a set of choices. They can lend Greece more money on promises
to turn things around, which can't happen because of (1) the very austerity
being imposed and (2) the 10% of GDP trade imbalance with the rest of Europe.
But if they don't lend the money and there is an uncontrolled default, they
will get to inspect that Abyss more closely than they would like. It will mean
hundreds of billions of euros in losses at their banks, which will have to be
bailed out eventually by taxpayers.
Europe is worried about "contagion." If Greece gets a 50%
reduction on its debt, will not Portugal point out that they deserve it more?
There have been deep fiscal cuts by the free-market government of Pedro Passos
Coelho in an attempt to reduce the deficits, but estimates are that, even with
those cuts, the deficit will still be 6%, falling only to 4% in 2013. And that
is if things go well.
The market is not acting as if it expects things to go well. Yields on
Portugal's 10-year bonds climbed to 14.39% on Thursday. Credit default swaps
measuring bond risk have reached 1270 points, pricing a two-thirds chance of
default over the next five years.
While Portugal's public debt of 113pc of GDP is lower than Greece's, the
private sector has much larger debts and the country's total debt load is
higher, at 360pc of GDP – much of it external debt. Jürgen Michels, Europe
economist at Citigroup, says, "Without a sizeable haircut to its debt
stock, Portugal will not be able to move into a viable fiscal path. We expect a
haircut of 35pc at the end of 2012 or in 2013."
Ambrose Evans-Pritchard, writing in the London Telegraph (I
really like his work), notes:
"Portugal is a troubling case for EU officials, who insist that Greece
is a 'one-off' case rather than the first of a string of countries trapped in a
deeper North-South structural rift. The official line is that Portugal will
pull through because it has grasped the nettle of retrenchment and reform.
"Europe's leaders have vowed that there will be no forced 'haircuts'
for holders of Portuguese bonds. If the country now spirals into a Grecian
vortex as well they will have to repudiate that promise or accept that EU
taxpayers will have to shoulder the burden of debt restructuring. While all
eyes are on Greece, it is the slower drama in Portugal that will ultimately
determine the fate of the eurozone."
Let's turn to some charts from a well-written report called "The
European Crisis Deepens," from the Petersen Institute, by Peter Boone and
Simon Johnson. Both authors have a long list of credentials.
The first one is a chart of the cost of five-year credit default swaps.
Notice they all are rising. (This is a log chart, so the scale rises by a
factor of ten for each level.) Now, notice that Portugal is where Greece was
last year. Then pay attention to the fact that Italy is likewise where Portugal
was last year. Just thought I would give you a preview of coming attractions,
horror-movie edition.
Then they offer us this chart, which compares the labor-unit costs of six
countries in Europe. Only Ireland has seen their costs drop, as their labor has
accepted pay cuts and productivity has increased. And pay attention to the
ever-rising costs of France vs. Germany. This trend suggests France is on a
path that Greece took. There are dragons down that path.
And it also illustrates the problem of why it will be so hard for Greece to
turn around without being able to resort to a currency devaluation. They have
to endure a 30% pay cut relative to core Europe if they want to compete. There
will be no volunteers in Greece for such cuts. After two years of IMF and
European institutional involvement (meddling?) in Greece, there has been hardly
any movement in Greek labor costs.
Greece is not alone. Are you reading of any general pay cuts in the
proposed solutions for Italy, where labor costs are now above those of Greece?
Likewise, no move in Portugal (not shown in graph). The entire eurozone is out
of balance, and no one is making any moves to deal with it or even acknowledge
the basic problem.
Much of establishment Europe was predicting a positive GDP for the region
only a month ago. The recent trend suggests the data they were smoking was
hallucinogenic. And given the seriousness of the problem, it must have been
primo stuff. Germany was in recession for the 4th quarter of
last year and is likely to be there this quarter, which is the technical
definition of recession. Clearly, peripheral Europe is in recession, some
countries in what looks like it could be called a depression. Below is the
Purchasing Manager's Index for six major countries in Europe. I have added a
thick red line at the 50 mark, below which there is negative growth.
With all of the above as a backdrop, let's now see if I can outline the
choices Europe faces. First, let's take Greece, because it is instructive.
Greece has two choices. They can choose Disaster A, which is to stay in the
euro, cutting spending and raising taxes so they can qualify for yet another
bailout; negotiating more defaults; getting further behind on their balance of
payments; and suffering along with a lack of medicine, energy, and other goods
they need. They will be mired in a depression for a generation. Demonstrations
will get ever larger and uglier, as the government has to make even more cuts
to deal with decreasing revenues, as 2.5% of their GDP in euros leaves the
country each month. There is a run on their banks. Any Greek who can is getting
his money out.
Greek voters will then blame whichever political group was responsible for
choosing Disaster A and vote them out, as the opposition calls for Greece to
exit the euro. Which is of course Disaster B.
Leaving the euro is a nightmare of biblical proportions, equivalent to
about 7 of the 10 plagues that visited Egypt. First there is a banking holiday,
then all accounts are converted to drachmas and all pensions and government pay
is now in drachmas. What about private contracts made in euros with non-Greek
businesses? And it is one thing to convert all the electronic money and cash in
the banks; but how do you get Greeks to turn in their euros for drachmas, when
they can cross the border and buy goods at lower prices, as inflation and/or
outright devaluation will follow any change of currency. It has to. That is the
whole point.
So how do you get Zorba and Deimos to willingly turn in their remaining
cash euros? You can close the borders, but that creates a black market for
euros – and the Greeks have been smuggling through their hills for centuries.
And how do you close the fishing villages, where their cousin from Italy meets
them in the Mediterranean for a little currency exchange? What about non-Greek
businesses that built apartments or condos and sold them? They now get paid in
depreciating drachmas, while having to cover their euro costs back home? Not to
mention, how do you get "hard" currency to buy medicine, energy,
food, military supplies, etc.? The list goes on and on. It is a lawyer's dream.
There is a third choice, Disaster C, which is worse than both of the above.
Greece can stay in the euro and default on all debt, which cuts them off
completely from the bond market for some time to come. This forces them to make
drastic cuts in all government services and payments (salaries, pensions etc.),
and suffer a capital D Depression, as they must balance their trade payments
overnight, or do without. Then they choose Disaster B anyway.
The only real options are Disaster A or Disaster B. Whether they opt to go
straight to the drachma (Disaster B) is only a matter of timing. They will get
there soon enough.
Why then do they wait? What's the point of going through all these motions?
Because Europe fears a disorderly Disaster B. For the rest of Europe, it is the
Abyss. The Greek hope is that Europe (read Germany) keeps funding them in order
to keep back from the edge of the Abyss.
As one European diplomat noted, "There is a growing sense that despite
the valiant efforts of Papademos … the reluctant Greek establishment is biding
its time to the next elections, banking on the assumption that the world will
continue to bail them out, no matter what."
Europe is getting closer to the point where it must make a decision about
what to do with Greece. In theory, the deadline is March 29 for the next round
of funding. It is a game with very high stakes and deadly serious players. Can
Sarkozy be seen as weak and giving in to Greece, with elections coming up in
April? Can Merkel appear to give in and keep her troops in line? There are
elections not long after that in Greece. Can Papademos cave in to further cuts
and promises on future debt that will be hard to keep and intensely unpopular?
The markets are getting exhausted. There will be no private market for
Greek debt at any number close to what is sustainable. Greece will be on
European life support for a very long time if they stay in and there is no
disorderly default. It will mean hundreds of billions of euros over the decade,
debt forgiveness, etc. There are no good choices.
And Europe will all too soon face what to do with Portugal, which will want
to dispense some haircuts of its own. Don't forget Ireland, which is very
serious about not paying the debt the previous government took on for its banks
in order to pay British, German, and French banks. That is a default that is in
the cards. I think "polite" Ireland is just waiting until its
$60-billion default is seen as small potatoes, which will not be too long, as
Italy must raise almost €350 billion just to roll over current debt. Italy
projects that its deficit will be down to 2%, but if Europe goes into recession
that projection goes out the window.
The bottom line is that Italy (and most likely Spain at some point) cannot
raise the debt it needs at rates it can afford without massive European Central
Bank involvement. Rates are already approaching 7% again. That is unsustainable
from an Italian point of view. Germany must be willing to allow the ECB to take
on massive balance-sheet debt, or Italy will not make it without haircuts. And
a mere 10% haircut for Italy dwarfs what is happening in Greece – and doesn't
do much for Italy. If they go for a haircut, it will be much larger. French
banks holds 45% of Italian debt. Italy is too big for France to save. They
cannot even backstop their banks if Italy becomes a solvency risk. They simply
cannot get their hands on that much money without destroying their balance
sheet. The most recent downgrade of their debt was just the first of many.
Speaking of downgrades, Egan Jones downgraded Germany from AA to AA- and
put the country on negative watch. This is important, as this is what I believe
to be the most credible rating agency; and over 95% of the time the other
"Big 3" agencies generally follow their lead, after a period of time.
Part of the reason for the downgrade is all the debt that Germany is
guaranteeing. Sean Egan was one of the first serious analysts to suggest that
Greece would default. He was talking a 95% eventual default a long time ago.
(Very nice gentleman, by the way. Or maybe he just left his Darth Vader mask at
home when I met him.)
Europe will have to make its choice this year. Either a much tighter, more
constrictive fiscal union with a central bank that can aggressively print euros
in this crisis, or a break-up, either controlled or not. I don't think they can
kick the can until 2013, as the market will not allow it. Either the ECB takes
off its gloves and gets down to real monetization when Italy and Spain need it,
or the wheels come off.
The quote at the beginning returns to mind: "If we want everything to
stay as it is, everything will have to change."
Like any long trip, the drive (or flight) seems to take forever,
particularly if you are very young or you are an investor. But then suddenly
you are there. The LTCM crisis mentioned above took a long time to develop, but
then it ended with a bang. One day Lehman or Bear is a big player and the next
they are gone. I think this is the year the crisis moment for the euro arrives.
Let's hope they are ready.
When Europe approaches the edge of the Abyss and looks over, the rest of
the world gets to take a look, too. We can all be taken to the edge and over. I
was reminded while in Singapore and Hong Kong how much we all need Europe to
come through this.
Europe has problems that are structural and can't be fixed with just
another treaty or more ECB liquidity. With that in mind, here are my thoughts.
1. The European
Union works, mostly much more than less. Keep the free trade zone. There are
countries that work just fine that are not in the euro. We live in the world of
computers. Currency exchange is a computer operation and relatively easy. And
keep working on coordinating with the rest of the world. Take advantage of what
you can do together. We are all better off with a united Europe. Until such
time as there are stable labor and productivity markets across Europe, don't
press for a single currency. Single currencies don't insure there will be no
conflict. Really integrated free trade and open borders do.
2. Admit the
euro just doesn't work for some countries, and let them leave the eurozone (but
stay in the free trade zone, like Denmark and Sweden are now). Establish as
orderly as possible a path for a country to revert to its old currency. Yes,
there are going to be some very large losses. If you control it, they will be
far less than if you don't. You can set up a two-tier system, just as you did
when you created the euro. And pass some laws so everyone isn't spending the next
two decades suing everyone else. Deal with it like adults who want to be
friends after the divorce rather than enemies for life. If you have to make up
some rules, then make them up. But do it quick. The longer you take, the more
it will cost you (and the world).
3. Greece has to
be told no. No more loans. No more threats. If they want to stay, then let the
market deal with them. I doubt it will be kind, but they have to take
responsibility for themselves. Nobody forced them to borrow too much. Cut your
losses now. Use the money to salvage your own banks. When (not if) Greece
decides to go, help them with some humanitarian aid (medicines and emergency
supplies) but stop piling on debt they can't pay. Work out the terms so they
can get on their feet and go on with their lives. Allow them to stay in the
free trade zone. And learn your lessons. Be careful whom you lend money to!
4. Sadly, the
same goes for Portugal, although with a reasonable and very healthy haircut
they may be able to stay.
5. Ireland is
not going to pay that bank debt. Get over it. Just let the ECB swallow it. Then
Ireland will pay the rest of its government debt and can grow its way out of
its problems. They have a positive trade balance. Besides, who doesn't love the
Irish?
6. Italy and Spain
are problems. If they stay they are going to need some major ECB help on rates
while they get their deficits under control. Either do it or don't, but don't
keep the world in limbo. Germany needs to make a decision and make it very
publicly.
7. I don't know
what to suggest to France. That is the toughest question. They are losing labor
competitiveness with Germany and others, and already have taxes that cannot go
much higher, large fiscal deficits, poor demographics, and huge future unfunded
liabilities in the form of health-care and pension benefits. They have time to
get things sorted out if they will use it (like the US). The world surely hopes
they do. The concern about the problems of French banks was voiced everywhere
in Hong Kong and Singapore. They are integral to world trade in ways that US
banks (or others) can't come close to. They just have the experience and
infrastructure in making those trade loans. You can't build that up in a short
time. A problem with French banks would be a problem for world growth, which is
already slowing down.
I know the markets are discounting a happy ending to the euro crisis. I
just see the substantial "tail risk" and suggest you manage
accordingly. Large pensions and foundations may be happy if they end the year where
they started. Smaller investors should assess their risk tolerance from the
perspective that Europe does not work through its problems.
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