John Taylor On The Transition From "Win, Win" To "No Free Euro Lunch"

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Who Pays for the Euro?
November 18, 2010
By John R. Taylor, Jr.
Chief Investment Officer, FX Concepts

One of the most popular American sayings between the 1940’s and the 1970’s was “there is no such thing as a free lunch.” Somehow that phrase and the pithy concept behind it seemed to have dropped from common parlance in the last twenty years to be replaced by the idea of “win, win.” Win, win still has many adherents but its days as the global credo are dwindling down toward zero. During the next few years ‘no free lunch’ should roar back in vogue, especially in the Eurozone. The euro brought tremendous benefits to almost all Europeans over the past decade, but there is no free lunch, and now someone has to pay for all the good times. The question is: who? This simple query is behind the millions of man/woman hours of meetings and writing that has been, is, and will be spent trying to parcel out the costs. Remembering that hundreds of millions of people gained a great deal for many years, the costs will be huge and they will be drawn out for at least a decade as well. All those who are in the markets’ sight as likely payors will pose as victims with much gnashing of teeth, at a minimum, and violence at a maximum. The scene is only just being set and there will be many plot twists before we reach the denouement, but we can sketch an early draft of those groups that will struggle mightily to avoid the brunt of the previous euphoria.

The candidates that the world leaders seem have chosen to pay this bill are the common people of the countries that are in trouble. At first blush this seems a very logical idea as they look like the most obvious beneficiaries of the good times. The value of houses in Ireland quadrupled in the 10 years up to 2006, jobs were very plentiful (often building houses) and everyone was wealthier than they had ever been. As these people were the winners, now they should pay for this privilege. Although this is happening in Greece and in Ireland, these people do not have the money; at best it is in their houses but more likely it is just gone. They are suffering mightily but can’t pay. The argument then goes that the leaders of these countries – Greece, Ireland, Portugal, Spain, and also the Baltics – let the boom go on uncontrolled when they could have stopped it by raising lending standards and by running large government surpluses to slow the growth of private incomes. So, it’s the local politicians’ fault. 

This is appealing except for the fact that every single ‘slightly’ lesser developed country that joined the Eurozone, no matter what its strategy, suffered the same fate. When capital is re-priced from the teens to the low German levels and then becomes almost universally available, there is almost no way to stop a boom from occurring. It is not just houses that are the problem, it is factories, shopping malls, and developments of all sort. That a government would be so anti-growth is just not practical.

Maybe the agents who financed the boom should pay. The banks, the investors, and the entrepreneurs that made the loans, bought the bonds, and invested in projects would be the losers. Actually, some are already paying for the good times, but others are shielded by the ECB and their governments. Although bonds that had a face value of 100 now trade at deep discounts as their principal might be lost, European banks that own them have not recognized this major risk. Because Angela Merkel grew up in East Germany, she knows how the authorities can fabricate a false front, a Potyomkin village. She knowsthat the investors must accept their losses to give the euro legitimacy. But, how can that be done when the European banks are holding most of the questionable assets? The last candidates to bear the cost of this ‘lunch’ are countries that ran current account surpluses with the countries in trouble. The more successful the German export machine is, the worse the problems of Greece and the others. They can’t compete, so they are the victims and the exporters are the victors who have enjoyed the ‘free lunch.’ The burden should fall on everyone, but the battle to allot the blame will be ferocious.