One of the more persuasive analyses on the fate of the EMU that we have read recently, comes, oddly enough, from JP Morgan, although not from the firm "proper" but from its somewhat more iconoclastic Private Bank division (which manages portfolios for the ultrawealthy). At the core of the argument, which is far more subtle and nuanced than any report by Ambrose-Evans Pritchard, yet which reaches the same conclusion on the viability of the Eurozone, is the now accepted schism between the core and the periphery, in virtually every aspect of their economies: "how can the European Central Bank simultaneously maintain the “right” monetary policy for inflation-phobic Germany and the weak periphery at the same time?" What many don't know, however, is that this very dichotomy was the reason for the collapse of the first attempt at a monetary union in Europe, the European Exchange Rate Mechanism, which ended with a loud thug back in 1992, "when the UK needed a much weaker monetary policy than Germany, which was overheating in the wake of Unification stimulus." Of course, instead of taking no for an answer, Europe merely upped the ante and layered monetary unification on top of an artificial political and customs union. The current state of affairs is all Europe has to show for it. So what happens next? Just as Dylan Grice suggested on Friday that China may have realized that its inflationary endgame has now entered its "out of control" phase, so too perhaps Europe, now accepts the realization that the same unsuccessful outcome as 1992 is inevitable and the premise of a European Union can finally be shelved. Yet in a world in which, as JPM claims, the need for an artificial European union to preserve the peace ended in 1954, and the far more critical peace-perpetuation mechanism - global corporatocracy - is far more important, perhaps Europe should instead focus on doing all it can to promote the interests of various multinational corporations, whose viability may be far more important to Europe's continued non-wartime status. Or perhaps that is the idea all along - with corporate viability more reliant on a healthy banking sector than anything else, are Europe's taxpayers now expected to pay for the 50+ years of peace and social welfare they have received by rescuing the various banks whose bad investments would not sustain one day without an explicit and implicit sovereign backstop. Is Europe essentially saying that should Europe's banks be impaired, that war will certainly follow? Or if the message is not too clear yet, perhaps it will be made soon enough...
From JPM Private Bank:
A Don Quixote Thanksgiving
The diverging economic conditions between Europe’s core and periphery are severe, but not insurmountable1. However, a flaw in Europe’s creation myth may lay at the heart of the inability of the European Monetary Union to survive over the long run. As Europe deals with its latest weak link (Ireland), I am reminded of Don Quixote, who among other things, went on a difficult journey for all the wrong reasons. For Europe, the EMU may turn out to be the same. First, the economics.
The Periphery and Pompeii
Peripheral Europe (Greece, Portugal, Ireland and Spain) is dealing with the aftermath of a consumption boom gone wrong. As we discussed in our “Sick Men of Europe” paper last February, a pattern of faster consumption, growing current account deficits and a loss of competitiveness began in the Periphery almost immediately following the adoption of the Euro.
In the wake of the global recession, like Pompeii, growth in the Periphery is frozen in time while Core Europe has revived. One reason: home prices actually rose more relative to income in Spain and Ireland than they did in the US (see below). Recall as well that while banks grew to be 100% of GDP in the US, in Spain they grew to 200% of GDP, and in Ireland, 400% of GDP (that’s why GDP measures may not be the best barometer of event risk). Irish banks essentially became European banks in the broadest sense of the word. But who pays the freight if something goes wrong? More on that later.
Another sign of Core Europe’s revival: Germany (15x the size of Ireland) is doing quite well, and represents a large part of the European equity holdings that we do have in portfolios (see post-script for more on European equities). As shown below, German unemployment is at a 20-year low, and there are increasing signs of labor shortages reported by German manufacturers. These are “good” problems to have at a time of low global growth, particularly across the developed world.
But this is part of the problem: how can the European Central Bank simultaneously maintain the “right” monetary policy for inflation-phobic Germany and the weak periphery at the same time? This conundrum lay behind the collapse of the prior monetary union in Europe, the European Exchange Rate Mechanism. This effort collapsed in 1992, when the UK needed a much weaker monetary policy than Germany, which was overheating in the wake of Unification stimulus.
As Maastricht orthodoxy is imposed on Greece and Ireland, we are reminded again of how infrequently belt-tightening has been attempted without an exchange rate devaluation to help cushion the blow. The chart above plots current fiscal adjustments in Europe (orange) compared to prior ones in Europe and Latin America (yellow). No one (other than Latvia) has tried this before: large fiscal adjustments in a low-growth, no-devaluation environment.
In Ireland, austerity measures have simply led to lower growth, lower tax revenue and more austerity. Pursuing this course of action to repay foreign bondholders is causing political and social pressure (as well as 8% real interest rates) which we do not believe can be withstood in the long run. As things stand now, the Irish bank bailout may cost 8-10x more than its US equivalent (TARP). The “Irish Bailout” is more a bailout for Ireland’s lenders (European banks and the ECB) than for Ireland itself, as Irish taxpayers are stuck with the bill.
Optimists concede problems in Ireland but point instead to improvements in Spain, which is 6x the size of Ireland. As shown, while Ireland has become more reliant on the ECB, market conditions for Spain improved after bank stress tests this summer, which allowed Spain to reduce its borrowing from the ECB. Improvements in Spanish credit markets unleashed an array of “Mission Accomplished” banners, mostly from strategist and economists that work at European banks.
However, let’s not get too excited about Spain just yet. In a world of US Fed bond purchases and Asian currency intervention driving down rates, the desperate thirst for yield is helping Spain sell its debt, and is a natural market stabilizer of sorts. But…Spain’s Q3 GDP growth was zero; the service sector (60%-70% of the economy) has rolled over; car sales are down 40% to their lowest level in 20 years after the expiration of an incentive program which ran out in June; the improvement in Spain’s trade deficit reflects a massive, unhealthy collapse in imports (see EoTM 6-7-2010); and unemployment remains over 20%, possibly a reflection of Spain’s limited labor mobility, one of the lowest in Europe.
One key thing to watch in Spain: the Achilles heel of the EMU, competitiveness gaps between countries. There are a lot of ways to measure this; below (left) we look at unit labor costs. While the difference between Spain and Germany is not rising anymore, the gap is still large. How big is this gap? For comparison’s sake, we show as well the widest labor cost differentials across US regions over the same time frame. While the Fed’s challenge is a large one, at least it is dealing with a more homogenous set of economic conditions.
This is not “new news”: such problems were highlighted within Europe well before the recession hit. The German Institute of Economic Research2 looked at labor cost divergence in 2007, and was concerned about what they found: permanently higher rates of labor cost increases in Portugal, Greece and to a lesser extent, Italy; labor-cost differences that were much greater in Europe than across US states or German Lander; and a loss of competitiveness, such that countries might experience excessive investment in housing, lower productivity and higher structural unemployment.
“Prolonged boom-and-bust cycles as a result of divergences might actually endanger the political stability of the euro-area. A country which finds itself at the beginning of the bust leg of a business cycle amplified by the structure of EMU might find the idea of leaving monetary union increasingly attractive. Leaving the union would allow the country to depreciate sharply and forego the adjustment costs of relative wage deflation …..”
As we noted in our Sick Man of Europe article, UK stocks rallied sharply in 1992 after they left the ERM and were able to engineer their own monetary policy.
Flaws in the Creation Myth of Europe3
In the wake of the 1992 ERM collapse, why did Europe attempt another monetary union given large differences in language, labor mobility and productivity? It makes sense if seen as part of a broader effort to create a United Europe, both politically and economically. A few years ago, Swedish and Dutch politicians responsible for mobilizing support for the EU Constitution referred to “Yes” votes as necessary tribute to honor the dead from the Second World War, and more urgently, to avoid the pre-war divisions which led to it. Conflict between European empires existed for hundreds of years (1871-1914 was the only period of peace in European history until 1945), so the idea of a united Europe would have seemed appealing in 1945. However, conditions for securing a lasting peace within Western Europe were arguably already in place by 19544:
- The Soviet threat rendered any lingering grievances moot, as did the large presence of US and British troops
- Unlike reparations imposed on losers in the wake of WWI, vanquished countries received aid after WWII (Marshall Plan)
- By 1954, Germany had become a stable, liberal, democratic society, one of the most amazing transformations in history given what preceded it. Just ten years earlier, rather than surrender after Allied victories in Africa, Russia and Italy and the Normandy invasion, Germany kept on fighting, losing 1.8 mm soldiers in 1944 and another 1.6 mm in 1945
To summarize, Europe seems to be on a Quixotic quest for mechanisms to support a peace that had already been obtained by
1954, or shortly thereafter. As a result, the European creation myth of the 1990’s (“Europe must accept supranational
political and economic structures to prevent future conflict”) may be flawed. Such a flaw, to the extent that Europeans no
longer believe it, may explain a lot of things, from public referendums rejecting the EU constitution; to the lack of widespread
support for regional transfers; and the reluctance of countries like Ireland to yield sovereignty over their fiscal affairs5. Taken
to its logical conclusion, the European Monetary Union may continue to struggle under both the strain of its economic
inconsistencies, and the weakness of its political roots.
The author of the 1992 German Constitutional Court opinion on Maastricht described this issue in plain terms. The treaty…
“…is not able to support its own premise: the common ground of a European Staatsvolk which belongs together: a minimum of homogeneity in basic constitutional attitudes, a legal language accessible to all, economic and cultural similarities or at least some forces of approximation, the possibility of political exchange through media, which reach the whole of Europe, a leadership known in Europe and parties active across Europe. A Europeanisation without a prior European consciousness and therefore without a European people with a oncrete capability and readiness for common statehood would be, in terms of the history of thought, un-European.”
Support amongst EU countries for EU membership is close to its lowest levels since the surveys began in 1973 (see chart). To be clear, this paper is about the durability of the current European Monetary Union and the risk of bondholder losses, not the viability of the EU as a political entity. But as support for the latter wanes, steps that need to be taken to support the former may be more difficult to achieve.
The European Financial Stability Facility does suggest that Europe understands the need for fiscal transfers to get through this crisis. Ireland may now draw upon it, and its creators see it as a bridge to a more secure monetary union. It is designed to allow member countries to straighten out their finances, refrain from having to issue in the debt markets for 3 years, and then come back to the debt markets once they run Germanic fiscal policy, but with debt/GDP ratios well over 100% and stuck in a rut of low growth. It’s a great vision and makes total sense on paper. I think I see a windmill in the distance…
Chief Investment Officer
Postscript: on investments in Europe
Ten-year Irish debt is currently pricing in an 80% probability of a default (55% for Spain). Some hedge funds and high yield funds we invest with may find value here, as a lot of bad news is priced in. However, our managed fixed income funds aim for steady income and capital preservation, so they generally do not hold much Ireland, Portugal, Spain or Greece debt. We have been investing in bank non-performing loans and distressed corporate debt in Europe, opportunities we expect to continue as the European banking system continues to shrink. Given the current reliance on the ECB, this process has a long way to go.
On European equities, we have highlighted before the large degree of non-European revenue earned by European companies. That explains why European equities have over long periods of time kept pace with other markets despite low nominal growth. This year and since January 2008, however, European equities have trailed the S&P 500 in local currency terms (“European equities” include countries like the UK, Denmark and Sweden; EMU equities trailed the S&P by even more). Our European equity holdings have been tilted towards German mid-cap exporters, which have outperformed the rest of Europe and the US as well.
In terms of valuation, European equities trade somewhere around 10-12x earnings, so like the peripheral European bond markets, there’s a lot of pessimism priced in. We have a regional equity preference for the U.S. and Asia in our portfolios at the current time, but it cannot be said that European equity markets are unaware of the challenges facing the EMU.
1 The regions of the United States, for example, experienced tremendously divergent economic conditions during the depressions of the 19th century and the Great Depression of the 20th. Throughout these periods, monetary and labor conditions converged and a system of fiscal transfers was put in place to endure them. In prior “Eye on the Market” notes, we covered the convergence of labor costs in the Northeast and Midwest from 1820 to 1900, and the fiscal transfers which took place from the Northeast to the Midwest during the Great Depression, when farm prices fell by 40%.
2 “Does the Dispersion of Unit Labor Cost Dynamics in the EMU Imply Long-run Divergence?”, Dullien and Fritsche, Deutsches Institut für
Wirtschaftsforschung, Berlin, March 2007.
3 This section draws heavily on an article by Bernard Connolly, now CEO of Connolly Global Macro Advisors, “Monetary Union: a political impossibility theorem”, Banque AIG Market Intelligence Update, May 2005.
4 This view is supported as well by Stanford University’s James Sheehan in “Where have all the soldiers gone”, which describes the turning point for Europe as 1945, rather than 1968 or 1989.
5 While Ireland may accept bilateral EU and IMF money, it has so far resisted giving in on the greatest thorn in the side of Continental
Europe: its 12.5% corporate tax rate.