21/10/2011: The Grand Plan

At the European summit on 23 October, the seventh definitive plan, also named the “Grand Plan,” to solve the crisis of the euro is supposed to be unveiled. Perhaps we’ll have to wait until Wednesday or another week for the G20 summit in Cannes on 3 – 4 November.

The last Merkel-Sarkozy summit ended without clear direction, and since then leaks of dubious veracity, hints and second-guessing have put market participants on alert. We will not add to the noise; instead we point to some critical factors that need to be addressed: the size of the Greek default, the avoidance of geographical contagion and the recapitalization of European financial intermediaries.

Consensus view now even among European leaders is that Greece will have to default. What this means in terms of haircuts is still unclear. While the sixth definitive plan (how long ago was that?) aimed at a 21% haircut on a voluntary basis, 50% is heard most often now.

Eurogroup President Jean-Claude Juncker even alluded to a 60% figure. He later apologized for having misspoken, but this latest number actually comes closer to the haircut we believe will be necessary to put Greece back in a sustainable situation: 70% (see our latest UBS research focus for more details).

Since the start of the Greek crisis the question of who is next in line has always been present. Ireland and Portugal are usually seen as the riskiest candidates. However, their finances are secured by rescue plans until end of 2013. The critical countries are Italy and Spain. Both have currently stable debt dynamics, which could, however, become explosive if interest rates exceed 6.5–7%. This is why the European Central Bank has recently bought Italian and Spanish debt on a large scale, de facto applying the same policy as the Federal Reserve or the Bank of England with their respective quantitative easing programs. An alternative to this bond-buying program currently discussed by analysts would be to let the EFSF work as a sovereign debt insurance company, like the monoline firms in the US do for the municipal bond market. The advantage of such a solution would be to increase the “firepower” of the EFSF, but there is a residual risk that such a solution is not credible in the long run.

The dismantling of Dexia made clear to European leaders that the two stress tests carried out on European financial intermediaries were indeed too soft. A recapitalization of the European banking sector is now very likely. IMF head Christine Lagarde has put the price tag of such intervention at EUR 200 billion. We think it could even go beyond EUR 300 billion.

Who will pay for this? In our view, here lies the largest rift between France and Germany. France is striving for a European solution, aware that in the case of a national solution it might lose its AAA rating, already now under scrutiny by Moody’s. Germany aims at a national solution because there is great risk that a renewed increase of the EFSF will not pass the German parliament. The risk of France losing its AAA rating does need serious consideration by Germany, because that loss would almost surely mean that the EFSF would not have a AAA rating either, increasing its cost of capital.

All this leads to the conclusion that while we might finally get a Grand Plan to solve the crisis of the euro, it is not yet the silver bullet which will end it.

19/10/2011: Growth now! If only it were so easy…

There is a new fad idea espoused by many economists, analysts, pundits and other editorial scribblers today: that debt is not the problem, at least not the most urgent one; the lack of growth is. If growth would return, the thinking goes, all our problems would be solved. Unfortunately, bringing growth back in the current environment is a rather daunting task.

Austerity measures are counterproductive because they weigh on growth. They could even lead to a self-reinforcing deadly spiral such as in the Greek case, where the government is shrinking the economy and thus the tax base, ultimately increasing or at least not reducing the public deficit as it is supposed to be doing. To the faddists, it would be better for governments to boost growth by even more deficit spending and only at a later stage care about the debt.

While at first glance it might bear some logic, this analysis occludes the simple truth that what led us to our current dismal situation in the first place – excessive debt from private households and governments – will certainly not be the solution that would pull us out of our misery. Asking financial intermediaries to lend with abandon conflicts with forcing the same financial intermediaries to repair their still shaky balance sheets. Creating incentives for private households to borrow more through low interest rates can only work if those households are not already overly indebted and trying to reduce their burden.

In the 1930s the great economist John Maynard Keynes advocated large public infrastructure projects to boost demand, but he did so in an environment in which governments were not facing massive debts and the risk of being downgraded by rating agencies.

Keynesianism, according to Keynes – though many self-proclaimed Keynesian economists would oppose this statement – should only be used in times of crisis. This is where we are now, so it seems to make perfect sense to use it. But this is a threadbare policy. Having been used so often, even in good times when Keynes did not mean for them to be used, fiscal stimuli have lost their traction.

So since the demand push cannot come from private households and is currently rather inefficient when coming from the public sector, it leaves only one possible growth booster: demand from abroad. Blaming the Chinese, the Germans, the Swiss and all other countries that were exporting instead of incurring debt over the last ten years for acting stingy now has become one of the most popular acts of political posturing in the deleveraging countries. But leaving aside possible cultural differences, is it any wonder why a country would choose not to follow the same debt-ridden path taken by the US, the UK and many countries in the European periphery?

Starting a trade war now in the hope that the winner would be able to boost growth might worsen the current slump. Even without retaliation from the trading partner, protectionist measures usually increase consumer prices, which further depresses real incomes. Patience coupled with ongoing efforts to slowly but surely bring down debt and repair balance sheets – in other words, to keep calm and carry on in the face of austerity – is the only sound advice an economist can give. Unfortunately, this is not what politicians facing elections want to hear and, even more importantly, want to tell their constituents.

14/10/2011: Europe's Black Swan

Greece is poised to default within the next six months. This view, which we also hold, has now become market consensus. The question now is more: what will happen after a Greek default? Many analysts are pointing to the fact that this would fatally lead to an exit of Greece from the euro with the possible scenario, if this becomes nasty, that other countries might also leave it. De facto, the euro experience would end.

One needs, however, to ask whether a Greek exit would really be in the best interest of Greece. Greek exports could obviously profit from it, but Greece does not have much to export anyway, save tourism. But who would visit a country which just defaulted and contains risk of social unrest? Turning the other way round and knowing that Greece is importing many goods including energy, who would accept the new drachma as a means of exchange to pay the oil bill? Hence, I personally remain very skeptical, when confronted with a Greek euro exit scenario.

I also do not believe in a scenario in which Germany leaves the euro. A certain number of German politicians are pleading for such a move, arguing that Germany is currently loading unbearable costs upon its shoulders to ensure the future of the common currency. However, this view forgets that an exit of Germany from the Eurozone would also cause massive costs to the country.

A recent, thorough report from UBS Investment Bank states: “If Germany were to leave, we believe the cost to be around EUR 6,000 to EUR 8,000 for every German adult and child in the first year, and a range of EUR 3,500 to EUR 4,500 per person, per year thereafter. That is the equivalent of 20% to 25% of GDP in the first year. In comparison, the cost of bailing out Greece, Ireland and Portugal entirely in the wake of the default of those countries would be a little over EUR 1,000 per person, in a single hit.” (See: Stéphane Déo, Paul Donovan and Larry Hatheway: Euro break-up – the consequences, UBS Investment Research, 6 September 2011).

The German costs of leaving the euro come mainly from exporters facing a massive appreciation of a new Deutschmark and of financial intermediaries facing a massive depreciation of their assets remaining in euros. In my view, the euro will not be unraveled at the top or at the bottom.

But there is a risk that this could happen from somewhere no one is really looking: Slovakia.

Slovakia entered the Eurozone in 2009 as the second-to-last member (before Estonia, which joined the euro in 2011). It is also the second-poorest country in the Eurozone (again before Estonia). Its GDP per capita is only 60% of that of Greece and 40% of that of Ireland. To be accepted into the Eurozone, Slovakia made enormous efforts. Its debt-to-GDP ratio went down from 50% in 2000 to 27% in 2008, while the Greek debt-to-GDP ratio increased from 103% to 111% during the same period. And this country is now asked to contribute EUR 7.7 billion to the European Financial Stability Facility (EFSF); this contribution would represent almost 10% of its GDP.

So it shouldn’t surprise anyone that the Slovak parliament might vote against the EFSF and by that, since it requires the unanimity of all 17 Eurozone members, it might jeopardize the whole project. Europe is likely to put heavy pressure on Slovakia both with carrots and sticks. But Europe is walking on thin ice here, since a euro exit by Slovakia could be the best strategy for the country. Given its current fiscal soundness as well as the fact that the old Slovak koruna appreciated against the euro before the country joined the Eurozone, a new Slovak currency would certainly be credible and internationally accepted.

Moreover, given the rather high unemployment rate as well as rather low inflation, Slovakia could in fact benefit from an autonomous monetary policy. Finally, one should not forget that Slovakia has some expertise in leaving currency unions; less then twenty years ago it exited the common currency with the Czech Republic.

All those arguments could make Slovakia the proverbial Black Swan of the Eurozone, which if a euro exit would be perceived as successful, might give other unhappy Eurozone members ideas. While an exit by Slovakia is not our main scenario, the tail risk of such an event needs at least to be flagged.

07/10/2011: Ricardo equalizes Keynes

The dismal science has seen a practitioner lauded with a Nobel Prize since 1969, to be awarded this year on 10 October. Dismal as the present economic situation appears, the reigning confusion on what should be done to get us out of it hardly seems like science.

In the US, for example, the monetary base has tripled since fall 2008 on two sprees of quantitative easing (QE), Fed fund rates are at zero, where they will stay until 2013, and Operation Twist as well as angst about the overall economic outlook have lowered 10-year Treasury yields to some 1.7%, a low for the last 60 years. Lending is stalled, the housing market still ails and unemployment hovers over 9% for three years running.

Monetary policy seems useless. This is a typical liquidity trap, in my view. John Maynard Keynes studied this, a situation in which monetary policy becomes ineffective. Households and firms are not spurred by low interest rates to consume or invest, but hoard cash due to a grim economic outlook and/or because they are deleveraging. Hence, in this environment neither Operation Twist nor still more QE would boost the faltering US economy.

So should we do nothing? Keynes and prominent successors, most notably 2008 Nobel Prize winner Paul Krugman, argue loudly instead: no, to the contrary. Fiscal policy provides greatest traction to an economy stuck in a liquidity bog.

Moreover, low interest rates ease government deficit financing and can stimulate the business cycle through infrastructure investments. This is the theory, and is how one would have reacted in the 1930s, when Keynes wrote his General Theory.

Today, though, a major caveat undermines such fiscal policy. The Ricardo equivalence theorem, after the classical English economist David Ricardo and rediscovered in 1973 by “neoclassical” economist Robert Barro, states that rational subjects are indifferent to the financing origins of government expenditures, i.e., to whether these are taxes or deficits. Why? Because deficits can be seen as future taxes, and one can show that discounted future taxes correspond to the current tax one would pay if government expenditure were financed through tax receipts instead of deficits.

The Ricardo equivalence has been downplayed in economics articles as a nice theory removed from reality, criticized among other reasons because it assumes that individuals have perfect foresight about the future of taxes. However, the present context in the US could make it more relevant. In the recent debt ceiling debate the US government agreed to reduce the debt later, though it is still making deficits now. So future tax increases should not surprise anyone.

In anticipation thereof, citizens might start to adapt and reduce their consumption and investment patterns now. But what of those, who despite the US government’s commitment, do not expect future tax increases to reduce debt? They fall under another “neoclassical” theory developed by 2004 Nobel Prize winners Edward Prescott and Finn Kydland about the “time inconsistency” of political decisions. In its simplest form this theory grants that a government commitment to reduce debt at a later stage is worth only as much as the paper on which it is written.