25/11/2011: Dear China, give me your money! Signed: the euro

In trying circumstances, European leaders can lose their aplomb, and naively expect counterparties to behave outside of economic etiquette. We can learn a lesson from China.

A couple of weeks ago in Brussels, to save the euro once and for all, leaders agreed to create an off-balance-sheet, special-purpose investment vehicle to the European Financial Stability Facility. This SPIV to the EFSF would be fed with capital from China, Japan, Brazil, Norway and anyone else with a vested interest in the euro's survival. That was the idea.

Hence, after negotiating through the night of 26-27 October, tired European leaders told bleary-eyed journalists that French President Sarkozy, still perky, was on the phone with Chinese Prime Minister Hu Jintao, begging him to back the plan with funds. So far, none of the potential donors has agreed to fund the EFSF, even after detailed explanation by European leaders at the G20 in Cannes. Distrust not only of the EFSF but also the ability of Europe to resolve its own crisis is profound.

Shameful, in my view, is that such a rich continent as Europe now needs external help from emerging markets to save its own currency. This walk to Canossa answers the question of whether the euro could ever rival the US dollar once and for all with a resounding “no!” There are more fundamental flaws imbedded in the plea for foreign aid, however. They come from international bookkeeping.

If China gave 500 billion euros to the EFSF, this would be an import of capital to the Eurozone from China. So what would stand opposite this import of capital in the ledger? Very likely it would be found in the current account balance as a deficit, implying an increase of the Eurozone trade deficit with China.

The US is getting much more money from China than Europe and the Eurozone ever will. In fact, the vast US current account and trade deficits mirror the massive growth of China's dollar reserves through buying of US treasury and agency bonds. The US never explicitly asked for this money, but did not refuse it, either. Current grandstanding by US politicians about Chinese currency manipulation aims to reduce those deficits and ultimately – by extension – at not accepting Chinese money as capital anymore.

By asking China to contribute to the EFSF SPIV, Eurozone leaders are taking a path opposite to that the US pretends to cancel. But I am not sure that European politicians really grasp the full implications of the EFSF SPIV. Begging China for money invites the fox into the henhouse, even if China does not seize the chance to leverage its own agenda.

In international macroeconomic quid pro quo, a benefit (funding) requires eventual payment. Here the Chinese are more thoughtful economists (and bookkeepers) than Europeans. Europe's petition to China will be answered: “Dear Europe, open your markets to our exports wider first, then we might consider investing into your funny currency.” China is right in this.

European politicians might consider this response a form of blackmail, but it is merely normal economic behavior. Especially in international markets and capital flows, no one gets a free lunch.

18/11/2011: Navigating drunken sailor markets

The gales of politics and economics have markets sailing in circles, pitching and rolling on nervous seas. Anchors and safe havens seem wishful, steering a long-term course is harrowing. The volatility of it all might actually deliver some return. Just don’t try to predict what tomorrow may bring.

I arrived in the office just past seven in the morning on Monday, 14 November. Silvio Berlusconi had resigned as Italian Prime Minister, replaced by Mario Monti, a move seen by many as the one needed to calm markets.

To prepare for an interview about the Italian political change and its implications for the euro, I head to the coffee machine and punch it twice for a double espresso, then switch on the TV for the latest news from Asian markets to start the week. On CNBC, the news anchor asks a clever trader from an Australian investment boutique, “Well John, what is your feeling for today? Will the market be in a risk-on or risk-off mood?” The double espresso is to no avail; this line of inquiry depresses me.

Is this what things boil down to now? Worldwide, thousands of dedicated analysts, economists, strategists and theorists, technicians and rocket scientists, scrutinize every asset class, dissect economic statistics, examine historical patterns, weigh every word and central banker antic, plumb the Byzantium of Greek politics and the Florentine of present-day Italy. For what? Is all we need to know now “risk-on or risk-off?” Even a dart-throwing chimpanzee seems a worthier benchmark.

What to do in such a market? Wait until European politicians finally make up their minds? For sure, if “risk-on, risk-off” sounds like coin flipping, then trying to time the market is no better strategy. Neither is thinking that a magic, unshakable asset exists somewhere. In my view, capital protection, over a longer time horizon, can already be achieved with a well-diversified portfolio. While equities might induce tachycardia on occasion, at least those paying high dividends consistently grant some income for the doctor bills. Many “safe” government bonds don’t even do this anymore.

Bolder investors seeking opportunities in this challenging environment should focus on market volatility. It is currently very high and hence expensive to buy. History has shown that it tends to revert to its mean. Looking ahead six months from now, we think the euro crisis will have been resolved, either through forceful ECB intervention to end speculation against sovereign European debt (best case scenario), or by a break-up of the Eurozone (worst case scenario). In both cases, the uncertainty will be gone and market participants should again return to fundamentals. This means that market volatility and its price will have dropped. So why not sell some volatility today?

A final piece of advice to those who are flummoxed by market mood changes: don’t try to explain those swings – and therefore stop watching CNBC, or whatever other TV channel. They only focus on high-frequency jitters. While we can explain why the sailor drank and why markets are currently in a “risk-on, risk-off” mood, we will never be able to forecast whether the drunken sailor’s next step will be to the left or the right.

11/11/2011: The politics of scapegoating

The Greek prime minister has resigned, the Italian one will. These are the desired results of the “friendly” pressure from France and Germany and the less amiable sort from financial markets. But now what? Beyond these symbolic outcomes, everything is more or less the same, or even worse.

Greece is still bankrupt and Italy has entered an explosive debt spiral with interest rates shooting above 7%. Even a “technocratic government of experts” in both Athens and Rome wouldn’t change these facts. Next year, Greece will clock negative growth for the fifth year in a row. Its GDP, as I see it, will be somewhere between 20% and 25% lower than it was in 2007. This evolution recalls the US experience during the Great Depression from 1929 to 1934. Even had the Greek debt stayed constant in the last five years, Greece’s debt-to-GDP ratio would still have increased by more than 25 percentage points. This means the drastic austerity measures adopted so far have only succeeded in pushing Greece further into poverty.

We can continue to joke about the number of untaxed swimming pools in Athens and the supposed 400 blind people living on an Aegean island with 800 inhabitants. But at some point, we need to question whether the brutal and collective punishment of the Greek population for the misdeeds of their government – falsifying statistics to gain acceptance into the euro – is justified. After all, it was the foreign creditors who eagerly lent money to a country they had perceived as being as solid as Germany. And by the way, did we ever hear the Germans voicing doubts and concerns about Greece before 2010?

Italy is even more of a sad story. I remember the first time I was confronted with economic statistics. It must have been in the early 1980s, when I was still a youngster. My father and I were watching news on TV announcing that Belgium would be the first developed country since World War II to post a government debt higher than its GDP. The journalist went on to say that Italy was just behind. And what did it mean? Nothing.

Italy has had a high debt-to-GDP ratio for the last thirty years, yet no one seemed to care until a couple of weeks ago. The ratio occults the fact that Italy has been among the most virtuous European nations in the last decade. It entered the Eurozone with a debt-to-GDP ratio above 115% and reduced it to about 104% by 2007 despite having almost no growth at all. For comparison, take the supposedly more serious countries of France and Germany. From 1999 to 2007, their debt-to-GDP ratios went from roughly 60% to almost 70%. The soon-to-be-former Prime Minister Berlusconi might be considered a buffoon by many, but fiscal profligacy was not one of his flaws.

You might object that Italy has a growth problem, and you would be right. Since entering the Eurozone, its competitiveness as measured by unit labor cost has declined relative to Germany’s by more than 30%. But austerity will not solve the lack of growth. It will only exacerbate it.

After Greece, Ireland, Portugal, Spain and now Italy, who will be the next in line? Belgium, or even France? The politics of scapegoating the weak European countries has so far worked for the Grande Nation. It kept a government that has increased its debt by half a trillion euros in the last five years from becoming the center of the market’s attention. This could change rapidly. Moody’s has put France’s AAA credit rating under review. In case of a downgrade, President Sarkozy, who faces elections in May, could be the next casualty of the euro crisis. If such a scenario came true, the weak politicians would obviously blame the markets.

But remember: The euro was conceived as a political project, not an economic one. Thus, if the euro fails, it will be a failure of politics, not economics. Finding scapegoats and blame-gaming wouldn’t help then.

04/11/2011: Wishful sinking

In a funny commercial run by Berlitz Languages a few years ago, a young German coast guard is left alone in a control room to monitor the radars. Suddenly, a voice comes out of the radio: “Mayday, mayday! Can you hear us? We are sinking, we are sinking!” In a rather thick German accent, the novice officer nervously answers the distress call: “Hello? Zis is ze Cherman Coast Guard. What are you sinking about?”

In my view, there is no better metaphor to illustrate the latest compromise to solve – once again and once for all – the crisis of the euro. Yet again, it is too little, too late, and continues to rely on a fundamental disagreement between Germany alongside other northern Eurozone members, and the European periphery alongside France, despite the fact that President Sarkozy would deny any rift between France and Germany.

Two trilemmas, one concerning Europe as a whole and the other specific to Germany, are leading to the current crisis. A trilemma—unlike the either/or situation of a dilemma—demands a choice of two out of three options since, logically, only two are possible at any given time. The one that pertains to Europe is the Rodrik trilemma of globalization, named after the Harvard economist Dani Rodrik who was among the first to identify it.

In the current context, it states: you cannot have at the same time a supranational entity (the EU) using a common currency (the euro) with sovereign nation-states that practice democracy. Between the Eurozone, the sovereign nation-states and democracy, at least one will have to give.

You can have a Eurozone and nation-states at the expense of democracy. This is what the populations of Greece, Portugal and all other peripheral European nations are currently experiencing: not having any say in the austerity measures imposed upon them. In this respect, the recent decision of Greek Prime Minister Papandreou to submit the Brussels accord to a referendum can only be applauded, despite having caused markets to scream bloody murder. You can have a democratic Eurozone, but this would imply a hefty loss of sovereignty among the nation-states, and this is what the ultimate goal of a fiscal union is. And you can have democratic nation-states without the Eurozone. This would be the euro-breakup scenario.

But the Rodrik trilemma unfortunately does not encompass the full complexity of the crisis. On top of it, you have a Germany-specific trilemma: We want to keep the euro, but we want neither to pay more nor any solution that would increase inflation. Here again one of the three wishes is incompatible with the other two. If you want to keep the euro, then the path to fiscal union will imply much more in terms of transfers from the European core to the periphery.

An alternative to keeping the euro without having to pay for it would be to monetize the toxic debt of the European periphery. This is a strategy practiced on their own sovereign debt by such “serious” central banks as the Federal Reserve and the Bank of England under their quantitative easing programs. But for historical reasons, this is a no-go for Germany.

So if both paying more and building inflation potential are out of the equation, the whole concept of the euro needs to be questioned. Neither of the two trilemmas has been seriously answered and tackled by the seventh definitive plan. Hence I foresee more definitive plans and meetings of last chance down the road, unless a solution imposes itself. Such a solution would not necessarily be the best outcome. Hence, without serious thinking, the euro will be sinking.