The Euro Rescue Package
This week has been a fascinating time in the markets as participants look on to see what European Politicians, playing the role of contemporary “Keystone Cops“, manage to achieve with their much hyped rescue package for the Eurozone and its attendant debt crisis.
We thought it opportune to comment on this newly unveiled package, having also attended a thought provoking debate last night organised by The Policy Exchange on this very issue.
The markets reacted with potentially excessive euphoria yesterday, and bounced with some exuberance. Perhaps they had priced in a form of policy deadlock and lack of political uniformity? All that we know is that Major U.S. stock indexes are up about 2.5%, Germany’s DAX jumped 5%, France’s CAC 40 leaped more than 6%, whilst the FTSE is comfortably into the 5700s again.
What the rescue deal comprises
The main takeaways from the latest Eurozone deal are:
– A 50% haircut will be imposed in Greek government bonds
– The EFSF will be leveraged by four to five times to backstop over €1 trillion of Eurozone debt.
– And, receiving slightly less attention has been the fact that European banks are being required to raise their tier one capital ratios to nine percent.
Let’s explore the first two points in greater depth as they are the newest offerings to the markets, and increasing bank capital ratios has had plenty of air-time and consideration. What do these two points really mean?
What sort of haircut for bondholders
Firstly, it is good to see some form of haircut being imposed on Greek debt so that bondholders finally have to feel a more proportionate degree of burn from this crisis of solvency in Euroland.
However, we agree with Allister Heath, Editor of City AM and the second speaker at last night’s debate, that a 50% haircut will not be enough, and that something over 70% should have been enforced.
When assessing the facts that the hair cut will not be imposed uniformly, with different standards being employed for private sector creditors (is this fair and conducive to a properly functioning lending market?), and that the write offs will involve contentious assumptions about discount rates, Allister Heath writes that “even the haircut itself is dodgy“.
Even with the proposed haircut, as Andrew Lilico of Europe Economics represented in his opening presentation, Greek debt to GDP levels will still be over 120%. This is still concerningly high and could rise given Greece’s rapidly shrinking economy and GDP.
Debt levels are still too high
Our concern with this new reduced debt to GDP ratio is that it is still worryingly high in relation to a level of 170% that Professor Peter Bernholz, one of the World’s experts on sovereign debt and inflation, finds as problematic.
In his book, “Inflation and Monetary Regimes“, the now Emeritus Professor finds that, whilst different countries have different “debt tolerances“, typically once a country reaches a debt to GDP ratio of 170% or greater there is significant risk of default and hyperinflation. Bernholz describes a hyperinflationary episode as when inflation exceeds 25% per month.
Can Greece really grow fast enough to manage a new debt to GDP ratio of just over 120%? We would posit that this sovereign cannot, and would broaden concerns with lack of growth across other over indebted western nations. Some of our readers may be familiar with Bill Bonner’s ‘Great Correction’ thesis that we are subscribing to here.
Secondly for assessment is the newly beefed up European Financial Stability Fund which has been leveraged up by four to five times to act as the back stop to the European financial system. Like the level of haircut on Greek debt, we cannot help but feel that even using leverage to puff itself up to over €1 trillion, the new EFSF merely represents an offering that is most acceptable politically but that in practice will be ineffective.
European FUBAR Slush Fund
One of our favourite commentators, Ben Davies, CEO of Hinde Capital, recently asserted that the EFSF,or “European FUBAR Slush Fund” as he calls it, could need to take the form of circa €3 trillion to satisfy the markets that it was a credible and sizeable enough backstop to Europe’s problems.
In this interview with King World News, Ben describes “another fudge packet coming along… very much along the lines of the monoline insurer concept“. Some might remember another prominent hedge fund manager, Bill Ackman, lobbying against the activities of monolines, who had strayed dangerously far outside of their knowledge domain of insuring municipal bonds, prior to the Credit Crunch.
Ackman was ignored and now the EFSF looking like history could be repeating itself. Ben Davies finds these political efforts “asinine” and observing the use of “more leverage to of course bail out a deleveraging system” describes the EFSF as an ineffectual Ponzi scheme.
These thoughts were echoed by Wolfgang Munchau’s Tuesday FT article where he expresses concerns that in 2008 the monolines ‘ended up as crisis amplifiers’ and considers what a monoline like EFSF really means. Are we naïve in thinking that 40 years of growing leverage in the financial system has been compounded by structurally flawed euro to now wash like an irresistible tide over the EFSF sand castle?
Structural flaws in the EU
To continue the euro discussion more widely we should now bring in Charles Hugh Smith, from “Of Two Minds“, who urges that the “model for understanding the increasingly unstable dynamics of the EU is the post-colonial “plantation” model.
1. Low cost labour and low-value materials flow from the periphery (colonies) to the Empire (centre), which then ships high-value, high-profit finished goods back to the colonies.
2. The colonies must buy the high-value finished goods on credit that is issued and controlled by the Imperial centre”.
This sounds rather like the Euroland project that has been relatively undemocratically implemented. Charles Hugh Smith continues:
“The euro cemented this co-dependency: Germany had the most efficient production, and once the euro raised the cost of production in the periphery nations, then of course nobody could beat Germany’s cost advantages.
The euro actually lowered Germany’s cost of production in terms of foreign exchange rates while raising the costs in periphery nations that were previously able to lower their cost of production via currency devaluations.
Having surrendered that mechanism to access the deep credit markets of the centre, then they had no choice but to buy the high-margin finished goods from Germany, as nobody else could make the same goods for the low German price.
These booming high-profit German exports of finished goods to the European periphery generated vast surpluses of capital that were then loaned to the periphery to enable their further purchases of German goods. Why risk the heavy investment costs of production in the periphery when Germany had the lowest costs of production and was willing to loan the buyers the cash needed to keep buying?
It’s the classic mercantilist-consumer co-dependency on a gigantic scale, with low-cost credit fuelling both increased consumption and production. As long as the credit flowed in vast torrents of low-cost, easy to borrow money, the co-dependency looked like a “virtuous cycle”.
Debt junkies eventually have to start servicing their debts, of course, and that’s when the ugly realities of colonial dominance become visible…
…this co-dependency based on credit flowing from the mercantilist centre to the periphery is both exploitative and systemically unstable. Now that the ontological instability of the euro is being revealed, the dysfunctional family members are blaming each other and desperately trying to conjure up something for nothing to bail themselves out of a system which was doomed to implode from its very inception”.
Time to face the music
European leaders still have a great deal more reality to face, and we find it hard to believe that the euro project will survive in its current form.
The euro project itself is beginning to look like more cack-handed meddling in markets by the authorities, and feels about as improper as the American state’s efforts to interfere with the residential lending market from 2000 onwards to achieve another political goal, that of increased house ownership.
Tensions between the centre and the periphery within Europe are now very evident, and at times comically so. Let’s look at a narrow but we feel representative example. The main creditor nation, Germany, has, as Ambrose Evans- Pritchard writes, now paid off her “war guilt” and points the finger south to the apparently lazy Greeks who work fewer days a year, take more days holiday, serially evade tax, and retire earlier.
The Greeks scowl back with some appreciation of their euro currency strait-jacket and refuse to become slaves to internationally held debt. The issue of Germany’s removal of Greek central bank gold during the Second World War has even been reheated by some.
Can the euro be saved
What these dynamics seem to reveal is that as the economic imbalances caused by the euro currency manifest themselves a problematic lack of cultural affiliation between member states grows to hamper efforts save the structurally flawed euro.
The EFSF cannot be funded to the required size because the creditor nations are not willing enough to keep bailing out those “naughty, lazy, and profligate PIIGS“, and the debtor nations like Greece would prefer to walk away from their debt rather than work as debt slaves to pay back sovereigns and foreign institutions they don’t fell sufficiently culturally affiliated to.
We will finish our discussion today by urging that the recent euro rescue package will be found wanting, and the markets will force politicians back to the negotiating table again. It is difficult to see how these limited and remedial efforts can solve what is at heart a structural problem.
The euro project itself was politically driven and sought to unite different economic locomotives and their peoples. Perhaps they were simply too diverse to operate as a stable and virtuous currency union. We will leave you in the hands of Nigel Farage MEP, as he throws some light on the suffering and strains being felt in some of the euro nations.
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