Thoughts from the Frontline

And Then There Is Disaster C

August 11, 2012

Choose your language

They say that breaking up is hard to do.
Now I know, I know that it's true
Don't say that this is the end.
Instead of breaking up
I wish that we were making up again.
– Neil Sedaka, 1962

I have contended for some time that Europe is faced with two choices: Disaster A, which is the break-up of the eurozone, or Disaster B, which is the creation of a fiscal union, which keeps the euro more or less intact. Over the last few months I have come to realize that there is indeed a third option, which now looks increasingly possible. This is rather sad, as the third option is just an even worse Disaster C. Each choice carries with it its own unique set of problems, but the outcome of any of the choices will be that the people of Europe face a serious recession, if not a depression. This will impact global growth for more than a short time and, depending on the choice, could plunge the world into a crisis as bad as or worse than the recent credit crisis. In today’s letter we look at all three choices, meanwhile musing on how we arrived at the bottom of such a deep hole, shovels flailing.

Breaking Up Is Hard to Do

“Breaking Up is Hard to Do” was written and sung by Neil Sedaka. It was a #1 hit exactly 50 years ago this week. And while that song was written for a different era, it could be the theme song for much of Europe today.

“Don't say that this is the end. Instead of breaking up, I wish that we were making up again.”

And indeed Europe is quite the dysfunctional family, seemingly always on the verge of breaking up, but somehow managing to patch up the differences. We all have a family member (or two or three) who cause that sort of trouble. We watch the incessant squabbling with unease, wishing they would just settle things and move on. They never deal with the real issues, as that would mean facing too much personal angst and maybe even lead to an admission that the problem is not just with the other party. The euphoria of the initial relationship has been lost in the reality of day-to-day existence. Now, they either sort it out or break up.

These sorts of relationships devolve into co-dependency, where no one is happy. And the rest of us are liable to get sucked in. Even though it’s uncomfortable to be around these people, we still have to interact. But don’t you wish they would get some serious therapy?

And Europe was again acting out this week. First, Italian Prime Minister Mario Monti gave an interview to Der Spiegel, in which he warned of the disintegration of Europe if the European Union allows the euro to fail: “The tension which sprang up in the eurozone in recent years is beginning to look like Europe’s psychological disintegration.”

Remember, Monti was a compromise prime minister, brought in by a parliament wracked by chaos, in the wake of Berlusconi’s withdrawal. But alas, the latter party refuses to slink off quietly into the night with his billions and personal peccadilloes. Monti was appointed rather than elected and is a “technocrat” prime minister. Given the nature of Italian politics, he has done about as well as could be expected. He has an outstanding resumé and is part of the Europhile elite that defends the vision of a united Europe.

The interview itself was mostly the standard-issue political noise emitted from European centers of power. It would have gone unnoticed except for one little item. The Italian prime minister suggested that the heads of the EU national governments make decisions independently from their countries’ parliaments.

“If the governments are tied by their parliaments’ decisions, the lack of freedom of action will result in Europe’s breakdown, rather than deeper integration …”

Was the prime minister not listening to what he was saying? Let me paraphrase for him: “How can we keep the euro together if we have to listen to those pesky parliaments, elected by actual voters?” And he says this prior to the German Constitutional Court ruling on September 12, when most of the German leadership is treading lightly, assuming a “positive” outcome but knowing that nothing is certain? And he does this in one of Germany’s leading publications? Maybe there’s a reason he has never actually run for office. This bonehead statement must have chagrined even his most ardent supporters.

It certainly brought quick responses all over Europe, and especially in Germany.

“German politicians from across the spectrum have reacted furiously to warnings by Italy’s Mario Monti that Bundestag control over EU debt policies threatens to bring about the ‘disintegration’ of the European project. ‘We must make it clear to Mr. Monti that we Germans will not shut down our democracy to pay Italian debts,’ said Alexander Dobrindt, secretary-general of Bavaria’s Social Christians (CSU).” (Ambrose Evans-Pritchard, the Telegraph)

In the time-honored tradition of political spin and “clarification,” Mario Monti almost immediately went back before the press to insist that the words he spoke were not the ones he meant.

The Italian paper Il Libero ran a front-page photo of Angela Merkel, under the headline “The Fourth Reich.” And it gets a lot worse if you start looking.

But just to show off my own ecumenical nature, let me point out that German leaders have their own set of issues. Mainly, they simply have not told the German people what the costs of staying in the eurozone or leaving it are.

In past weeks we have looked at the two major options Europe faces. Let’s call them Disaster A and Disaster B. Disaster A ensues if they decide on a close fiscal union, which will entail giving up substantial national sovereignty (although it will not be sold that way to the voters). It would also mean that the northern states (Germany, the Netherlands, et al.) would have to shoulder large tax burdens in order to share with their southern neighbors and pay for the massive debts they have run up.

Of course, Germany helped create the problem, with its Landesbanks enthusiastically financing the various and sundry debt issues of the peripheral governments and their citizens. Note that when the German government revoked its guarantee of the Landesbanks (regional banks), their cost of borrowing rose significantly. The banks began to “reach for yield,” buying not only US subprime debt (which bankrupted a few of them) but also huge amounts of peripheral European sovereign debt.

The entire Greek bailout was really about using “European” taxpayer money to pay off German and French bank debts. Ditto for the other early bailouts. Now we are down to saving the euro (with the Spanish bailouts), which is an even more costly proposition.

Sidebar: ECB President Draghi famously remarked a week ago that he was prepared to do “whatever it takes” to save the euro, a message that was echoed by Merkel, Monti, and Hollande over the next few days. Then we found out, a week later, that “whatever” did not include using EFSF money to buy Spanish bonds (at least for now and until the German Constitutional Court ruling on September 12). Care to place a bet on what happens after that ruling? I bet there will be a compromise of some sort, to allow the EFSF or the ECB to fund. Draghi did say, after all, that he was simply waiting for a formal request before committing funds. And Spanish PM Rajoy is waiting until September 12, as well, perhaps because he wants to find out exactly what he will be agreeing to if he asks for help.

There is an unwritten rule in legal and political proceedings: never ask a question if you don’t already know the answer. If Spain asks for a bailout and then, for whatever political reason, cannot actually abide by the austerity rules, then that would be worse than not asking.

But it is not just northern (German) taxpayers who will be hurt. Southern-tier countries will have to endure serious austerity measures in order to get the money, which will mean even higher unemployment and deeper recessions – if not depressions. There is no free lunch.

And then there’s Disaster B: the break-up of the eurozone, one way or another. Maine fishing buddy Josh Rosner included this graphic from Der Spiegel in a very impressive report he sent me on the cost to Germany of either leaving or staying in the euro (and which I posted here for Over My Shoulder subscribers). He demonstrates that it is actually much more costly for Germany to leave the euro. He also agrees with me that German leaders are not telling their people what the costs of either option are.

Note that no country does well in a break-up. But the outcomes vary, as some see serious inflation and others see deflation, while all see unemployment rise significantly.

I also note that 56% of Germans want their government to “do everything” to save the euro, with 76% saying a euro break-up would be bad for Germany. In addition, 64% of Germans believe the euro will survive, though 84% think the crisis will worsen, and 56% worry that the economy will deteriorate next year. Finally, 70% believe Merkel is doing a good job. (Source: Bloomberg, reporting on an ARD TV poll)

And Then There Is Disaster C

There is yet a third option that may be turning into the choice du jour. And that is, rather than opting in a straightforward manner for either fiscal union and a eurozone-wide backing of banks, etc., or a break-up of some sort, European leaders might do nothing more than deal with the problem immediately in front of them, moving from crisis to crisis in a slow-motion drift toward fiscal union.

To detail what a real fiscal union would mean and cost, you end up having to ask voters to approve something, and European leaders just don’t know what they will say. What if they say no, nein, non, não, ochi, nee, neen, cha toigh leam, or ei? There are so many ways to say “no” in Europe.

Which is why Mr. Monti is frustrated with the whole parliamentary process of dealing with the euro crisis. It all gets so very messy when you have to explain to voters exactly why and how much they should pay for your personal vision of their future. “If the governments are tied by their parliaments’ decisions, the lack of freedom of action will result in Europe’s breakdown, rather than deeper integration.” This is not unlike someone telling a Russian president to be patient because he will have more flexibility after the election. Just saying.

Who Do You Trust?

The European Union is a rather odd creature. It has a parliament that is widely seen as a joke, with the real work being done by various commissions appointed by national leaders and perhaps ratified by the EU parliament. From my reading, most Europeans are anti-Brussels as opposed to anti-euro. They see Brussels as a creation of bureaucracy.

They expect their own national governments to do the hard work of governing and to protect them from the worst of the European issues. They would be reluctant to give up their national sovereignty in the same manner as the states have in the US.

And if you go back to the founding of the US, you see that modern European attitudes are not at all different from what 18th-century Americans felt about Washington DC. Washington the man was more important than most now realize, as he gave the early government much of its legitimacy. The competing visions of Jefferson and Hamilton and the rest of the founding fathers led to some serious disagreements and public dissension. The election of 1800 was perhaps the most bitter and contentious one in US history, far nastier than today’s (“If Jefferson is elected all the churches will be shut down,” etc). And then there was that little dispute over states’ rights that came to a boil in 1860.

If politicians in 1792 had tried to sell voters on a full fiscal union as a reason to vote for the Constitution, we might still be debating the Articles of Confederation today.

And that is the crux of the problem that Europe. The costs of choosing either break-up or a fiscal union are so high and fraught with contention that to ask voters to choose with full knowledge of the costs would be to ask the question and not know the answer.

So why not choose fiscal union light? Rather than trying to reach the finish line in one huge leap, why not take a series of smaller steps? Let the pot heat slowly, rather than bringing it to a boil quickly. Like the proverbial frog, by the time European voters notice how hot it is, it will be too late to jump out.

But the hitch is, that might be the most costly route in the long run. It would mean bouncing from crisis to crisis, with each crisis costing more to resolve – but just not enough to make everyoone walk away. The longer the process is drawn out, the more expensive it will be.

We know about Spanish and Italian problems. What European leaders have not recognized (and indeed most of the world hasn’t, from what I see) is that France is the real problem. France is careening toward a dénouement of biblical proportions. Within a few years it will be just as problematic as Spain is today. France is in deep, deep foie gras.

Germany thinks it has an AAA debt partner for its guarantees of European debt in the EFSF, ESM, etc. It does today, but France will soon lose that AAA rating, absent significant changes that are not going to be forthcoming under Hollande and the Socialists. It could happen as early as September, although I doubt Moody’s or S&P will move before the German Constitutional Court ruling on the 12th – unless of course they really want to demonstrate their independence of thought from the political considerations of the moment!

And that ratings cut will just be the first of many. France is in the process of raising taxes on “les riches,” or those making over €1 million, to a nose-bleed 75%. Why stay in France when you can move, pay lower taxes, and visit when you want to? The new law will end up lowering, not raising tax collections, as has been shown by recent state tax hikes on the rich in the US. People vote with their feet.

In France it is not just the tax on the rich that is leading to trouble but so many other actions, like lowering the retirement age to 60, even though people are living longer and there are fewer people paying into the system as the nation ages. France has a near-term entitlements problem at least as severe as the US’s, but government spending is already at 55% of GDP.

By the time France becomes the clear problem, European voters will have committed so much to the process that to walk away will be far more costly than it would be today. Unless Merkel can somehow convince Hollande to really cut social spending dramatically in the coming years, the day of reckoning will arrive. And how has the deficit-cutting approach worked out for Spain, Greece, et al.? For that matter, Germany is in violation of the treaty deficit rules.

My guess: it will be Disaster C, which will mean a longer and more pronounced recession cum depression for much of Europe. And there could be mass public movements to leave the euro in any number of nations. While there is nowhere near a majority for that move in any country in any poll I have seen, it is a growing minority.

As part of this save-the-euro process, I fully expect that at some point there will be a mechanism that allows the ECB to monetize debt and buy peripheral bonds on a very large scale. We are talking multiple trillions of euros, as once you start that process you must continue it until the target country has gotten its deficit under control and is growing again. Whether it is the ESM becoming a bank or being allowed to issue bonds that the ECB can then use as collateral, or any of several schemes being proposed, the only real source of adequate firepower is the ECB. Sooner or later, the Germans will have to let the ECB off its leash, and that will not be good for the euro. And most definitely not when it is France with the problem.

The corollary to this view is that the euro problem will not go away for years. We will get euro fatigue, like Greek fatigue but writ larger. As in the days of my youth, this is going to be like a very long road trip across the country in a car with no air conditioning in the middle of summer, with three young kids and a cranky mother-in-law. Stay tuned.

Carlsbad, San Francisco, Atlanta, and Buenos Aires

I am home for a few weeks, until early September, although I might take a few days off for an actual vacation – I have some very tempting offers. I will be at the Casey Research Conference on “Navigating the Politicized Economy,” September 7-9 in Carlsbad. You can sign up at http://www.caseyresearch.com/2012-fall-summit?ppref=JMD459EM0812A. Then I will be in San Francisco, Chicago, and Atlanta during the next two months for brief engagements with my partners at Altegris Investments, as well as a few speaking gigs here and there. Thankfully, this will be nothing like the schedule I have had the last four months. Details will follow on the various times and places. We are also working on a trip to Buenos Aires and Montevideo in late October, in conjunction with their local CFA groups.

Night has turned into morning, so it really is time to hit the send button. Have a great week and enjoy your summer.

Your wondering when we get there analyst,

John Mauldin

Discuss This

18 comments

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Peter Melia

Aug. 13, 2012, 1:37 p.m.

We have a working example of the results of any country exiting the Euro, and one single actual history is worth all of the other theories put together.
  Actually we have two historical examples of currency switches.
  In 1992 the UK, where I then lived, was ejected from the European Exchange Rate Mechanism.
  It was followed by the predictable panic, with the predicted huge financial losses, the then Government turned the situation around very quickly, and the British economy roared away, to become one of the strongest in the world, until a succession of governments of leftish conservatives and even leftier labourites eroded the advantage.

That is the first example, that of leaving a Euro-like structure.

  Here is another, that of entering a Euro-like structure, in fact, entering the Euro itself. I lived in France at the time, and took part in a European-wide, seemingly seamless transition from national currencies to the Euro. As I recall, the incoming exchange rate Franc to Euro was set at about 6.9555, every country had a different entry exchange rate.
Everything for sale was labelled in both the old and the new currency. Bi-currency hand calculators were for sale at extraordinary low prices (they had two screens, on above the other, you entered a currency in one screen and the conversion immediately appeared in the other).
  The transition was seamless.

  Now, why should not these two historical examples be repeated.
  Why shouldn’t a country exit the euro as the UK, effectively, did, and switch currencies as all the European countries did?
  Why should disasters occur on exiting, when none occurred on entry?

  Perhaps you might like to explore the following two “thought experiments?”
 
  Thought experiment 1. 
Suppose, late on one friday soon, Germany announced that from that moment on, it’s currency would be called the “Mark”. Then details would be revealed of how the notes and coins were already being transported to banks all over Germany.
  The exchange rate between the Mark and the Euro at that moment was set at 1:1, that is, 1 Mark equalled 1 Euro.
  What would happen?

  Thought experiment 2  
Suppose, late on one friday soon, Greece announced that from that moment on, it’s currency would be called the “Drachma”. Then details would be revealed of how the notes and coins were already being transported to banks all over Greece.
  The exchange rate between the Drachma and the Euro at that moment was set at 1:1, that is, 1 Drachma equalled 1 Euro.
  What would happen?

EPual Jacobsen

Aug. 13, 2012, 12:27 p.m.

You cannot fail to address 25 % unemployment.  A generation on the dole.  Unemployed aged 18 - 25 who is hiring you at age 26 with no experience and a bumper crop of fresh CVs from University right behind you.  Technology alone will have surpassed them they won’t know how to function on new computer systems.

Either A.  plan for uprising of some nature, and/or B.  plan to build many prisons, or C.  Incorporate them in your financial planning as permanently unemployed and unemployable.

Germans may want Euro, but they may change their mind when they find out that must pay for Greece’s unemployed generation for 60 years.

steven graham

Aug. 13, 2012, 6:01 a.m.

What was missing from the following paragraph:
The entire Greek bailout was really about using “European” taxpayer money to pay off German and French bank debts. Ditto for the other early bailouts. Now we are down to saving the euro (with the Spanish bailouts), which is an even more costly proposition.

was that was what happened in the US and the bailout of the big investment banks here-
When is doubt- always rip off the tax payer….

Paddy Secretan

Aug. 13, 2012, 2:02 a.m.

Excellent analysis of the options. France is defiitely the proverbial “elephant in the room”. Nobody I have come across can bring themselves to believe that France will give up one cintilla of sovereignty to save the Euro. France will do what she always does - fight to get her way, fight to get advantages over everyone else, and when things don’t tun out as she likes, ignore the rules and continue to do exactly what she wants!

Giovanni Isaksen

Aug. 12, 2012, 10:10 p.m.

Although it seems like it happened a long, long time ago in a galaxy far, far away the fact that we (the ‘advanced’ economies of the world) are facing a planet full of competitive market economies, often with lower wage structures, is the successful outcome of a plan we devised at the end of WWII to make sure WWIII doesn’t happen (One of the most successful human endeavors to date really). Yes it is painful now for us to lose jobs to those ‘poorer’ countries with less worker protection and less concern for the environment but compared to the Mutually Assured Destruction kids of the sixties and seventies grew up with, it’s the best thing since sliced bread. As someone who grew up with at least a handful of MIRVs pointed at my backyard I can tell you this is the good problem. See ‘A Boy And His Dog’ here: http://www.imdb.com/title/tt0072730/plotsummary

I am not saying there haven’t been huge mistakes made but our current situation as bad as it is, is the one preferred by those who survived WWII along with those impressionable youths (including yours truly) who grew up in the cold war.

The whole Euro experiment, as flawed as it is, was a serious attempt to avoid Europe being the cause of WWIII or the next 100 years’ war. Everything I’ve read points to the fact that the Euro experiment was designed to eventually drive those countries into a United States of Europe; kicking and screaming if need be but in the end USE.

John McCullough

Aug. 12, 2012, 2:59 p.m.

“We watch the incessant squabbling with unease, wishing they would just settle things and move on. They never deal with the real issues, as that would mean facing too much personal angst and maybe even lead to an admission that the problem is not just with the other party.”

Is there anyone who does not feel this comment is applicable to us in the US. Perhaps we will have the luxury of seeing our future unfold from a distance. There are differences, but the end of the welfare state is the major underlying commonality, driving all before it.

Jack Rivkin

Aug. 12, 2012, 11:07 a.m.

You mention Argentina and there is hyperinflation. Friends visiting this past week indicated that grocery prices are going up daily and there is now a limit on how much one can spend on one visit to the grocery store without filling out forms for the federales. It is also one of the few countries with a sanctioned black market for currency. Latest rate is 6.6:1 and rising.  This is spreading north.

Paul Weaver

Aug. 12, 2012, 6:30 a.m.

Fear can cause paralysis and indecision. It takes strong brave clear thinking people to take charge . How? Not like Hitler, rooted in tyranny and dictatorship but like Churchill, acting in the service of the people, plugging away with reasoned argument and clear thinking in parliament. Lets hope this person/persons can be found sooner rather than later.
Europe is one problem but the other is the USA.  The roots of much of this started there first.  Starting with Enron and the dot-com crash followed by the Subprime banking scandal. Did Senator Carl Levin ever get a satisfactory answer from Goldman Sachs over whether it was morally correct for the firm to sell its clients products described internally as “crap”? Now the prosecutors have scrapped plans to bring criminal charges against Goldman! Our Banks and hierarchy seem free to carry on much as before after creating Sovereign Debt - passing on the “crap”.
Paul Weaver
Winchester, UK

David Bollich 20966321

Aug. 12, 2012, 5:55 a.m.

Regardless of the idiocy of another massive can-kicking, Plan C changes the investment outlook for a couple of years or so.  Get back on the merry go round.

Ismael Castella Clerch

Aug. 12, 2012, 4:48 a.m.

First of all, congrats for your thoughts Mr. Mauldin.

Your thoughts have strongly reminded me of the ones that Mr. Xavier Sala i Martin (Harvard doctorate and Professor at Columbia University, one of our “universal catalonians”) warned a few weeks ago: The real elephant in the room is ... France.

Greece, Spain, Italy ... all of them are a funny & sunny “park promenade” when compared with what’s-below-the-surface in France.

Most surprisingly ... interest rates for French long term sovereing went NEGATIVE a few days ago. First time ever!

Crazy picture. Crazy markets. Crazy debt ratings!

Just a few macro-data about France:

Public spending: 56% of GDP ... and counting. Average in OECD countries, 43%. In Spain, 41%. Germany and UK, 50%.

Civil servants: 90 per 1000 inhabitants. In Germany ... 50.

Public debt: >90% ... and quickly rising, because public deficit is running at 5.2% of GDP speed.

Income tax on “rich” tax-payers: 75%

Competitiveness: Unit labor costs have grown 21% during the last decade. Whilst in Germany ... they’ve grown 5%.

Labor market efficiency as per World Economic Forum (Davos) assessment: 113th spot in a 144 countries list.

French universities among world’s best 35: None. Among best 100: Three. For UK: 2 in top ten, 10 in top 100.

The ticking bomb in Europe doesn’t speak neither Greek nor Spanish or Italian. The countdown sounds like “dix, neuf, huit, ...”. The elephant in the room speaks French.

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