Let Sleeping Corpse Lie: Dawn of the Eurozone

Europe has long been a place of economic stagnation. Asides from the odd place or two such as Ireland or the Baltic States, Europe has generally seen its citizens’ standard of living stagnate over the years. Europeans are used to seeing inflation slowly eat away at their purchasing power, asset price inflation eat away at housing affordability and taxes reducing their disposable income. But when you are some of the richest people in the world as measured by per capita GDP stagnation isn’t the worst thing that can happen to you. What is about to happen to Europeans however is less tenable. What is about to happen to Europeans is a repeat of the Japanese experience with their ‘Lost Decades’, but in a World with heightened international competition and rapidly increasing productivity of developing nations this version of the Lost Decades syndrome will seem much more punishing.

On the face of it bank bailouts may seem like the appropriate thing to do when your banking system looks like a rocking Humpty Dumpty on the wall. The Japanese experience should have served as a warning to other governments against the dangers of bailing out banks. When Japan’s property and equity bubble burst at the end of the 90’s the government hit the bailout peddle full steam in an effort to avoid bank runs. The result, was the creation of Zombie banks. Bank’s in Japan had the real value of their assets crippled, forcing Japan’s central bank to come in and pump massive amounts of liquidity into the banking system to keep banks liquide. As banks used the extra liquidity to pay down their overstretched balance sheets’ liabilities, instead of lending them out into the real economy, growth stagnated for years. Japanese banks became simultaneously liquide and insolvent.

The usual process of bankruptcy is to have a judge look over the balance sheet of a corporation and determine how much of the liability side needs to be reduced to create a solvent and sustainably profitable firm. Equity investors are typically wiped out and debt investors get a ‘hair cut’ on their bonds, or see their bonds converted into equity (shares). The process reduces the debt of a bankrupt company to a level that can be covered sustainably. The alternative to this form of bankruptcy is a winding down of the business. If a company is recognized to have a permanently crippled business model and is expected to sustainably loose money, it becomes preferable to liquidate all assets and try and pay back as many debts as possible. In the US these two forms of bankruptcy are called chapters 11 and 7 respectively.

Following a chapter 11 bankruptcy two things may occur that will send a company back into bankruptcy or forced to liquidate. Either business conditions deteriorate and the company’s revenues no longer suffice to pay its interest costs, or the debt reduction is not steep enough from the get-go and the corporation’s normal revenues never really cover the newly diminished interest expense.

The emergence of Zombie banks would occur when both the above mentioned difficulties arise. Bailouts, taking the usual form of a capital injection (the government buying lots of newly issued shares, to the detriment of previous share owners) has the partial effect of of wiping out equity investors but saves debt investors. Without hair cuts to bonds a banks interest expense remains high hence crippling the banks ability to inject loans to underpin the real economy. This problem is further compounded by a lack of chapter 7 style bankruptcies.

Banks’ profit margins tend to be extremely narrow in the best of times; According to the Bank of International Settlements Spanish banks’ current profit margin as a percentage of assets is a measly 0.61% at present, while Germany’s big banks barely squeak out a 0.20% profit margin in 2011. Hundreds of variables will explain why European banks profit margins are razor sharp but Anglo-Saxon banks in Canada and Australia rise above the 1% mark, most economist and financial analyst would chalk up a big part of this discrepancy to the competitive nature of banking in different countries. Canada and Australia are countries were industry concentration is high whereas in the US and Europe the banking industry is atomized and fiercely competitive.

When chapter 7 style bankruptcies are effectively ruled out by bailouts, banking industries are prohibited from consolidating to a more natural level of concentration. Profitability is kept artificially low by excessive competition to issue loans and attract savings. The effect of too much competition in an environment where bank profitability is hampered by both excess industry atomization and crippled balance sheets is obviously the creation of Zombie banks. What European authorities are doing with bailouts is stopping progress in its tracks. While bank bankruptcies might raise long term interest rates in the sector, it would mostly lead to consolidation and concentration which would embolden banks to lend to the real economy. This is how over the counter European bailouts are killing growth.

There is however bailouts of the under the counter sorts. The ECB has done what the Bank of Japan has tried before it, albeit in its own way. The ECB’s LTRO (Long Term Refinancing Operations) have been used to increase the liquidity of banks in Europe. Instead of its normal refinancing operation, lending to banks for less than 6 months with adequate collateral posted, the ECB has accepted lower quality collateral (despite what it may say) and refinanced at maturities up to 3 years at favorable rates. The idea was to buttress banks’ balance sheets to avoid a dry up in lending. The effect however was to lend cheaply to banks in PIIGS countries (but also elsewhere) who then plowed the money back into high yielding Spanish, Italian governments bonds and the like. So we are in a funny situation, bank profits in Europe are dismal (Italy’s banking sector is yielding -1.22% profits over assets) but their net interest margins are creeping up, all while real business is starved for credit.

Astute observers will have seen this all before, in Japan. Most will be distressed at the pueril actions of leading bureaucrat financiers and economists. Many now regret the resignations of Jurgen Stark and Axel Weber, some of the last monetary hawks who warned against the current ECB roster of economists frivolous policies. Time alone will tell how foolish or not the current fiscal and monetary policies of the Eurozone are. Let’s all hope that a repeat of Japanese banking woes don’t make a repeat appearance and finally slay what was one of the noblest experiments of our times.

Spanish Bank’s Get Government Brokered Bailout

Madrid / Brussels. While Spanish Prime Minister Mariano Rajoy continues to deny Spain’s need to bailout its banking sector an informal agreement has been reached on the possibility of Spain taping 100 Billion Euros for the purpose of restructuring its banks. The agreement was apparently reached in less than two hours over the weekend at which time Spain was offered $125 Billion with virtually no strings attached. While the details of the agreement remain unannounced, previous rounds of austerity measures and structural reforms were enough to convince Northern Europe of Spanish fiscal credibility and bailout merit.

Whether the European Stability Mechanism will be employed to fund the European loan to Spain or whether the temporary European Financial Stability Facility will be used remains to be negotiated as the ESM is not slated to be in operation before the end of June 2012. Spanish borrowing needs till the end of the year amount to roughly 70 Billion Euros and estimates for a banking bailout in Spain have ranged from 40 to 90 Billion Euros, meaning the European loan could very possibly be large enough to cover all governmental liquidity needs till 2013. If that is the case the nominal yield on Spanish debt will matter little in for the short term and give Spain another 6 months to implement structural reform conducive to growth.

The loan will be provided to the Fund for Orderly Bank Restructuring (FOBR), a Spanish regulatory group created in 2009 to oversee bank mergers and acquisitions, with the objective to ensure that all banking groups in Spain remain solvent. With a war-chest previously estimated at 99 Billion Euros minus the Bankia bailout, the European loan will bring the FOBR’s capital firepower up to ~180 Billion Euros.

The downside of the loan is that it would bring Spanish debt to GDP levels up to ~90%, a historically undesirable number. Another worry for investors is whether the ESM or EFSF will be the loan issuers. ESM issued loans and rescue passages will have senior status and subordinate all previously issued bonds and treasury bills, while the EFSF originated loans have the same status as privately marketed debt securities. This uncertainty wiped out all the gain in Spanish bond prices initially generated by the announcement. It is widely speculated that the loan will not subordinate private debt as Germany and co. would like to see Spain return to capital markets to finance its deficits at reasonable yields.

Another concern is the continued slid in property values that could lead to higher bad loan ratios at the banks. Banking loans past due by 3 months have already reached highs not seen since the mid 90’s, at a staggering 143.5 Billion Euros. With property values continuing to slide and unemployment still at ~24% the risk of a continued slid in Spanish bank assets may eclipse the size of the current bailout proposal.

Negotiations are expected to resume once Mariano Rajoy has finished watching the Euro football championship, which might be soon seeing as the Spaniards could not even beat Italy in round robin play.

Letter for Spanish Bankers

Spanish Banks are in a tough spot. A commercial property collapse on the tails of the financial crisis and recession of 2008-2012 has investors wondering how safe spanish bank balance sheets really are. With the recent failure and oncoming bail out of Bankia most investors have stopped wondering. The real risk to spanish banks however is a run on deposits. The Greek banking sector is already suffering from capital flights on worries of forced conversion of Euros to Drachmas. With a new election coming up in Greece and mounting fears of a Grexit, the risk for contagion of depositor fear is now quite heightened. With balance sheets already substantially weakened by the property bubble burst the spanish banking sector can ill afford to fall pray to deposit redemption ‘en masse’.

The ECB under Mario Draghi has shown some inclination to incarnate the ‘lender of last resort’ role, while the scale of these intentions have been of a large magnitude they remain modest in scope. While the extending of Long Term Refinancing Operations’ maturities and accepting collateral composed of downgraded sovereign bonds was still accepted, represented a bending of the spirit of monetary hawkishness, these actions still respect the rules imposed on the ECB by its Bundesbank roots. So the political will and the monetary structures of the Eurozone will not be available to monetize spanish debts away. The reality is that to avoid a Greek downward spiral the solutions to Spain’s problems must come from within Spain.

One way to partially bypass the ECB’s reluctance to engage more forcefully in solving the oncoming spanish banking crisis is to create a private and local version of a central bank. A bank of banks could be created and capitalized by the largest banks in Spain. A rigorous stress test could be undertaken to determine which banks have the necessary capital buffers and risk management practices to be eligible to participate in the scheme. Once fully capitalized enough and large this bank of banks could provide liquidity guarantees to the banks having passed the stress test. This would represent the mutualization of risk in the banking sector, essentially reducing un-systemic risk for the participating banks.

The remaining banks could then either be recapitalized by the federal government through the purchase of equity by the government (as was the case in the US in 09) or be closed following a bank holiday as was the case in the 30’s. While this would be costly, with a large enough proportion of banks’ liquidity needs covered by the bank of banks hopefully the cost of bailing out the insufficiently funded banks would not be fiscally crippling to the nation.

While these actions could alleviate the risk of a system wide shut down and bailout as was the case in both Ireland and Iceland, the issue of systemic risk stemming from the property bubble burst would remain.

Only a jolt of growth could sustain property prices at levels high enough to preserve bank balance sheets. Liberalizing the spanish through labour market deregulation is a good way to grow an economy in the long run, but with the global economy still teetering, a rebound in industries outside construction seems unlikely. The only option remaining to banks to preserve their balance sheets would be to take a hit on their cash flows. To prevent a further deterioration in housing prices banks will have to consider the inconsiderable. Banks must collectively agree on some form of debt forgiveness. Preferably it would take the form of mortgage extensions and interest payment sabbatical. Such a move could alleviate the pressure on spanish consumers and avoid a series of foreclosures of a magnitude from which banks could not survive. After their stress tests the banks could agree on what levels of temporary interest forgiveness could be acceptable without sparking bank bankruptcies.

This would hopefully give the Spanish economy enough time to begin restructuring towards external sectors such as manufacturing for export. While the moral hazards are numerous and the conditions for success are many, only bold actions undertaken by the banks and acceptable to them will lead to a sustainable solution. These actions would lead to a temporary crimping of banking profitability, but it might preserve their balance sheets and offer their government the respite needed to find solutions to the underlying competitiveness issues that face the nation. Their shareholders may thank them one day, and so may all the indignados.

European Quantitative Easers Let’s Talk

The Eurozone sovereign debt crisis is posing a real challenge to Europe’s policy makers. The un-abating liquidity squeeze on government borrowing is threatening to turn into a solvency crisis in which more Eurozone countries are at risk of defaulting on their debts. The interest rates at which governments are currently borrowing are for the most part unsustainable, with countries like Italy and Spain borrowing at dangerous levels previously reserved for the smaller members of the PIIGS group. Broadly, two schools of thought have emerged with solutions to the problems at hand, one we will call the Monetary Keynesians and the other the German School of thinkers. The former are represented by such personalities as Roger Bootle of Capital Economics, the famous Dr Doom Nouriel Roubini and the New York Times Econom ic’s Nobel Prize winner Paul Krugman, while the latter are represented by the likes of the resigned ECB Governing Council members Axel Weber and Jurgen Stark.

The first group is advocating using the printing press and nationalizing (or federalizing) distressed sovereign debt. That is to say they want the Eurozone, through the ECB, to print money to by debts that can’t be paid back by member countries who spend more money on goods and services than they produce. The excuse found to justify this action is that the fledgeling economies are actually able to produce enough wealth to sustain their social systems but that because of a temporary bleep of liquidity issues they need temporary help. Nothing could be further from the truth. France to name just one of the irresponsible countries (although not yet a crisis country) has not passed a balanced budget since 1973! Greece has lied about its overspending for years prior to the crisis and the Eurozone as a groupe only managed a budget surplus in 2001 in the last 20 or more years. What does this say about European fiscal rectitude? it says that it doesn’t exist the Eurozone has always had a structural deficit. The sovereign debt crisis has been in the making for a long time, the Keynesians excuse that it is a temporary problem needing papering over is bogus.

Not just bogus but also internally inconsistent. Keynesianism calls for counter cyclical fiscal policy, while american liberals like Paul Krugman say that pro growth spending is positive in bad and good times alike. In any case the Greeks have proved that policy wrong. Another solution proposed by the less hawkish of economists is to have the ECB double down on its LTRO or renew its sovereign bond buying program. Imagine the ECB mostly backed by Germany buying Spanish, Portugese or Italian bonds. Now imagine investors believe that the problem remains unfixed and that primary deficits can’t be fixed by liquidity improvements, yields will continue rising and bond values will continue dropping. The ECB will either have to print money to paper over its loss sparking inflation or it will have to beg the big Eurozone economies to bail it out. Now assuming Europeans remember what low growth high inflation looks like (see 70’s and 80’s) they will surely stay true to their feelings of entitlement and choose to pressure the Eurozone core to pay up.

Now the Germans, Finnish, Dutch et al. have already shown their distaste for profligate Mediterraneans’ bail outs, so does anybody really think the ECB will go down that road? Well you’d be right if you think it might happen, with all the German resignations at the ECB, the institution seems to be loosing its hawkish edge. Forget the stellar inflation busting record under Trichet, the ECB is going south.

These are disappointing times for some economists, the world is awash with exemples of virtuous macroeconomic policy and yet some continue to advocate tried and failed policies or policies that are untried and risky. Why does no one point towards Canada where austerity in the nineties have led to stable government expenditure levels today, or Germany where austerity was imposed, unit labour cost were lowered and how about Estonia which consolidated spending massively in the face of a deep contraction in output and today is one of the Eurozone’s fastest growing economies. The Eurozone periphery is small enough that deep primary-surplus generating government spending contractions wouldn’t affect he currency zone as a whole too deeply. Portugal and Greece could have been the next Estonias, instead talks of bailout and quantitative easing has inspired periphery politicians to stall and not make the necessary decisions for growth.

The PIIGS, France and all other fiscally week Eurozone countries need to do three things: stop dithering and waiting for someone else to bail them out. They need to emulate Mario Monti’s drive for competitiveness, shoot for growth and competitiveness. Then they need to emulate the tiny Estonian country and actually start generating budget balances through lower expenditure and not through heightened taxes. What the rest of the World needs to do is stop giving ball-less politicians excuses for their failures and easy solution proposition. The road to wealth has already been traced, it’s time Europeans stopped pretending they are smarter than the rest of the World and American liberals need to open their eyes to the reality that free lunches dont exist and the hard road is the better road!

In praise of all that is German

Germany hasn’t been getting a lot of slack of late. Between accusations of trying to succeed where they’ve failed in two previous World Wars – dominating Europe – or accusations scuttling the European Project out of selfishness, and again with cries that Germany is abandoning the Euro, the nation of sauerkraut and beer is in the throws of a full blown Greek tragedy (lol pun intended). Asides from the on camera superficial Merkozy marriage, no french love seems to be crossing the Rhin. Further compounding the courteous hate fest, Italian flirting has gone from invitations to the bunga bunga parties (most often refused anyways) to the sober and stale Monti ear whispering for more cash. Somehow, I don’t think encouragements from the euro-sceptic nationalisty Finns was the recognition Berlin technocrats were looking for. The Euro area is eerily looking like an Animal Farm in the throes of its Orwellian infancy. Need I really specify which Euro countries are acting like over-eager egalitarian PIIGS, hrum I mean pigs, seeking the overthrow of opulent and oppressive markets, hrum… I meant masters. All punning aside, I believe there may be a little lack of balance in the debate over fiscal and monetary policy proposals to the Euro area mess.

Let’s start by awarding praise where it is due and sing the virtues of the German machine, hrum… economy sorry forgot about the inter-temporal analogy bank. To my knowledge German policymakers are the only ones of any major economy who seem to have learned the lessons of history. This is no coincidence as not-repeating the errors of history has become part of German culture. Little children are taught at school about the immeasurable harm generations of their ancestors have wrought upon the world (maybe even too zealously). A cursory look at the lessons young children learn from Dortmund to Munich, leaves the history amateur with a few residual lessons in economic virtue, that we shall survey here:

1) Inflation = bad. How so? Well inflation leads to economic inefficiencies most notable of which is the rise of unemployment, which then leads to socio-political problems we need not raise here. To see just how hawkish they are monetarily, read anything on the Bundesbank or even the ECB.

2) Trade competition = good (especially when your winning). How so? The best buffer when in hard times is to have a trade surplus and savings. Germany has been at the forefront of multilateral trade talks, especially in Europe (see European Union history) but also internationally. I guess Germans remember how bad Smoot-Hawley was for everyone and how good the life has been since… well… 1946 I guess.

3) Hard work = prerequisite to 2). Now I know this might sound sacrilegious to all of us westerners getting used to resting on the laurels of previous generations hard work but bear with me. Our current level of wealth is tied if anything to previous generations working hard, earning dough, not spending but saving dough in the bank account, that dough being magically transformed by the financial industry into fixed capital formation, a.k.a. every single piece of equipment, factory infrastructure that buttresses our current economies. If you didn’t follow the flow working harder than your living standard would entail serves as the anvil of tomorrows wealth. Germans get that, they preach it, than they actually do it. This saving/underspending/fixed capital forming needs to happen at the household level, the firm’s level and the governmental one.

4) Mash up all of the above = hawkishness in every sphere of public policy (and private actually) = kicking the worlds butt economically.

So what has been going on exactly in Europe? following the above stated framework for success lets see where things went wrong. Europe was a place of high savings (or at least American savings though the Marshall Plan)a, hard working and rebuilding for while following WWII. No problems so far. Italy, Britain and France had thriving industries, peripheral Europe slowly started democratizing itself. Than they started moving towards the European Union. Savings and investment flows started getting a little complex at this point. Big Euro countries started saving for peripheral ones, sending money so that those countries could invest in infrastructure modern

isation and other stuff of the like. Eventually thy took a bunch of countries with a myriad of fiscal and monetary systems and patched them together into a big currency block. Germany kinda knew where this was going so they tried the  true and tested policies. They retrenched further into fiscal and macro-prudential austerity. So yes this national savings craze as measured by a current account surplus peaking at 7.4% of GDP just before the crisis hit in 08, did lead to some imbalances within the Euro block by depressing Euro wide inflation numbers and interest rates. The real trouble however wasn’t German economic virtue it was the rest of Euro countries, more particularly the PIIGS, reaction to these circumstances. How did they react, like all good socialisty, humanisty, mushy hearted westerners, they indulged in profligate entitlement spending. Riding on the coattails of previous generations of hard work and contemporary German virtue (i know redundant), they offered their people an easy life at low borrowing costs.

Then one day the masters hrum… markets, sorry, woke up and said “the break is over back to work”. The current crisis boils down to looking to the Germans and saying no we don’t want to work as hard as you! keep paying. Unfortunately markets tend to act like the tough love parents that they are and Germany seems content to not act like the over-indulgent parent its savings temporarily were. Now some might quibble that the crisis is one of solvency or simply liquidity needing some temporary patching to be corrected. What needs correcting is peripheral Europeans expectation of living standards they must go down! if they are one day to go up to Germany’s level. Increasing the ESM or EFSF or introducing eurobonds does not solve the problem. Even Angela Merkel’s suggestion of limiting federal governments deficits to 0.5% of GDP remains to timide a goal. Mario Monti is somewhat on the right track in Italy. Although his reforms are limited in scale they are in the right direction. A combination of fiscal austerity coupled with market liberalization is the equivalent of putting italians back to work. Less play more labour! is the key to making labour unions howl and incidentally generating long-term wealth. Let’s hope more european nations decide to go the german path to prosperity before the s*** really hits the fan.

Cius