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.

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!