Europe’s fiscal and debt crises have dominated the financial news for months, and with good reason: the fate of the European Union and its common currency, the euro, hang in the balance. As the world’s largest trading bloc, Europe holds sway over the global economy: if it sinks into recession or devolves, it will drag the rest of the world with it.
As investors, we are not just observers, we are participants in the global economy, and what transpires in Europe will present risks and opportunities for investors around the world.
The issue boils down to this: is the European Union and the euro salvageable, or is it doomed for structural reasons? The flaws are now painfully apparent, but not necessarily well-understood.
The fear gripping Status Quo analysts and leaders is so strong that even discussing the euro’s demise is taboo, as if even acknowledging the possibility might spark a global loss of faith. As a result, few analysts are willing to acknowledge the fatal weaknesses built into the European Union and its single currency, the euro.
In the first part of this series, we’ll examine the structural flaws built into the euro, and in the second part, we’ll consider the investment consequences of its demise.
Fatal Flaw #1: Expanded Private Credit, Toothless Fiscal Discipline
We can start with the flaw that has been widely acknowledged: the asymmetry between the benefits of extending credit to member states and the lack of control over those states’ Central State fiscal budgets and structural deficits.
While the European Union consolidated power over the shared currency (euro) and trade, it did not extend control over the member states’ current-account (trade) deficits or budget deficits. While lip-service was paid to fiscal responsibility via a 3% cap on deficit spending, in the real world there were no meaningful E.U.-controlled limits on private or sovereign (central government) borrowing and spending.
In effect, the importing nations within the union (Ireland, Greece, Portugal, Spain and Italy) were awarded the solid credit ratings and expansive credit limits of their exporting cousins, Germany, The Netherlands and France. In a real-world analogy, it’s as if a sibling prone to paying life’s expenses with credit was handed a no-limit credit card with a low interest rate, backed by a guarantee from a sober, cash-rich and credit-averse brother/sister.
Rising Risk Leads to Rising Rates
Needless to say, it was highly profitable for the big European and international banks to expand lending to these new, previously marginal borrowers. This led to over-consumption by the importing States and staggering profits for big Eurozone banks. And while the real estate and credit bubble lasted, the citizens of the bubble economies enjoyed the consumerist paradise of borrow and spend today, and pay the debts tomorrow.
Tomorrow has arrived, but the foundation of the banks’ assets—for example, the market value of housing in Spain—has eroded to the point that both banks and homeowners are insolvent. The heightened risk of default, both by banks and the governments trying to bail them out, has caused interest rates in the debt-burdened countries to rise.
Faced with the rising costs of servicing their debt and deep cuts to government budgets, the citizenry of the profligate member states are rebelling against austerity measures. Meanwhile, taxpayers and voters in the exporting member states such as Finland and Germany are rebelling against the gargantuan costs of bailing out their weaker neighbors.
There is no way to resolve this asymmetry between credit expansion and sovereign fiscal imbalances without sacrificing national autonomy to E.U. bureaucrats, who would presumably gain authority over tax laws and collection in Greece, Italy, Spain, Portugal and Ireland.
To expect these states to surrender their autonomy for the dubious benefits of servicing their crushing debts to big European banks is an exercise in political fantasy: it isn’t going to happen.
Fatal Flaw #2: Profits Are Private, Losses Are Public
But beneath this one acknowledged structural imbalance lies even deeper flaws embedded in the model of Neoliberal Capitalism, the "liberalization" of trade and capital flows as a means of opening markets and enabling free enterprise to take on tasks formerly reserved for government (the Central State) or State-sanctioned corporations.
The key feature of the Neoliberal model borrowed from Classical Capitalism is that the risks of enterprise and the investing of capital are (supposedly) transferred from the Central State to the newly liberalized private sector. But this turns out to be a charade played out for public-relations/perception management purposes: when the expansion of credit and financialization ends (as it must) in the tears of asset bubbles popping and massive losses, then the Central State absorbs the losses which were supposedly private.
My definition of Neoliberal Capitalism differs significantly from the conventional view: markets are opened specifically to benefit the Central State and global corporations, and risk is masked by financialization and then ultimately passed onto the taxpayers. In this view, the essence of Neoliberal Capitalism is: profits are privatized but losses are socialized, i.e. passed on to the taxpayers via bailouts, sweetheart loans, State guarantees, the monetization of private losses as newly issued public debt, etc.
The Neoliberal model is superficially a win-win for both global corporations and Central States, as the Central State benefits from the explosion of tax revenues created by financialization and the expansion of credit, and from the schwag showered on political apparatchiks by the global corporations.
From a Neoliberal perspective, the union consolidated power in a Central State proxy (The E.U.) and provided large State-approved cartels and quasi-monopolies access to new markets—the previously marginalized importing states.
From the point of view of the citizenry, it offered the benefit of breaking down barriers to employment in other Eurozone nations. On the face of it, it was a “win-win” structure for everyone, with the only downside being a sentimental loss of national currencies.
Thus the expansion of the united European economy via the classical Capitalist advantages of freely flowing capital and labor were piggy-backed on the expansion of credit and financialization enabled by the Neoliberal model of the union.
The alliance of the Central State and its intrinsic desire to manage the economy to benefit its fiefdoms and classical free-market Capitalism has always been uneasy. On the surface, the E.U. squared the circle, enabling stability, private-bank credit creation and easier access to new markets for all.
But the fatal flaw in the Neoliberal model has now been revealed: once the unlimited credit issued by financialization poisons the sovereign states’ balance sheets and cash flows, then there is no mechanism to bail out all the players: the “too big to fail” European banks, the sovereign debtor states and private-sector borrowers. All three are now hopelessly insolvent, and the conventional fixes of renegotiating the terms and extending additional credit are simply papering over this stark reality.
Fatal Flaw #3: Low Interest Credit Spurred Misallocation of Capital
The financialization unleashed by the E.U. had other poisonous consequences.
Credit at very low rates of interest is treated as “free money,” for that’s what it is in essence. Recipients of free money quickly become dependent on that flow of credit to pay their expenses, which magically rise in tandem with the access to free money. When access to free money is suddenly withdrawn as the borrower’s ability to service the debt comes into question, the debtor experiences the same painful withdrawal symptoms as a drug addict who goes cold turkey.
Other pernicious effects follow. Free money soon flows to malinvestments whose risks and marginal nature are masked by the asset bubble which inevitably results from massive quantities of free money seeking a speculative return. This systemic misallocation of capital is exemplified by the empty McMansions littering the countryside in Ireland and Spain.
The Neocolonial Model of Financial Exploitation
The E.U.’s implicit guarantee to make good any losses at the State-sanctioned large banks—the Eurozone’s “too big to fail” banks—enabled a financial exploitation that is best understood in a neocolonial model. In effect, the big Eurozone banks “colonized” member states such as Ireland, following a blueprint similar to the one which has long been deployed in developing countries.
This is a colonialism based on the financialization of the smaller economies to the benefit of the big banks and the member state governments, which realize huge increases in tax revenues as credit-based assets bubbles expand.
As with the Neoliberal Colonial Model (NCM) as practiced in the developing world, credit-poor economies are suddenly offered unlimited credit at very low interest rates. It is “an offer that’s too good to refuse” and the resultant explosion of private credit feeds what appears to be a “virtuous cycle” of rampant consumption and rapidly rising assets such as equities, land and housing.
Essential to the appeal of this colonialist model is the broad-based access to credit: everyone and his sister can suddenly afford to speculate in housing, stocks, commodities, etc., and to live a consumption-based lifestyle that was once the exclusive preserve of the upper class and State Elites (in developing nations, often the same group of people).
In the 19th century colonialist model, the immensely profitable consumables being marketed by global cartels were sugar (rum), tea, coffee and tobacco—all highly addictive, and all complementary: tea goes with sugar, and so on. (For more, please refer to Sidney Mintz’s book, Sweetness and Power)
In the Neoliberal Colonial Model, the addictive substance is credit and the speculative consumerist fever it fosters.
In the E.U., the opportunities to exploit captive markets were even better than those found abroad, for the simple reason that the E.U. itself stood ready to guarantee there would be no messy expropriations of capital by local authorities who decided to throw off the yokes of European capital colonization.
The “too big to fail” Eurozone banks were offered a double bonanza by this implicit guarantee by the E.U. to make everything right: not only could they leverage to the hilt to fund housing and equities bubbles, but they could loan virtually unlimited sums to the weaker sovereign states or their proxies. This led to over-consumption by the importing States and staggering profits for the TBTF Eurozone banks.
Now the losses resulting from these excesses of rampant exploitation and colonization by the forces of financialization are being unmasked, and a blizzard of simulacrum reforms have been implemented, none of which address the underlying causes of this exploitive financialization.
The European Central Bank (ECB) and the E.U. political leadership are trying to stabilize an intrinsically unstable private-capital/State arrangement—profits are private but losses are public—by shoving the costs of the bad debt and rising interest rates onto the backs of taxpayers. The profits from this Neoliberal exploitation were private, but the costs are being borne by the taxpaying public.
In the insolvent states, taxpayers are seeing services cut and higher taxes/fees, while those in the mercantilist (exporting) economies are being saddled with higher taxes to fund the bank bailouts.
The useful fiction (useful to the banks and their apologists in office) is that it is the insolvent nations that are being bailed out, but in reality it is the big banks which loaned vast sums to these nations which are being bailed out.
In effect, the residents of the E.U. are being forced to bail out private banks. At some point, the citizens of one or another sovereign state will refuse, and the Union will break along the lines of those states committed to saving the banks and those which are willing to throw the banks under the bus as an act of self-preservation.
Fatal Flaw #4: The Imbalance Between Exporting and Importing Nations
Another intrinsic source of instability is the imbalance between export powerhouse Germany that generates huge trade surpluses and its trading partners in the EU that run large trade and budget deficits— Portugal, Italy, Ireland, Greece, and Spain.
Those outside of Europe may be surprised to learn that Germany's exports are roughly equal to that of China ($1.2 trillion) even though Germany's population of 82 million is a mere 6% of China's 1.3 billion. (Germany and China are the world's top exporter nations, while the U.S. trails as a distant third.)
Germany's emphasis on exports places it in the so-called mercantilist camp which depends on exports for their growth and profits. Since the inception of the euro, Germany's exports rose an astonishing 65% from 2000 to 2008 while its domestic demand was near zero. Without strong export growth, Germany's economy would have been at a standstill. The Netherlands, which reaped a $33 billion trade surplus from a population of only 16 million residents, is another example of a Eurozone country which runs substantial trade surpluses.
The "consumer" countries, on the other hand, run large current account (trade) deficits and large government deficits. Italy, for instance, has a $55 billion trade deficit and a budget deficit of about $110 billion. Total public debt is a whopping 115.2% of GDP.
Spain, with about half the population of Germany, has a $69 billion annual trade deficit and a staggering $151 billion budget deficit; fully 23% of the government's budget is borrowed.
Though German wages are generous, the German government, industry and labor unions kept a lid on production costs even as exports leaped. As a result, the cost of labor per unit of output—the wages required to produce a widget—rose a mere 5.8% in Germany in the 2000-2009 period, while equivalent costs in Ireland, Greece, Spain and Italy rose by roughly 30%.
The consequences of these asymmetries in productivity, debt and deficit spending within the Eurozone are subtle. In effect, the Euro gave mercantilist, efficient Germany a structural competitive advantage by locking the importing nations into a currency which made German goods cheaper than domestically produced goods.
Put another way: By holding down production costs and becoming more efficient than their Eurozone neighbors, Germany engineered a de facto devaluation of its own products within the Eurozone at the expense of its importing neighbors.
Fatal Flaw #5: The Euro Removed the Mechanism of Currency Devaluation
The Euro had another deceptively pernicious consequence: the overall strength of the currency enabled debtor nations to rapidly expand their borrowing at low rates of interest. In effect, the Euro masked the internal weaknesses of debtor nations running unsustainable deficits and those whose economies had become precariously dependent on the bubble in housing (Ireland and Spain) for growth and taxes.
Prior to the advent of the Euro, when overconsumption and over-borrowing began hindering an importing, "consumer" economy, the imbalance was corrected by an adjustment in the value of each nation's currency. This currency devaluation would restore the supply-demand and credit/debt balances between mercantilist and consumer nations.
For instance, the Greek drachma would fall in value versus the German mark, effectively raising the cost of German goods to Greeks, who would then buy less German products. The trade deficit would shrink and lenders would demand higher rates for Greek government bonds, effectively pressuring the government to reduce its borrowing and deficit spending.
But now, with all 16 nations locked into a single currency, then devaluing currencies to enable a new equilibrium is impossible. As a result, Germany is faced with the unenviable task of bailing out its "customer nations.” Meanwhile, the residents of Greece, Italy, Spain, Portugal and Ireland are faced with the unenviable task of cutting government benefits to realign their budgets with the productivity of their underlying national economies.
Germany helped enable the over-borrowing of its profligate neighbors by buying their government bonds; according to BusinessWeek, German banks are on the hook for almost $250 billion in the troubled Eurozone nations' bonds.
This has pushed Germany into a double-bind: if Germany lets its weaker neighbors default on their sovereign debt, German banks will fail, but if Germany becomes the "lender of last resort" then the German taxpayers end up footing the bailout bill.
If public and private debt in the troubled nations keeps rising at current rates, it's possible that even mighty Germany may be unable (or unwilling) to fund an essentially endless bailout. That would create pressure within both Germany and the debtor nations to jettison the single currency as a good idea in theory but an ultimately unworkable one in a 16-nation bloc as diverse as the Eurozone.
Fatal Flaw #6: Crushing Private and Public Debts
Banks around the world have a major challenge in the next few years: trillions of dollars in debt must be "rolled over" or refinanced. Globally, banks owe about $5 trillion to bondholders and other creditors that will come due by 2012, according to the Bank for International Settlements (BIS).
But European lenders have a substantial share of that burden: about half of the liabilities—some $2.6 trillion--are in Europe.
The BIS has several fundamental concerns about this stupendous Eurozone debt load. One is that banks desperate for refinancing will compete with governments such as those in Greece and Spain which must also roll over gigantic sums in the global bond market. Competition for bondholders' favors will result in higher credit costs for business and consumers, with predictable consequences: higher borrowing costs lead to reduced economic activity.
The BIS's second great concern is the gargantuan sums that have been promised to citizens in Eurozone social welfare programs. As Europe's working-age population shrinks and the number of its retirees rises, the ability of governments to pay the benefits and service the huge debts which have been accumulated is in question.
The choices facing governments with rising social welfare costs and debt costs are bleak: either cut benefits and/or raise taxes on a dwindling base of workers.
The bottom line: The flaws in the structure of the European Union and euro cannot be resolved by face-saving compromises and additional bailouts.
Since the devolution of the Eurozone and the euro is baked in, as investors we need to think through the consequences of a probably messy restructuring of the EU and the euro. In Part II of this report: Positioning Yourself for the Devolution of the Euro, we delve into the most probable series of outcomes for the euro and how investors can position themselves to protect and likely increase the purchasing power of their captial vs this troubled currency.
Click here to access Part II of this report (free executive summary, enrollment required for full access).
