WE NEED TO TALK ABOUT EUROPE 2.0

Another European soccer championship is behind us (Eviva Espana) and it will be 4 years before the next one comes around. I wish the same could be said for EU summits which seem have become an almost constant feature in our lives.  The recent summit has brought some results, namely the attempt to break the link between banks and sovereigns, however, no game changer is in sight: same, same – just different. Whilst the market reacted positive, the crux is in the detail and the sovereign debt crisis is far from over. More drama and summits are likely on the cards, muddling through will continue to be the policy response du jour. The best way to cope with the sovereign crisis is to accept it as the new normal – and with it more volatility and less liquidity – as for various reasons an end is very unlikely in the short-term.

Fundamental disagreement over the causes of the crisis

An often overlooked point is that the Euro states are in strong disagreement of what the root of the crisis is. If you can’t agree on what went wrong, how can you agree on how to fix it?

There are two camps in Europe. The first believes that a monetary union among countries with fairly different economies cannot work and the stronger nations need to support the weaker ones. This view is mostly supported by the Southern European states: it-is-not-us-but-the-system is for obvious reason quite popular.  The Northern camp believes that the crisis states have pursued ‘good’ old fashioned poor economic policies and lost competitiveness, something the rules  of the Euro offered little incentives to avoid. As it looks unlikely that the two camps converge, swift solutions are not to be expected.

Sovereign debt crisis has been in the making for a long time

The second obstacle for a quick fix is that the problem is rather bigger than most politicians like to admit (or grasp?). Undoubtedly having a single currency (and no ability to devalue) makes it harder for countries to maintain competitiveness, however, Europe’s problems are largely self-inflicted. Although there are differences between Euro nations, there are common themes: lack of competiveness and over-spending. Unfortunately none of these are easy to fix in the short-term.

The creation of the Euro coincided with globalisation which many nations happily ignored, foregoing important but unpopular structural reforms in order to maintain competiveness. Italy’s decade of virtually no growth is rather a consequence of its structural rigidities than the Euro. Portugal still needs to figure out where to position itself after Eastern Europe and Asia took its spot as low cost labour producer. Not only companies need a competitive advantage and product, but also countries – a concept which many European countries still have to embrace as they seem to live in a bygone area. Even Nadal could not win the French Open if he turned up with an old Björn Borg racket, or could he?

The European malaise is best summarized by the over-ambitious 2000 Lisbon agenda which aimed to turn Europe into the most competitive area worldwide within 10 years. Obviously that did not go to plan, particularly worrying is that policy makers seem to spend little time contemplating the reasons why.


Government annual surplus or deficit

Besides snoozing on globalisation, many nations continued to build out welfare states which were always unsustainable in the long run, never mind the Maastricht criteria.  France had its last government surplus in the early 70s and its expenditures have exceeded revenues ever since. Whilst politicians suggest that the sovereign debt crisis is a result of the bursting of the credit bubble, it has merely been accelerated by it. Sovereign debt levels in many nations were already on a path to unsustainability pre-2007. Few noticed as everybody was too busy buying structured credit instead of paying attention to something as mundane as government debt. Less charitable souls would call the sovereign spending behaviour over the last 30 years an intergenerational Ponzi scheme: spend now, let later generations figure out the mess. Well, if you are still in doubt, later would be about now!

Democracy does not help

Don’t get me wrong, I would rather live in the Western world than under an oppressive regime, however, democracy does not help solving the crisis. By nature, democracy breeds a type of politician which will overspend to get elected. When cuts need to be made,  most politicians have no incentive to run on/implement such an agenda, after all they never signed up to such a job description!

The perfect example is the recent French election in which Mr Hollande ran on a programme of lowering the pension age, increasing the minimum wage, making redundancies more difficult and increasing taxes. Pretty much an exact match of what most economists would put on a list of top policy errors to increase competitiveness. Still Mr Hollande got elected! Democracy is a wonderful thing when there is something to distribute, however, it fares less well when the contrary is required, delaying reforms further.

Lack of real solutions

Regardless if one accepts the previous points, the bigger issue is that there is no obvious solution. We are pretty much in unchartered territory (read deep trouble) as the sovereign debt crisis is not restricted to individual countries but most of the industrialised world is heavily indebted with the US and Japan also piling up debt we speak.  Deleveraging is easier if there is growth, however, with everybody nurturing their hangovers from over-indulgence, growth is rather elusive and unlikely to pick up significantly.  While market participants call for the big bazooka which would miraculously fix everything, it is pretty clear that most solutions do not hold up closer scrutiny.

 

Government debt as proportion of GDP

Eurobonds: By many considered as the saviour, it is hard to see the benefit of everybody guaranteeing everybody. While France seems to be in favour of them, as an owner of Italian or Spanish government debt I would get little comfort of having debt guaranteed by France which has a debt/GDP ratio of ca. 86%, trending upward, and a government in denial of economic realities. Even Germany’s debt/GDP stood at 81.2% at the end of 2011, levels which would have given us all heart palpitations a couple of years ago. It is credit 101, if several highly indebted entities guarantee each other the outcome is, well, still highly indebted (unless of course you put it all into a CDO).

In addition Eurobonds would be pure madness from a German stand point of view. Not only would its financing cost likely increase, but also Germany would have to back-stop other countries’ debt without having any say in their policy decisions. Easily there could be the situation where Germany (which increased retirement age to 67) could back stop countries with much lower retirement ages. Needless to say, this would take the concept of moral hazard to another level.

Fiscal/Political Union: It is little surprise that the German response to Eurobonds was that Eurobonds would only be acceptable once there is a fiscal/political union. A fiscal union would be basically an upgrade to Maastricht 2.0. Instead of agreeing on the outcome (debt and deficit levels), politicians would have to agree how to get there (taxation, expenditures etc.). It is still hard to envisage that countries would like to sign up to such changes and hand over control over important policy areas. In addition, call me cynical, but I struggle to see how anybody who has followed European politics for the last 20 years can believe that decision making would improve. Horse trading, agreeing on the smallest common denominator and breaching of previous agreements seem to be the hallmarks of EU decision making.  If one could not make Maastricht 1.0 work, why would the sequel be a success? It is like fixing a poorly working relationship by deciding to get married and start a family. The only thing which changes are the stakes aka the downside. Thanks, but no thanks.

Breakup of the Euro: If it does not work, let’s break it up. In theory not a bad idea, unfortunately it becomes harder to break up once you have moved in together and bought property which is what the Euro situation is like. As long as the cost and the uncertainty of a break-up will messier be than the status quo, muddling through will remain the preferred option.

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice.  Click here for full disclaimer]

Author: Anke Richter

Anke is a freelance lecturer and writer. She has over 15 years experience in credit markets as a credit analyst and credit strategist, working for JP Morgan, Deutsche Bank, Mizuho and Calyon where she was Global Head of Capital Markets Research. Throughout her career she has been frequently ranked as credit analyst in investor polls and has been regularly quoted in the financial press. She has lectured on financial markets at universities in the UK and France. Anke started her career as a management consultant in Germany and Latin America. She holds a degree in Business Administration from the University of Cologne as well as being a CFA Charterholder.