Economic Crisis: Good Luck Europe, You'll Need It

Europe: Your Rope

The financial crisis has shown the lies of transparency, disintermediation and risk management. The former maestro, Alan Greenspan, suggests that the crisis reveals a flaw in his thinking that bankers would act in the interests of their shareholders. At the same time, both friends and enemies of the United States say a function of excesses and inadequacies—excess consumption, excess borrowing, excess financial engineering—and insufficient supervision and regulation, created the crisis.

If the US is the epicenter of the crisis, then it is ironic, or “unfair” according to Niall Ferguson, that the situation has manifested more ferociously abroad. The Japanese economy contracted at an annualized pace of almost 13%, while Germany’s diminished at an 8% pace.

Double Bind

The economic contraction does not come close to capturing the challenges that Europe now faces. Unlike many US financial institutions, most European bankers did not lend to home buyers on terms that seem simply ludicrous. However, many of the same forces which led Americans down their own fallacious path, found expression in Europe. Corporate and emerging market loans at razor thin spreads displayed a profound under pricing of risk. What’s more, these errors were done with greater leverage than the fouls of the US Banks. Europe’s economic and financial emergency is every bit as severe as America’s, yet its ability to cope with the crisis is significantly less.

First, most countries in Europe are relatively small. Bank assets are often a multiple of countries’ GDP. In the US, the issue is often cast as “too big to fail”, in Europe it is that some financial institutions are too big to be rescued, at least by any individual country. Second, and more profoundly, the European Union and the euro zone lack the institutional capability to fully address the situation. The crisis has revealed the significance of a critical fissure in the very foundation of the European project: monetary union without political union.

The original drivers of European integration conceived of eventual political unification, but such a vision has been jettisoned by the current generation of leaders. Euro zone countries face a double threat. Internally, few members can maintain competitiveness with Germany, who has managed to contain unit labor costs better than their neighbors. Typically, under the exchange rate mechanism, countries such as Spain, Portugal, Italy, Greece, and even France would devalue their currencies when faced with this loss of competitiveness. With the advent of monetary union this course has been blocked and the alternative path of enacting the structural reforms necessary to level the playing field lacks political will. This was tolerable when the tide was high, and capital flowed like lager. As Warren Buffet once quipped, “It is when the tide goes out that you see who is swimming without a suit”. That time is now.

Alongside a liquidity premium, the lack of competitiveness and failure to enact structural reforms is a major factor behind the widening of bond spreads within the euro zone. If the first threat to euro zone countries comes from the loss of competitiveness within this still exclusive club, the second threat emanates from the fact that the monetary union itself is incomplete insofar as a number of key countries do not participate. The United Kingdom and Sweden, let alone the countries in central and eastern Europe, have seen their currencies depreciate substantially against the euro. This exacerbates the loss of competitiveness that many countries within the euro zone are experiencing.

EMU as Economic Solution to a Political Problem

The dissolution of the Soviet Union in the early 1990s provided the impetuous for European economic and monetary union. Under what conditions could France (and other countries) countenance the re-unification of Germany? The deal developed by the Socialist French President Mitterrand and the Conservative German Chancellor Kohl was to intractably tie Germany’s future to Europe’s. Western Europe would bask in the Bundesbank’s credibility and the super Deutschemark. This is economic and monetary union.

Yet with its substantial trade surplus and status as the largest European economy, Germany needed assurance it would not be forced to bail out the weaker, less disciplined European countries. Thus, the Maastricht Treaty, which created the EMU, specifically prohibits members bailing out insolvent members. Nevertheless, there does seem to be the basis of a work around, were the political elite inclined to explore it. For example, the EU Treaty allows the issuance of bonds by the EU on behalf of members having difficulty making payments. This option is currently limited to 25 billon euros, almost half of which is already committed to Hungary and Latvia. The Treaty also allows for EU nations to grant financial assistance to member states if a country is “threatened with severe difficulties” caused by “exceptional occurrences beyond its control.” In addition, there are two more institutions that can be drafted for the cause. The European Investment Bank could theoretically set up an emergency lending facility and the European Bank for Reconstruction and Development could also provide assistance. In addition, some countries could buy the bonds of other members that are being squeezed but not collapsing.

WWW—Where in the World is Will?

The signals coming from European officials indicate they lack the will and creativity—innovativeness—to address these challenges themselves. Like politicians everywhere, they are attempting to pass the buck whenever possible. On one hand, they are pushing for the IMF to have a greater role. In 2005-2007, the IMF was a large bureaucracy without much of a mission. However, since the crisis mushroomed, the IMF has established a number of programs, mostly for those countries in Eastern Europe, like Hungary, Ukraine, Latvia, Belarus and possibly in the not-too-distant future, Turkey. Although it is not in Eastern Europe, it can be argued that Iceland’s IMF program fits into this group as well. That would leave Pakistan as the main exception—receiving IMF assistance but not in Europe.

Central and eastern Europe have borrowed roughly $1.7 trillion from abroad, the lion’s share from Western Europe. Short-term borrowing is particularly heavy. More than a quarter of which needs to be rolled this year, which is roughly equivalent to a third of the region’s GDP. In addition, some $800 billion of corporate loans and bonds are also coming due this year, versus a $200 billon in the US. Consider that Austria’s exposure to central and Eastern Europe is more than three-quarters of their GDP. Belgium’s exposure is nearly a third of its GDP, while Irish, Dutch and Italian exposure ranges between 11% and 16%. Given their exposures to eastern and central Europe, the IMF programs to date are helping to provide a life line to west European banks, and by extension, west European countries.

Similarly, the unlimited swap lines that the Federal Reserve made available to the ECB and other central banks in Europe, have also been an under-appreciated element of international support. Moreover, imagine the ramification for European banks if the US had not nationalized AIG. The American insurance corporation sold more than $600 billion of credit-default swaps to European banks to help them game their own system, to take on more leverage even as the conventional risk models showed less risk. The IMF simply does not have the resources to do the kind of heavy lifting that Europe apparently doesn’t want to do itself. This is why UK Prime Minister Brown, who is struggling to hold on to the office he coveted for so long, is proposing that the IMF raises another $500 billon. Others are recommending a new allotment of Special Drawing Rights, which is IMF created money that can be used to settle bilateral sovereign obligations.

European leaders also are looking toward the April G20 meeting, a broader forum than the G7. They apparently are hoping to convince countries that have accumulated large reserve holdings or sovereign wealth funds to help finance an international solution to their problems. Many European countries have been extremely reluctant to surrender some of their IMF voting shares to make a more equitable distribution for sometime. Now they want these countries, such as China, who have essentially been on the sidelines till now, to play ball. The European Bank for Reconstruction and Development warns that bad debts in Europe will likely top 10% and may reach 20%. The current mortgage default rate in the United States is near 12.5% and still rising. The US can bring to bear a range of institutions, like the FDIC, the SEC, the Federal Reserve, the Treasury Department, and the Office of the Comptroller of the Currency. It has the constitutional authority to do what is necessary. Europe simply doesn’t. And therein lies the problem with the euro.

During the upswing of the credit cycle, some people actually thought the euro was a rival to the dollar. They confused being lucky with being smart. The scale of Europe’s financial exposure through corporate and emerging market loans, in combination with the lack of sufficient institutional mechanisms, means that the economic contraction in Europe will likely be deeper and more protracted than America’s. These forces will continue to exert downward pressure on the euro in the months ahead. Just as it overshot in 2007-2008 period, it needs to undershoot now. The decline of the euro, which began last July, is not complete. Medium and long term investors may be best served by taking advantage of the occasional euro rally to reduce exposures either directly or through disciplined hedging strategies.

Disclosure: no positions

Comments

[Ferdinand E...:]

You say that the US has the constitutional authority to do what is necessary, but not Europe. In a sense this is correct, however individual countries can still do what is necessary - if, as the singer Prince puts it, they have eyes. I am thinking of course of France, because Mr Sarkozy has made it clear that he is in charge in that country, and not the parasites in Brussels. Unfortunately, doing what is necessary may not be sufficient at the present time.

A country that will need luck is Sweden, because under no circumstances does a government of this country want to offend Washington or Brussels. They/we are going to pay for this servility, as will other countries whose governing parties are too ignorant to get a handle on the economic issues,

Feb 27 08:25 AM

[CLH:]

I pretty much agree with your view of Europe. However, with our present Leader I think we are in worse shape,

Feb 27 09:01 AM

[Alexandre K...:]

Great and accurate article, Marc.

Although being a European, and a French (but not an anti-american one, lol), I must say that I agree with you. The lack of political will weighs heavily on the Eurozone countries and the broader EU. It will take a serious crisis, to bring this political will back. I was one of those strongly in favour of the European Constitutional Treaty. But France voted against it in 2005. The EU is losing its ground in the global competition that is taking place. As is Japan. The Obama election should be a lesson for all of us Europeans. The US is back on the international scene after the shameful Bush era. In Europe, we lost our dreams. It is time to revive the European Idea.

Feb 27 09:21 AM

[phil from E...:]

Thanks for the article. The AIG credit default swaps are interesting. In the 2007 annual report for AIG the credit default swaps to the European banks were expected to mature or discontinue within 18 months as the European banks reached Tier 1 capital requirements by other means. Is there anything you can add on the exposures the CDS covered.

Feb 27 09:24 AM

[hardmanb:]

The "pre-bubbles" US had a (service-economy) GDP of $7.4 Trillion consisting of 71% consumer spending.

The service economy, understandably is contracting in free-fall. The bottom has fallen out of consumer spending with the Housing equity collapse; housing lending collapse; credit card consumer credit collapse; and catastrophic rise in unemployment.

Europe and Asia's economies and budgets were balance on exports to the US and consumption (however unwise) of US citizens.

This was unsustainable, is increasingly ceasing, and US consumers will reduce consumption and borrowing. After the shocks of our "great recession" Americans for decades are and will be switching from consumption to savings...a generational change in psychology and habits.

Those who depended on American consumption to balance their budgets are in for big trouble, for a long time.

Feb 27 10:01 AM

[American in...:]

The European economy will stabilize sooner than the American economy because the system has a more generous safety net and because the real estate markets are healthier in general (with obvious exceptions). The fall in the Euro will also boost exports as well.

Feb 27 10:08 AM

[jdl51:]

As opposed to the leader we just got rid of who got us into this mess? Give me a break.


On Feb 27 09:01 AM CLH wrote:

> I pretty much agree with your view of Europe. However, with our present
> Leader I think we are in worse shape,

Feb 27 12:07 PM

[OldLimey:]

"The signals coming from European officials indicate they lack the will and creativity—innovativen... address these challenges themselves."

True. But what are the signals coming from the cabal of bankers who control the US? That they will spend as much taxpayers' money as is necessary to preserve their own power and privilege?

Europe and the US are in it up to the higher reaches of their respective anatomies. Some problems are shared, some are unique to each. What separates them is not so much resources as the fact that the US prints the world's primary reserve currency. It has been blindingly obvious for several months that US political interests and their camp followers (e.g., the Daily Telegraph in London) have been working hard to place stories emphasising European difficulties. No threat to the primacy of the USD can be brooked. Whilst it is very difficult to directly manipulate a market as large and liquid as EURUSD, it is less challenging to change perceptions and create a new climate. This article, whilst it touches upon some very real issues, is far too self-serving to be taken seriously. Mindless anti-Europeanism is as objectionable and unhlepful as mindless anti-Americanism. We are all in this together.

Feb 27 01:23 PM

[Dave Wrixon:]

I never heard so much drivel!

Feb 27 02:16 PM

[EUARTE:]

Let us stop this left wing nonsense about a "cabal" of bankers controlling the USA. EU difficulties are not made up. They are real! The money is as phoney as the dollar.

Feb 27 08:52 PM

[letsmakemoney:]

Great article. An aggressive way to trade this weakening euro theme is by buying DRR (FD: I'm long as of yesterday). My belief is that the $/Euro level goes back to parity, or 1.0 (down from the current 1.27 level), DRR should theoretically provide 2x this % move, or 2 x 21.25% = 42.50%. I think this happens by year end.

Seeking Alpha has a good currency ETF/ETN guide:
seekingalpha.com/artic...

Feb 28 10:18 AM

[Jan Baker:]

". . .it is ironic, or 'unfair' according to Niall Ferguson, that the situation has manifested more ferociously abroad. . ."

It may be ironic, but it's not unfair. Europe makes choices, and those choices have consequences that force them to use our markets. They choose to abandon the values that lead to stable familial relationships that in turn to lead to robust family sizes. So their 'internal markets' stink. That's just another name for population.They don't have enough.

And now they've waited too long in many cases to pursue 'pro-natal' policies and governments can't afford, with no taxes coming in, to pay women their equivalent salaries to stay home and have babies (women's salaries, mainstay pro-natal strategy, are simply too high in many countries to try to replace with a 'mother's salary' due to the educational levels which women have obtained throughout Europe). Women in Sweden are not responding to all the allurements the government can offer. Same in the Netherlands. You must read the deal they are offering women to go home and procreate. No dice. But Europe chose each turn in the road. So has Japan. China hunts women down and forceably aborts them to maintain its one-child per couple birth rate. They planned to leave consumption to us, since our birth rate was at least at replacement level. And for workers, they've relied on immigration, and are suffering for it now.Europe is in chaos.The UK is in a cultural crisis. Sharia law is replacing British common law like vegetation overtaking a rotting courtyard.

If we turned to a buy American, hire American policy, if we began our own pro-natal policies to encourage the formation of procreating families, instead of imitating those same suicidal European values, or non-values, we could survive this. Our young people are still willing to have babies (According to Self magazine's recent poll, which made fun of them for it).

How about we wake up? This is about very simple things.

Mar 01 09:33 PM