I would like to explore the long-term options for the EU and the eurozone out of this crisis. Most observers have offered two options for Europe, but I would like to raise a third - of financial repression. The options, which I list from the least likely to most likely are:
- Exit from the eurozone: Greece and perhaps Portugal and other weaker economies of the eurozone exit the euro, either individually or as a group. This would be a disaster, not only for Europe but for the global economy and financial system.
- A fiscal union: When the euro experiment began, it was acknowledged that this was a monetary union without a political union. A fiscal union, in which individual member states give up some degree of sovereignty to a greater EU authority, is the next step towards a politcal union. Taking such a step requires constitutional change by all eurozone member states, which is a long and involved process and may not be successful in the end.
- Financial repression: If you read Reinhart and Rogoff, first comes the financial crisis, then the sovereign crisis. The next step is financial repression, where the authorities try to extract greater wealth from its citizenry. Given Europe's predilections towards muddle through solutions that kick the can down the road and its tolerance towards higher taxation, I believe that this is the most likely solution for Europe. Though such a path will impose a significant constraints on its engine of long-term economic growth.
I am getting tired of writing about gloom and doom so I won't dwell on this option too much. I wrote about it before here and extensively elsewhere. The worst case scenario is the Argentina one, as described by John Hempton of Bronte Capital:
When Argentina defaulted not only did the government default but they forced a private default. If you had a debt in US Dollars in Argentina prior to the default you were forced to pay it back in Peso. Indeed it was illegal to make payment in US dollars.
Likewise if you had a US dollar asset you got back Peso. A dollar deposit in Citigroup in Buenos Aires became a peso deposit. If you really wanted to keep your dollars you needed to make your Citigroup deposit in New York.
The forced private sector default was necessary for Argentina. The Argentine banks all had lots of US dollar funding. If you devalued without forcing their default then they would all have uncontrolled defaults (a true disaster) and the country would lose its institutions. Telefonica Argentina would have failed too - failing to replay USD debts.
The same applies in Greece. If the Greek Government were to devalue the new Drachma (to perhaps a third the value of the Euro) then the banks (which are loaded with Greek Sovereign paper) would default. Even Hellenic Telecom would default because they would be forced to repay their billions of Euro borrowings whilst collecting only Drachma phone bills.
If Greece did that, it would mean the end of the eurozone banking system in the weaker countries:
Now if you are Irish or Italian or Portuguese (or even Spanish) you know the rules. You get to get your Euro out of the PIGS and into the core (Germany) as fast as possible. So max all your credit cards (for cash), draw all your bank deposits and load them in the boot of your car and make the drive to Switzerland or Germany. Somewhere safe. Otherwise you are going to lose half the value the day that the rest of the PIGS do a Greece.
And this bank run – a run including tens of thousands of Italians driving their Fiats - will surely blow apart every Italian bank. And their Euro-skeloritic compatriots will sign the death knell for for all their banks too.
You get the idea. Pulling an Argentina would create chaos in the financial markets.
Canada as a model for fiscal union
What about a fiscal union? A fiscal union would mean individual eurozone states ceding some form of taxation power to a central authority - sort of a "Brussels on the Rhine". What would a fiscal union look like? Well, it would sort of look like...Canada. Jeffrey Simpson, columnist for the Globe and Mail, explains:
The great virtue of real federalism is the sharing of risks, which is why Canada is a much sturdier federation than Europe. Canada’s central government raises far more revenue as a share of the national total than Europe’s central institutions, redistributes far more of it to less well-off regions, and takes a large share of borrowing.
In Europe, member-states must pay their entire debts; in Canada, provinces pay some of their debt, the whole country pays the rest. The difference means when highly indebted European economies falter or interest rates skyrocket, they face burdens that the European Central Bank and member-states try to ease with Band-Aid solutions.
In Canada, weaker provinces and/or highly indebted ones (Quebec and the four Atlantic provinces) don’t have to pay both their debts and their per capita share of the national debt. Ottawa pays the per capita share. The sharing of risk, opportunity, burdens and good fortune is what makes a federal system.
The European Union was never a federal structure like Canada. It worked best in sharing good fortune and some risk; it worked badly, as we now see, in sharing burdens because it lacks the central resources of a federal system.
The Canadian system is workable, but not perfect. We have seen our share of constitutional crises over the years and the Quebec sovereignty movement continues to lurk as a threat in the background. In Canada, the stronger provinces send money to the weaker ones in the form of equalization payments via Ottawa. This arrangement works because it isn't just welfare, but a form of counter-cyclical stabilizer. Simplistically speaking, Canada is economically divided between resource-based regions (which are mostly in the west) and the manufacturing heartland in southern Ontario and parts of Quebec. When resource prices are low, the manufacturing base booms; and when resource prices are high, manufacturing margins suffer. Equalization is a therefore a form of counter-cyclical stabilization for provincial economies and budgets.
In the eurozone, however, such counter-cyclical arguments fall flat. The perennially weak countries are not resource producers, nor does it appear that their economies are in any shape or form counter-cyclical to the industrial heartland. Consider how some of the more troublesome PIIGS countries achieved their recent success. Spain saw a property boom, which subsequently collapsed. Ireland became the Celtic Tiger because of its low corporate tax rate, which encouraged offshoring. Italy remains a world-class centre of manufacturing and design (think Ferrari and Gucci as examples) but suffers from competitive problems. While some of the PIIGS problems are cyclical, the root cause appear to be a lack of competitiveness that is usually solved by currency devaluation.
Such an arrangement leaves the industrial heartland permanently digging into their pockets to support their poorer cousins. The Germans get this concept quite clearly. German finance minister Wolfgang Schäuble has stated that Germany does not want to rule Europe (and by extension, be permanently on the hook for support payments).
For the recipient of EU largesse, the consequences of giving up fiscal sovereignty to a "Brussels on the Rhine" can have governance effects that appear to be heavy-handed. It may feel like your country is under occupation. Ambrose Evans-Pritchard of the Telegraph wrote about this problem when the EU presented Italy with an ultimatum [emphasis added]:
The EU has woven itself into this drama by presenting Italy with an ultimatum last week, giving the country barely 48 hours to commit to very specific and radical reforms.
It is in effect taking sides in an intensely polarized debate within Italy, intruding in the most sensitive matters of how society organizes itself. It is demanding ideological changes – in this case in favour of employers, and against unions – as a condition for further action to shore up Italy’s bond markets.
"We have three deaths in front of us: democracy, politics, and the Left," said Fausto Bertinotti, the elder statesman of Rifondazione Communista and one of Italy's great post-war figures.
"We are living in a neo-Bonapartist financial system. Not a single decision has been taken by the Italian parliament since the end of August except those imposed by the foreign power that now us under administration."
Those of us who live under an "Anglo-Saxon economy" may not find it odd that we demand our partners to end the labor friendly practices that seem outrageous to us in return for financial support, but Evans-Pritchard wrote that, in a democracy, you have to get the populace to make the decision freely:
The two bones of contention are Article 18 protecting workers from being sacked for economic reasons, and “firm level agreements” that undercut the power of trade unions to craft deals across sectors.
Those of us in Anglo-Saxon cultures may find it remarkable that Italy still has laws that make it extremely hard for companies to lay off workers when needed. It is clearly a reason why the country has struggled to adapt to the challenge of China, rising Asia, and Eastern Europe.
But that is not the point.
Are such changes to be decided by Italy’s elected parliament by proper process, or be pushed through by foreign dictate when the country is on its knees? “Political ownership” is of critical importance. The EU is crossing lines everywhere, forgetting that it remains no more than a treaty organization of sovereign states. Democratic accountability is breaking down.
Today, we have Troika monitors in Greece and IMF monitors in Italy. How far will it go before the people of the peripheral countries feel like they are under occupation? Jim O'Neill of Goldman Sachs Asset Management has stated that he believes that a number of countries, ranging from Greece to Finland, would rather pull out of the euro than live under the rule of a Brussells on the Rhine.
The most logical solution, given a willing populace, is then financial repression. Governments practice forms of financial repression all the time. CLSA's Russell Napier lays it all out:
So far, only a small section of the private sector has been forced to pay up for the follies of the public - the depositors whose saving are being destroyed by negative real interest rates and those on fixed incomes they can't force up to meet inflation. But the extension of this theft is likely to mean forcing institutions to buy government debt on previously unimagined scales. In India, the banks have a standard liquidity ratio of 25%, the explicit aim of which is to “augment the investment of the banks in Government securities.” Why not Italian banks too? And why not the pension funds?
The template was laid out by Carmen Reinhart and Ken Rogoff:
If you want to see how all this unfolds you should simply read - or re-read - what appears to be the best road map of the crisis so far, Reinhart and Rogoff’s This Time is Different or the paper Reinhart co-wrote this year titled The Liquidation of Government Debt. As they say “first comes financial crisis; then comes sovereign debt crisis; then comes financial repression.”
Already, such proposals are being floated. FT Alphaville wrote last week that while the Italian government is in debt, Italian households are remarkably debt free and have an abundance of liquid assets:
[There is] €8,600bn of household wealth vs. the €1,900bn public debt mountain. Around 50 per cent of Italian government bonds are already in domestic hands, according to Credit Suisse, but there still could some firepower left, in theory, thanks to the country’s decent stock of financial assets at a tidy €3,565bn, according to the Italian central bank.
The solution sounds a lot like financial repression to me:
Here’s one thought experiment floated by Tullio Jappelli, economics professor at the University of Naples Federico II, who told us via email that if the government decided to launch a raid on savings it could:
…seize a part of our checking / saving accounts and convert this cash into bonds.
In 1992, under the Amatao Government there was a wealth tax, passed in 24 hours (0.6 percent of deposits were seized by the government). [The above] proposal is better from the consumers’ standpoint, because you convert cash into bonds, not into taxes. But you need to do it VERY quickly, otherwise you risk a bank run and deposits to disappear. All these things are dangerous objects, so please be careful with how you handle them..
Governments have long practiced this form of financial repression. As an example, pension funds under certain regimes have been mandated to hold a certain portion of their assets in government bonds for "prudent" reasons.
Given the alternatives, this solution is probably the least politically painful for the authorities and will kick the can down the road for a few years. So watch for financial repression - coming soon to your European neighbourhood.
Disclaimer: Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.
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