By: Robert Salter, December 10, 2010
Edited by Shannon Hurd
The clutter was fascinating. One article after another decrying the fate of Ireland's banking system, how its sovereign debt was not the issue, and how bailing out Ireland's banks was all that was needed. This was the message you got if you you were tuned in to the Irish finance minister, Brian Lenihan. The clear omission here is that most of Ireland's banks are nationalized, thus they are an extension of the Irish government. Some in the European Union, in particular those who will carry the brunt of Ireland's financial burdens for decades, are singing a different tune. Germany's Chancellor, Angela Merkel, is clearly hitting a different note - and rightly so. Her positions are easily defensible.
Germany's Divergence - Bondholder Liability
Germany - unquestionably the linchpin of the European Union's economic engine - sees the handwriting on the wall. Merkel, on behalf of the German people, and at political risk of further infuriating peripheral European Union national leaders, is absolute and insistent in her stance that future sovereign losses are shared with private bondholders - they ought to be at least partially responsible for losses taken on any bad debt to which those sovereign bonds are attached. I will avoid sarcasm, as I generally believe it is a sign of either ignorance or redirection. To state things plainly, in the private sector bondholders take losses if the investments to which those bonds are attached go bad. While the private sector functions in a 'normal' manner, it appears the public sector continues to defy that normalcy. The standard for the European Union has/is becoming one of bailing out truly insolvent/illiquid sovereign nations while at the same time, and in effect, guaranteeing bonds issued by those sovereigns. The goal is to reduce/remove the risk to these bonds, thus driving sovereign bond yields down to affordable prices. Irish, Portuguese, Spanish, Italian and Belgian bond spreads against the German Bund are widening such that any reasonable investor, economist, analyst or politician cannot turn a blind eye - the flashing red emergency lights on the dashboard of the EU's financial machine are screaming of fractures to come in the very union itself. The ECB and European Commission have suddenly become very attentive, while publicly downplaying the threats. This "downplaying" is a smart move. Public acknowledgment of the degree of the challenges faced would do no less than fan the flames of contagion. A compromise on bondholder debt sharing was recently agreed upon, but would only apply to losses incurred by sovereign bondholders starting in 2013, and with no predefined value/rate at which bondholders would take 'hair-cuts'. Instead, losses would be negotiated by the IMF on a per-case basis...this is a vague approach, at best. The hope was to alleviate the flight from risk in sovereign bonds by removing any predefined/required losses bondholders would have to take. What losses might bondholders have to take? It's anyone's guess. But the message being sent is that bondholders will be protected at the cost of the individual tax payer - the little guy. The hope and goal is that sovereign bond yields will fall and borrowing costs become affordable to the respective issuers.
Fiscal / Monetary Policy Handicaps
The process of bailing out one nation after another is a dangerous policy - to save the Euro and the EU as it is today, a certain level of federalism will need to occur; fiscal policy must be addressed at the union level, in addition to the sovereign level, to avoid fractures in the EU itself (aka, a "fiscal union"). Today, EU member states are effectively using the equivelant of a foreign currency over which they have very little control. Heavily indebted nations cannot devalue their currency - they cannot devalue their way out of debt. Monetary policy lies in the hands of the EU/ECB as a whole. Unless the ECB embarks on quantitative easing, peripheral nations are stuck with a stronger-than-desired currency. I did not mention Greece above. Greece is the worst of the problem children. Fiscally speaking, Greece is insolvent, bankrupt and 'un-savable'. It needs to be allowed to go through a true bankruptcy, not a bailout restructure that cannot work. Yields on Greek 10YR bonds stand at just under 12%. For those familiar with sovereign bond financing (money borrowing), a normal sovereign bond rate is circa 3% - 5%. It is impossible for Greece to borrow money via sovereign bonds, thus the bailout it received...and will continue to be fed in the form of extensions on years to maturity on loans from the ECB, a more recent development. Additionally, the interest rate of the original bailout loan was adjusted downward to match that of Ireland's recent bailout terms. Germans, while conceptually in support of the Euro, are thinking twice given current circumstances. Roughly 60% of the German public are now in support of returning to the Deutsche Mark. This makes sense to me. One of the negatives of doing so is that the DM would immediately be viewed as a superior currency and would surely be the destination of a flight to safety - in turn strengthening the DM and putting pressure on exports. Germany has the second largest export economy in the world - ahead of the United States and Japan. Thus monetary policy would need to be managed to keep the DM from becoming too strong. It is doable, but not without pain.
The elite leadership of the European Union, the ECB, and the European Commission as a whole refuse to let their baby die. The survival of the European Union itself, it seems, is the primary reason they live and breathe. Simply stated, in their eyes, the European Union as it is today cannot be allowed to fail or fracture. If this thinking and ensuing policy making is not altered soon, the risks are magnified and the negative impacts to the EU will be made that much more pronounced. In the words of the famed investor Jim Rogers three days ago:
"You need to let Ireland go bankrupt. They are bankrupt, why should innocent Germans, Poles or anybody pay for mistakes made by Irish politicians."
Merkel / Germany Have Upper Hand
The bottom line is that Germany has the best hand in the union's house. Germany is the only major European country seeing noteworthy growth. Germany has the largest GDP, best debt/GDP ratio, and very cheap borrowing costs - though even the Bunds yield rose slightly in the last few sessions. The German Bund is the benchmark against which all other European bonds are measured. This gives Germany the upper hand. When the ECB or European commission says 'let's do this', Germany can say "well, no, let's not do that".
Many of the propositions put on the table are not in the interest of Germany since it will bear the brunt of what's required to bailout other nations. The recent proposition to form an E-Bond - a bond that is issued by the collective union - is a perfect example of where Germany's interests are harmed by initiatives raised for the sake of 'the greater good'. An E-Bond, Merkel argues, cannot be accurately priced on the open market - mixing together a group of sovereigns with terrible credit ratings into the same bucket as those with very good credit ratings. One E-Bond means one bond yield for the entire EU, and that rate would no doubt be far above Germany's currently coveted 3% 10-yr bond yield. An E-Bond would take the worst apples in the barrel and tie them more intimately, and permanently, to the best of apples. Aside from the fact that EU treaties would have to be rewritten in order to execute on an E-Bond issuance, Germany has no interest. It's simple: the weak Euro-zone nations want the stronger nations to pull them out of the ditch. I have to side with Merkel here. While she is very much in support of the European Union as a whole, there comes a point at which sovereigns must draw the line in the sand and say, "Okay, you're getting too far into my personal space," so to speak. After all, they are still a sovereign nation.
Jean-Claude Junker, prime minister of Luxembourg and current Euro-group chairman, blasted Merkel Wednesday as she rejected the idea of an E-Bond. I applaud Merkel for her boldness in taking what I believe to be the right stand for Germany.
Junker blasts Merkel's rejection of the E-Bond proposition
Taking A Stand In The Interest Of Germany
While there is no question that Germany benefits considerably as a member of the EU, and as a transactor in Euros, only Merkel is bold enough to take the hard-line stance - and publicly demand of the rest of the EU - that those who bought sovereign debt expecting a return should naturally assume a portion of the risk associated with it. And she has the 'upper hand' to be able to take this position...she carries the biggest stick in the Euro-zone. Period. Her position is that public and sovereign debt bondholders alike must be prepared to take a haircut (loss) where needed. That's how it works in the private sector. It shouldn't be any different in the public sector. Instead, the EU is effectively imposing onto the backs of the population at large the responsibility of paying back The Piper. How? Monetize then socialize the debt of the irresponsible, forcing the tax payers of the entire European Union to partake in the financial burden.
Austerity Strangling Growth
I make no argument in this piece either for, nor against, the implementation of austerity measures. The fact is, in practice, the EU is implementing austerity measures that are consistently forcing GDP growth downward. Germany is the exception, though even its export growth slowed 1.1% month-over-month September to October. It's a catch-22: Cut jobs, cut wages, increase taxes, extend retirement ages, while at the same time trying to execute toward the goals outlined as a condition of a given sovereign's bailout - reduction of debt/GDP ratios. Greece is a prime example of how all the goodwill of the EU/ECB isn't working. Greece, having received a large bailout, is already falling short of meeting the benchmark goals set forth earlier in 2010 as pre condition to receiving their bailout funds. The ECB just recently gave them an extension of several years by which they must pay back borrowed funds. Sovereigns are playing a psychological shell game here. Really, they are just "kicking the can down the road", as is often stated. Case in point - jumping back to north western Europe again - Paul Krugman recently stated:
It’s hard to escape the sense that European policy makers are just completely out of their depth. They know how to deal with liquidity problems, but they cannot come to grips with the reality that this requires more than buying a bit more time. It’s as if we’re having the following dialogue:
“Ireland really can’t afford to pay these debts.”
“Here’s a credit line!”
“No, really, we just can’t afford to pay.”
“Here’s a credit line!”
It really is like watching a car wreck.
The EU/ECB Commission Majority Opinion
Taking a look from the predominant perspective. This is a perspective that is not the flip side to that of Merkel's, but an alternate one. This alternate thinking goes like this: as the weaker peripheral nations benefit from being bailed out by the stronger, more responsible EU nations, the collective union benefits - including the strong.
Merkel is doing her job correctly in her efforts to temper that alternate argument with the ultimate benefit of the German people in mind.
Angela Merkel is keenly aware that Germany will bear the brunt of bailing out its less responsible neighbors. Photograph: Gero Breloer/AP
In my view a clear conflict of interest quickly presents itself. If I'm drowning in debt, I'm going to hold on to the strong swimmer in hopes of retaining my life. The strong swimmer, however, says 'no, you're not taking me down with you'. These are the two competing interests at play: mutual benefit to the collective vs. tempering self preservation with overall EU, and Euro, benefit.
In Defense Of Angela Merkel
Merkel clearly has no easy task. She has the clout of the stand-out German economy behind her. This gives her the upper hand. At the same time she must look out for the interests of the German people first and foremost. All of this in the context of balancing, and navigating, where overall EU benefit truly meets the interests of Germany.
Perhaps the return of the Deutsche Mark is not so far off. Perhaps it is. All options are on the table. Don't doubt that.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.