Source: Charles Gave of GaveKal Research
Was the Demise of the USSR a Negative Event?
Everything one reads on Europe these days varies from the seriously gloomy to the downright apocalyptic so let us immediately re-assure our reader: this is not yet another GaveKal paper explaining that the Euro is a doomed currency. GaveKal has done too many of those over the years to the point where our friend Marc Faber started to refer to us as the 'Euro perma-bears'. I even wrote a book, in French (Des Lions Menés Par Des Anes) in which I explained, as simply as I could, that the Euro would lead to the biggest misallocation of capital since the Soviet Union, leaving us with too many houses in Spain, too many factories in Germany, and too many civil servants in France, everybody specializing in what they were best at.
Amazingly, now that the markets finally seem to be putting an end to a political interference in the free market which, like the Soviet Union, or Fannie and Freddie Mac, could only lead to disaster, most commentators appear to believe that Europe is on the edge of a precipice. And two reasons are typically proposed to defend the notion of sending good money after bad: the first is that without a bailout of Southern Europe, the very existence of the Common Market and the dream of European Unity will collapse.
The second is that, without a bailout, the European financial system will enter into a tailspin which will make the Lehman crisis look like a dress-rehearsal. In our view, both of these assumptions are either tremendously self-serving (when wheeled out by politicians hoping to avoid the blame that should rightfully fall on their doorstep for putting together a monetary system that had no chance of working), or belie a lack of knowledge of European History, and a fundamental understanding of how financial markets work.
1– The Ideological Background Behind the European Idea
Every French school child will at some point have been told by his professors: 'very well, this works in practice. But more importantly, does it work in theory?' Probably for this reason, it is hard for me to believe that there can be any kind of political construction without some kind of hidden, or obvious, ideological backbone. Looking at Europe, I have long felt that two 'ideologies' have been competing since the 1950s to define what the future organization of Europe should look like:
The 'Roman Empire' Model:
the main goal is to have Centralized State, managed by an efficient techno-structure with a supremacy of the center over the periphery. Unification of the law through a common jurisprudence is necessary, as are regulatory powers leading to a de facto unification of all regulations. This vision is fundamentally Hegelian with the notion of 'History on the March" and while the process of integration is a work in progress, crisis should be seen as opportunities to re-enforce the center against the periphery either through new institutions being created to deal with the problem (e.g., the ECB, the creation of a European Ministry of Finance) or the granting of new powers given to existing centralized institutions (European Commission, European Parliament, etc.).
The end goal is obviously to arrive at a European State which will be "big enough" to have an impact not only on the rest of the world, but also on the underlying sovereign states which will have no choice but to become subservient over time. Aside from the Roman Empire, historical precedents for this include Charlemagne, Louis XIV, Napoleon, Hitler, Staline... The good news, of course, is that this time around, the integration is proceeding peacefully, rather than through military conquest. The main problem is that the institutions being built are less and less democratic and increasingly more technocratic and removed from public control (Commission, Court of Justice, ECB, soon a European EMF).
This leads to a general disenchantment from voters and a backlash from the countries with the longer democratic traditions (UK, Sweden...). The other problem in this model is that there are no obvious geographical limits to the growth of this vision of Europe since the main criteria of acceptance is a common belief in general humanist ideas loosely defined as 'European values'. So why not include Turkey, Georgia, Ukraine... and who knows, one day maybe even Russia or North Africa?). This leaves a lot of traditionalist voters feeling very uncomfortable.
The Catholic Model.
In The Rise of Christian Europe, Hugh Trevor Roper, explained the diversity of political systems was one of the key reasons why the Europe 'controlled' by Rome was successful while the Roman Empire of Constantinople failed. Under the catholic popes, Western Europe was catholic from one end to the next with free movements of people, traders, businesses, etc... But meanwhile, political structures were massively different systems, from independent cities in Flanders and Northern Italy, to Kingdoms, to Republics like Venice... So it could be argued that political diversity served Europe well; until, of course, the 19th and 20th century when Europe's nation-states (well, really France and Germany), in a mutual suicide pact, went for each other's throats in a bid to each become 'the new Rome, the new Imperial Power".
These fratricides led to the efforts towards European integration which, in their infancy, were heavily supported by the Catholic Church. Indeed, the real founding-fathers of Europe, Schuman (France), Adenauer (Germany), Alcide de Gasperi (Italy) were all Christian Democrats, and (German-speaking) Catholics. And their main bond was obvious enough: they shared a common, Christian, civilization. But beyond that, at inception, the European ideal's main legal principle was subsidiarity. Competing political systems were the norm, integration was the exception. Pieces of political sovereignty could be abandoned but never the principle of sovereignty itself (incidentally, we now have had a reminder of this view in the recent decision by the German high court to block any further abandonment of sovereignty by Germany).
Such a system automatically leads to the re-emergence of old political systems centered on provinces and ever closer proximity to the voters. Examples of such an evolution include Spain, Switzerland and Germany (with a lot of political powers such as taxation, education, police... being decentralized). Italy might be moving fast in this direction. Philosophically, this model has to stop at Europe's borders (no Turkey), since the common ground is Christianity. In this model Nation-States are weakened dramatically though instead of losing out to a super-state, they lose to provinces. Another fine example of this trend is the re-emergence of forgotten nations following the collapse of communism across Eastern Europe, either peacefully (Slovakia) or through bloodshed (Bosnia).
For this model to work, one needs adherence to the same legal rules (with final decisions belonging to the European court of justice, or to the Commission, used as some sort of arbitration court). Experiments are the rule and normalization to a common standard the exception. The main challenge is establishing processes to arrive at a common decision and the biggest is that some countries (think France, the inventor of the Nation-State) could decide to discard common rules and instead return to the old European ways of nationalism, protectionism, industrial policies, national champions, etc... Aside from that, the common institutions should be seen as places where arbitrages between different views take place, rather than places where decisions are taken. Another risk worth mentioning is the simple disappearance of nations which have no real reason to exist (Belgium?).
To summarize and put it in the language of today, at the risk of oversimplifying: In partisan political terms, Europe's Christian Democrats, typically led by Germany and Holland, were usually aligned with the "Christian" view of Europe, while Social-Democrats and Socialists, usually led by France, were more of the "Roman Empire" persuasion. And so, Europe went on and on, never really making a choice between the two models, which was quite wise. Europe was in fact a "Hayekian" construction, emerging from below in ways that nobody really understood, but which at the end delivered a satisfactory result. If Democracy can be defined as "government through discussions, compromises and debates", then Europe was indeed democratic, in its own inimitable and incomprehensible ways.
2– The Collapse of the Evil Empire Tips the Scale
However, this marvelous equilibrium was broken with the collapse of the Evil Empire and the German reunification. With a stronger Germany, a free (and very Christian) Poland, Hungary, Czechoslovakia... came the threat that the 'Christian' vision of Europe would overwhelm the 'Roman Empire' camp. The sense of urgency was profound: If a European State was not built rapidly, the newly freed Eastern European countries would, in the future, likely be very weary of abandoning large chunks of the sovereignty they had just recovered from the Soviets (without any help from the rest of Europe) to a European State (see Vaclav Klaus as an example).
For the proponents of the "Roman Empire", the European State had to be organized immediately, whatever the risks, and become inevitable. Otherwise, the proponents of 'Christian Europe' would win by default and History would likely never reverse its course. The collapse of the Soviet Union was the crisis which gave the opportunity, and drive, to the Roman Empire to push though an overly ambitious program. The scale had been tipped and the "Roman Empire" needed to tip it the other way; and the creation of the Euro, more than anything, came to symbolize the push by the Roman camp towards a centralized super-structure.
Of course, the reasoning was that a common currency would facilitate trade, tourism and exchanges amongst Europe's people and thus generate a large "Ricardian growth" spurt. But the common currency was also seen as a first step towards the creation of a European State. And the only reason "Christian Democrat" Germany, which for historical reasons should have been wary of such an endeavor, went along with the plan is that it was seen as a qui-pro-quo for German Reunification. The Germans thought: "we allow the French to build their European 'Roman Empire' and sacrifice the DM, and we get to re-unify with East Germany".
In this 'Roman empire' roadmap, The second step would be the writing of a constitution (by French ex-President Giscard) which would establish the super-structures of a functioning state. Unfortunately, this constitution was immediately voted down by the French themselves and then by the Dutch to boot (the Germans were never given a vote but would have most likely voted 'nein'). Having been shown the door by the citizens, the constitution came back through the windows, under a different name, which did not require a popular vote. Still, the new construct was not a "Constitution" per se, but merely a treaty. And this thus left the Euro as the only tool for the 'European State' to deploy its nascent power.
This is why today one reads everywhere that, should the Euro be consigned to the trash heap of History, then the whole European Union effort might disappear along with it. Of course, this is dead wrong. Rather than the death of Europe, a demise of the Euro would simply mean the collapse of the "Roman Empire" idea of Europe and the resurgence of the "Christian" idea of Europe.
After all, if some countries start to revert to their own currencies, why should this impact common market rules? A number of European countries are not members of the Euro (UK, Sweden, Denmark, Poland...) so who cares if Greece, or Spain, or Ireland join them? Instead, the bigger question investors, and commentators should ask themselves when confronting the current crisis is simple: for Europe to function, do we need more centralization, more government and more intervention? Or does Europe need more freedom to experiment? The answer to that question will dictate whether our reader is a proponent of the 'Roman Empire' idea of Europe, or the 'Christian' idea of Europe.
Needless to say, there are no prizes for guessing which camp I happen to fall into. However, let me dispel any possible lingering doubts by saying that, for me, the revival of the 'Christian idea' of Europe, and the possible, though still unconfirmed, demise of the 'Roman Empire' idea of Europe could actually be one of the most bullish developments since the collapse of the Soviet Union. So why does every one think it is bad news?
3– The End of Massive Capital Misallocation
As has now become painfully obvious, the low cost of financing which resulted from the Euro has allowed various governments to borrow at rates far too low for far too long. In other words, for the past decade, and because of political diktat, Europe has been grossly misallocating capital. That much is clear. So what could be the possible answer for Europe's policy-makers? Is it:
*Recognize the capital misallocation, restructure the debt, and reform a system which obviously, and painfully, does not work?
*Try to force a square hole into a round peg by imposing conditions on Greece, Portugal and Spain that would have made Bruning or Laval blush?
*Send good money after bad?
Somewhat unsurprisingly, Europe's policymakers first tried the second option and are now drifting towards the third. But this is where things are getting very exciting, and in my view, very long-term structurally bullish; the one conclusion we can draw from recent events is that the markets are simply not letting the European governments get away with the idea of sending good money after bad! Since the Greek rescue plan was announced, instead of tightening, and to the great surprise of all European policy-makers, spreads on Greece and all other risky European signatures have widened massively.
As our friend Alain Madelin (a former French Minister of Finance) recently said on French radio: 'politicians are saying that markets are acting irresponsibly but instead what is happening is that markets are starting to ensure that politicians act responsibly!' This reality means that Europe's politicians will either have to send even more good money after bad (and that too may fail), or throw in the towel and allow for the weak debt to be restructured.
Of course, it would be Panglossian of us to assume that a restructuring of the debt of Southern European nations, and the possible return to national currencies, would not trigger large hits across Europe's financial system. Indeed, the balance sheets of European banks and insurance companies are heavily distorted by past investments made in the debt of technically bankrupt governments. For the past 15 years, banks and insurance companies all over Europe have been lured into believing that the Greek risk was equivalent to the German risk, or the Spanish risk similar to that of the Dutch, etc. As a result, the capital of too many financial institutions was invested in very dubious paper.
Moreover, in the countries which have "enjoyed" a massive real estate bubble (Spain, Ireland...) because of the distortions in the cost of money introduced by the Euro, the banks are now loaded with real estate loans of very questionable value. To add insult to injury, regulatory powers all over Europe have literally forced banks and insurance companies into buying the bonds issued by European governments ("risk free" they were told, and zero reserve requirements!) while forcing them to sell good quality equity positions established over decades. So whether one looks at balance sheets, reserves, loan books or future sources of income, it is hard to avoid the conclusion that European financials are in a pickle. This is a true and very unfortunate consequence of the Euro.
But having said that, I believe that the banking crisis that a sovereign debt default in Southern Europe would most likely trigger need not unleash a wave of destruction similar to what followed Lehman's bankruptcy. Indeed, if we look back at the situation in 2008:
Financial leverage in the system was off the charts with every hedge fund, investment bank, retail investor, fund of funds... running on as much leverage as risk-blind commercial banks would provide.
Operational leverage was also at record highs with companies having built up stocks, double or triple-ordered commodities to cushion from further price increases, expanding rapidly on all continents, etc.
The situation could not be more different today. Following the Lehman shock, investors everywhere around the world have learned to focus disproportionately on risk rather than on returns. Companies have cut inventories, salaries, workers and are now as efficient as they have ever been (see Europe and The SAP Recession).
This profound difference between the 2008 and current underlying economic and financial conditions help explain why, while the bond markets are increasingly pricing in a debt default in Europe, an event which would undeniably trigger much gnashing of teeth amongst European financials, the larger European equity markets (Dax, FTSE, OMX, AEX...) seem to be taking the bad news in stride. The decent performance of European equity markets in the face of the EMU bond market meltdown indicates that, as things stand, the larger European companies do not need the banks.
The other possible explanation for the resilience of Europe's equity markets is that European stocks are looking beyond the near term hic-cups and problems linked to debt restructuring and towards a far more bullish 'Christian' Europe, which stops misallocating capital on a grand scale. After all, does any one seriously believe that, by maintaining the institutional arrangement which created the current problem, that Europe's policymakers would solve the balance sheet problems of the European financial institutions? Would creating an unprecedented depression in Greece, Portugal, Spain, Ireland and elsewhere across Europe, as the current plan seems to propose, really improve the ability of such nations to repay their debt?
Instead, isn't the reality that a nation such as Greece has now been found to be insolvent and that the longer we wait to acknowledge that fact, the worse the pain for both investors, and the Greek population, will be? To ease the suffering of this particular dog, should we cut the tail in one motion, or in small increments? The current reality is that the losses are already there, and now blatantly visible. The losses will thus have to be marked to market pretty soon and trying to sweep them under the carpet will not work now that the markets have understood that Europe's Roman Emperor has no clothes.
4– The Way Out
The question for Europe should not be how we can get the highly indebted and unproductive Southern nations to service their debt. Instead, the question should be how will Southern Europe achieve an improvement in its income statement? And the answers provided by both the economic textbooks and experience are obvious enough: the exchange rate has to fall to a level where the external sector starts contributing massively to growth and a level where asset prices become incredibly cheap for foreigners. Of course, right now, the weaker countries cannot devalue within the Euro.
Which leaves us with two possibilities:
*The Euro itself collapses and falls below its current purchasing parity of US$1.1/€. With Greece, and potentially others, having to restructure their debt and the European financial system having to take large hits, one would expect the ECB to maintain short rates at zero forever. But meanwhile, Northern Europe does not really need very low interest rates, nor does it need an undervalued exchange rate, but this will happen anyway. From there, we can imagine an export-led boom of historic proportions for Northern Europe. In turn, this should trigger tremendous capital flows which will no longer be recycled into Southern European debt. Instead, that money will more likely get re-invested in local real estate and local equity markets—for one of the consequences of the current crisis may well be that equities start being perceived as a better 'risk-free' asset than sovereign bonds! Or perhaps even in undervalued assets in Southern Europe (beach houses in Corfu).
*But if the above scenario is not bullish enough for you, try this one on for size: European governments decide that the Euro was a bad idea after all and that the time has come to return to national currencies. They restructure their debt— which at first triggers some volatility (a mild understatement) though, after that, the threat of defaults would disappear. From there, capital would start flowing in Europe according to the various nations' real comparative advantages, and not according to the monetary diktats of Frankfurt and Brussels-based technocrats. The currencies would settle at levels that would ensure the financing of external or domestic deficits... and Europe would then embark on the mother of all bull markets (think Asia post Asian Crisis).
As we write, the level of uncertainty about Europe's future remains at an all time high. The current lack of visibility, and the feeling that Europe's survival depends on the decisions of a few politicians, is leading most of the clients we talk to into a great level of despondency. But, although one has to acknowledge that the short term outlook will remain extremely challenging, there are very good reasons to start feeling cautiously more optimistic about the future. These reasons include:
The fact that the markets are simply no longer letting politicians send good money after bad. In essence, the markets are calling time on the disastrous experiment of the Euro and this should lead to a structurally more efficient allocation of capital across the Old Continent.
The fact that this crisis is coming at a time when EMU companies have never been so efficient, when leverage in the financial markets has never been so low, and the dependency on local banks has never been so insignificant. All this ensures very limited transmission mechanisms from 'weak hands' to 'strong hands'.
The fact that the "Roman Empire" idea may, with this crisis, have reached its nadir and will now never recover. Indeed, if Europe is now returning towards its marvelous historical roots of allowing diversities and differences to express themselves freely, then we should rejoice!
But we return to the most simple of questions, namely: Was the end of the USSR a negative event? When Americans stopped wasting capital building empty condos in Florida or Arizona, was that bad news? If, like us, our reader answers "no" to the above questions, then the Greek crisis should be seen as a reason for hope, rather than despair.Source: http://www.investorsinsight.com/blogs/john_mauldins_outside_the_box/archive/2010/05/05/was-the-demise-of-the-ussr-a-negative-event.aspx
Disclosure: No positions