Official Denial

by Michael Pettis

Slow growth is embedding itself solidly into the U.S. economy and the bond mayhem in Europe continues. The external environment for China is getting worse. This will almost certainly make China’s adjustment – when Beijing finally gets serious about it – all the more difficult. With still weak domestic consumption growth, and little chance of this changing any time soon, weaker foreign demand for Chinese exports will cause greater reliance than ever on investment growth to generate GDP growth.Europe’s travails in particular can’t be good for exports. What’s worse, it’s now pretty much official that the euro will fail soon enough. We have this on no less an authority than Angela Merkel. Here is what the September 7 Financial Times said:

Angela Merkel, German chancellor, declared on Wednesday that “the euro will not fail” after the country’s powerful constitutional court rejected a series of challenges to the multibillion-euro rescue packages agreed last year for Greece and other debt-strapped members of the eurozone.

In a passionate restatement of Germany’s determination to defend the common currency, the chancellor welcomed the court’s judgment as “absolutely confirming” her government’s policy of “solidarity with individual responsibility”.

First Rule of Politics

No, I didn’t misread the article. I just have a very different understanding of the logistics of a denial. Last year, for example, I wrote on my blog about ferocious denials by both Spain and Portugal that they would need any official help in funding themselves. But according to one of my favorite British television comedies, Yes, Minister, an official denial means something very different from what is intended. “The first rule of politics,” Sir Humphrey, the wily civil servant in the show, insists is: “never believe anything until it is officially denied.”

That’s why, citing Sir Humphrey, I was pretty sure that both Spain and Portugal would need to be bailed out. As long as they remained within the euro, I was convinced that there was no politically acceptable adjustment mechanism that would allow them to continue funding their debt in an orderly way. One way or the other they would have to be bailed out or default, and probably both, with the first happening a few times before the second. In the end the denial confirmed the bail out. Sir Humphrey usually knows how such things actually work.

So of course Merkel’s denial struck me as especially interesting. I don’t want to sound too glib or too jokey, but I wonder if there has ever been a forced devaluation that wasn’t preceded by ringing assertions from presidents and central bank governors that under no circumstance would the currency ever devalue.

What is all the more interesting is that I recently discovered that the quote “never believe anything until it is officially denied” doesn’t originate with the writers of the British TV comedy. Apparently it can be traced to at least as far back as Otto von Bismarck, who was born not too far from where Angela Merkel grew up. Never believe anything until it is officially denied, the Iron Chancellor warned us.

An interesting proposal

So if Germany’s Iron Lady is now denying that the euro will fail, can its failure be far off? It depends I guess on what we mean by failure. If any important reversal in the structure and membership of the euro is a failure, then it will almost certainly fail, but I suppose there are many ways the euro project can be transformed without quite calling it a failure.

At the end of last month Hans-Olaf Henkel, for example, the former head of the Federation of German Industries, had an interesting OpEd in the Financial Times. In his piece he says:

Having been an early supporter of the euro, I now consider my engagement to be the biggest professional mistake I ever made. But I do have a solution to the escalating crisis.

…Instead of addressing the true causes, politicians prescribe painkillers. The euro patient suffers from three discrete diseases: as a result of the financial crisis, many banks are still unstable; the negative effects an overvalued euro has on the competitiveness of the “south”, including Belgium and France; the huge level of debt of some eurozone countries. It would be misleading to proclaim there is an easy way out. But it is irresponsible to maintain there is no alternative. There is.

The end result of plan “A” – “defend the euro at all cost” – will be detrimental to all. Rescue deals have led the eurozone on the slippery path to the irresponsibility of a transfer union. If everybody is responsible for everybody’s debts, no one is. Competition between politicians in the eurozone will focus on who gets most at the expense of the others. The result is clear: more debts, higher inflation and a lower standard of living. The eurozone’s competitiveness is bound to fall behind other regions of the world.

As a plan “B” George Soros suggests that a Greek default “need not be disorderly”, or result in its departure from the eurozone. But a Greek default or departure from the eurozone implies risks too high to take. First in Athens, then Lisbon, Madrid and perhaps Rome, people would storm the banks as soon as word got out. A “haircut” would not improve Greece’s competitiveness either. Soon, the Greeks will have to go to the barber again. Anyway, we now talk also about Portugal, Spain, Italy and, I am afraid, soon France.

That is why we need a plan “C”: Austria, Finland, Germany and the Netherlands to leave the eurozone and create a new currency leaving the euro where it is. If planned and executed carefully, it could do the trick: a lower valued euro would improve the competitiveness of the remaining countries and stimulate their growth. In contrast, exports out of the “northern” countries would be affected but they would have lower inflation. Some non-euro countries would probably join this monetary union. Depending on performance, a flexible membership between the two unions should be possible.

I think Henkel is right, although I think the likelihood of Europe’s adopting his Plan C is pretty small. Still, it is interesting to consider why he might be right.

As I see it, we cannot continue with the existing currency arrangement. Countries like Spain (I am reverting to my habit of calling all the deficit countries “Spain” and all the surplus countries “Germany”) simply will not adjust quickly enough as long as they maintain the euro, and we are going to watch their economies contract and their debts grow until finally the electorate has had enough and forces a radical change in strategy .

Much if not most of peripheral Europe will then leave the euro and default, and Germany will have to eat the losses on its outstanding (and growing) loans. But why wait? The longer we put off the reckoning the worse it will be for peripheral Europe and the greater the losses that Germany will have to swallow. So shouldn’t Germany simply force Spain to leave the euro now?

Damned either way

The problem is that if Spain leaves the euro and returns to the peseta, it will be caught in a downward currency spiral like the ones suffered by Mexico in 1982 and 1994 and Korea in 1997. In both cases the currency plunged by far more than the amount of its theoretical overvaluation. This happened because a substantial portion of Mexican and Korean debt was denominated in foreign currency. Of course once Spain revives the peseta, it will be in a similar position – with a lot of its debt denominated in euros, which will become a foreign currency.

What does external debt have to do with the extent of the devaluation? Quite a lot, it turns out. Mexico and Korea (and a host of others examples) remind us that when a country is forced to devalue, the amount of the devaluation is not necessarily in line with estimates of the amount of overvaluation.

I would argue that Spain probably suffers from 15-20% overvaluation, but once Spain returns to the peseta the peseta will not devalue by that amount. It will devalue by at least 50%, and probably a lot more. Why? Because of the self-reinforcing relationship between the currency and external debt.

It always works the same way when a country with a lot of external debt devalues its currency. As the peseta devalues, Spain’s external debt will rise in tandem since it is denominated in the appreciating currency. Since Spain is already believed to be overly indebted, as the debt rises relative to domestic assets, Spanish credibility will decline quickly and financial distress costs will rise.

But of course as credibility declines and defaults rise, the peseta will drop even more as investors flee the currency and as domestic borrowers with euro-denominated debt try to hedge the currency risk. This will go on in a self-reinforcing way until the currency has been crushed. In the end, for Spain to leave the euro would probably cause its external debt to more than double – perhaps even triple – as the peseta falls. Of course it will be forced into default within days or weeks.

This, by the way, is not an argument for Spain to stay in the euro. If Spain stays in the euro we will still arrive at default, but much more slowly, and mainly at first through a grinding away of wages and economic growth over many, many years and a gradual building up of debt as Germany refinances Spanish debt at interest rates that exceed GDP growth rates. The default will occur anyway, but only after years of high unemployment.

This is why I think Henkel’s proposal makes sense. Rather than have Spain leave the euro, Germany can leave the euro. The new German currency would automatically appreciate and the euro would depreciate, but without the terrible debt dynamics, the adjustment in the currency value would be much closer to the theoretically correct adjustment. The relative adjustment would probably be in the 20% range rather than in the 50% range.

Of course German banks would still have a problem. Their deposits would be in the form of the new German currency, and a lot of their loans – all those to Spain, for example – would be in the depreciating euro, and so they would take large losses. But at least the losses will be less – and more importantly the process will be more orderly – than if Spain simply leaves the euro and defaults.

One way or the other Germany is going to take a pretty big hit. It is a complete waste of time trying to figure out how to avoid it. It would be far more constructive to resolve the problem as quickly as possible in as orderly a manner as possible, and as any good Minskyite would tell you, that means we have to pay special attention to the balance sheet dynamics. That’s why I think Henkel’s proposal is an interesting one.

Of course the really interesting thing about Henkel’s proposal (at least to me) is to figure out what decision France would make if something like this happened. If France remained within the euro (i.e. “peripheral” Europe in Henkel’s scenario), the possibility of a United States of Europe would be forever dashed, but it would almost certainly be replaced with a two-entity Europe – the United States of Germany and the United States of France, or perhaps, for those who like 19th Century monetary history, the new Zollverein and the new Latin Union.

Not so stunning

Meanwhile, still in Europe, and in a country not likely to join either entity, the Swiss National Bank decided to get very serious about the currency wars. Here is the Financial Times again:

The Swiss National Bank stunned financial markets on Tuesday by setting a ceiling for the Swiss franc against the euro in an attempt to prevent the strength of its currency from pushing its economy into recession.

The central bank said it would set a minimum exchange rate of SFr1.20 against the euro. The SNB action came after previous measures to weaken its currency proved ineffective as the worsening eurozone crisis prompted a flight to safety by investors, boosting haven

Analysts said the move raised the stakes in the global currency war as countries vie to protect their exporters and, by removing a release valve for investors looking for a haven from current market turmoil, could heighten instability on financial markets.

I am not sure how stunned to be about all of this. As I see it this is pretty much part of the expected evolution of international financial arrangements. The world is seriously deficient in demand compared to capacity and every country is going to try (has already tried) to capture as large a share of that demand as it can. This means every country is going to try aggressively to export capital or limit capital imports.

But of course it doesn’t work that way. If capital-exporting countries want to increase capital exports in order to acquire a bigger share of global demand, and capital-importing countries want to limit or reverse capital imports, something has to give way. This is basically what we mean by trade and currency wars.

And what’s bizarre to me is that in this muddled environment there are an awful lot of people, including some very respectable economists, asking that Asians help Europe out by funding their fiscal deficits. China and other Asian central banks, they say, should buy European bonds, especially the bonds that no one in Northern Europe wants to touch.

But do they understand what this means? If Asian central banks increase their flows to Europe – by buying more government bonds, for example – Europe will be transformed from a net capital exporter to a net capital importer, and with that Europe’s small trade surplus will reverse itself and become a trade deficit.

This means slower growth for Europe – Germany needs a trade surplus to generate growth and Spain’s trade deficit is so high that it cannot afford any further deterioration. Is it really a good idea to trade slower growth for another year or two in which Europe can further build up its debt burden?

The Swiss have clearly made their decision. They do not want any more foreign capital inflow and are trying to eliminate or at least reduce it by capping the rise in the Swiss franc. It probably won’t work. I guess now by having converted the currency into a one-way bet I assume that we are going to see massive speculative inflows into the Swiss franc on expectations that inflows will eventually force the SNB to revalue.

And one way or the other inflows must show up as a deterioration of the trade account. My guess is that in a few weeks or months the SNB is going to have to use more forceful measures to stop speculative inflows.

This is just a harbinger of things to come. As I discuss in the piece I wrote for Foreign Policy last week, no one wants any part of the exorbitant privilege that comes with the ability of foreign institutions to acquire your currency. Countries will continue trying desperately to export capital to each other while continually crying foul at attempts to force them to import capital. The currency wars will roll on.

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About the Author

Michael Pettis is a Senior Associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management, where he specializes in Chinese financial markets. He has taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business. He is also Chief Strategist at Shenyin Wanguo Securities (HK). Pettis has an impressive work history on Wall Street, Latin America, Europe and Asia (see his blog China Financial Markets for a complete bio).