by Guest Author Pippa Malmgren, PippaMalmgren.com, written November 11, 2011
The German and French policymakers have now realized that they may not be able to preserve the Euro and so they have focused their attention on a different problem – how to preserve the EU even as the Euro fails or members need to temporarily drop out of the Euro. Market events, including the blow out of the Italian bond spreads way over 7.6% (7% being considered walking dead/unsustainable/the game is over level), have caused the policymakers to realize that a temporary exit from the Euro may be the least bad of a many very bad options. This is why even Prime Minister Sarkozy is talking about a “two speed Europe”. There are no good options at this point as Martin Wolf has finally realized and points out in the Financial Times: “Only fear of the consequences of a break-up is now keeping it together”. Click on photo for larger image of only silver bullets available.All the options are bad and costly. Market forces are increasingly determining what the options are and foreclosing on options policymakers thought they had. One option which is now under discussion involves permitting a country to temporarily leave the Euro, return to its native currency, devalue, commit to returning to the Euro at a better debt to GDP ratio, a better exchange rate and a better growth trajectory and yet not sacrifice its EU membership. I would like to say for the record that this is precisely the thought process that I expected to evolve,but when I proposed this possibility back in 2009, and again in September 2010, I had a 100% response from clients and others that this was “impossible” and many felt it was “ridiculous”. They may be right but this is the current state of the discussion. The Handelsblatt in Germany has reported this conversation, but wrongly assumes that the country that will exit is Germany. I think that Germany will have to exit if the Southern European states do not. Germany’s preference is to stay in the Euro and have the others drop out. The problem has been the Germans could not convince the others to walk away.
But, now, market pressures are forcing someone to leave. Germany is pushing for that someone to be Italy. They hope that this would be a one off exception, not to be repeated by any other country. Obviously, though, if Italy leaves the Euro and reverts to Lira then the markets will immediately and forcefully attack Spain, Portugal and even whatever is left of the already savaged Greeks. These countries will not be able to compete against a devalued Greece or Italy when it come to tourism or even infrastructure. But, the principal target will be France. The three largest French banks have roughly 450 billion Euros of exposure to Italian debt. So, further sovereign defaults are certainly inevitable, but that is true under any scenario. Growth and austerity will not do the trick, as ZeroHedge rightly points out. Ultimately, I will not be at all surprised to see Europe’s banking system shut for days while the losses and payments issues are worked out. People forget that the term “bank holiday” was invented in the 1930’s when the banks were shut for exactly the same reason.
Different policymakers have different views about the “right” way forward. For Germany the only appropriate solution is one that involves fiscal consolidation and rules that permit the expulsion of any member of the currency that violates the “rules”. The Euro under this approach will be sound and will permit reinforcement of the EU and encourage widening of EU membership and powers. Of course, this idea introduces the teeny tiny problem that it involves handing over the power of the purse, the most fundamental aspect of a democracy to not only the centre of power in Europe, but a centre of power with a Germanic approach to economic policy. Political leaders may, emphasis on may, be able to commit to this. But, I gravely doubt the public anywhere will go along with it.
The French are driven by the commitment to preserve the EU. They will go along with any solution that permits preservation of the EU. They will emphasize that all solutions have an added advantage that the EU membership can be even larger over time, even if Euro membership is smaller. Meanwhile the Greeks, Italians and others have political pressures that even Superman could not bear. The idea that sensible former central bankers like Papademos or sensible former Eurocrats like Monti can “sort this out” is nonsense. The best that can be hoped for is that these new leaders are able to explain to their publics how dire the default option is for them. I think it unlikely that these men will be able to get the public to agree not only to the required level of austerity, which is a hard enough task, but to a new social order which involves loss of the social welfare state Southern Europeans are deeply wedded to. The news media and trading floors are dominated by the search for a solution. Everywhere one hears “somebody better fix this” or “who is going to fix this” “or else”. Examples: Open the taps, Carney warns; German economists urge vast euro debt fund; It’s time for you to fire the silver bullet, Mr. Draghi; Only the ECB can save Italy now; But it can’t act alone; Europe is creating ‘budget tsar’; But there is no fix; So now we are in “or else” territory.
The fundamental problems, to clarify, are these:
- You cannot fix a debt and deleveraging problem by adding more debt and more leverage.
- You cannot fix a solvency problem by providing more liquidity.
- Any monetization option will be fiercely opposed by Germany and will ultimately force Germany to have to leave the Euro.
- Any failure to monetize means defaults which will not only damage the banking system but also deprive Southern European citizens of their savings, their pensions, their jobsand possibly their democracy and their Social Welfare State.
- Any solutions (such as the ESFS or current austerity requirements) that only work if interest rates are artificially suppressed by government action are bound to fail sooner or later. See “Market spikes eurozone rescue guns”.
- Any solutions that rest on current growth trajectories (all austerity requirements) are also vulnerable to failure. And this is why we see headlines that say: “French and Germans explore the idea of a smaller euro zone” even though this solution is painful, unwanted, logistically complex and disruptive.
The US is Defaulting on its Debt As Well
I have argued for some time that the US would default through haircuts at the local level (municipal defaults) and through inflation at the national level. In addition, austerity is making its way into the US debt picture but through local, not national, initiatives. The most important news about the Jefferson County default is not that it is bigger than Orange County, making it the largest municipal bankruptcy in U.S. history, or that it happened without much notice or market impact. The most important aspect is that someone bought the sewer assets of the county, which had been the principal source of the debt burden, according to Bloomberg “Less than an hour after Jefferson County’s late-afternoon filing, an investor bought more than $1 million of its sewer debt for 58 cents on the dollar, down from about 74 cents a month earlier, according to Municipal Securities Rulemaking Board trade data.” In other words, the default process in America will be met by increased new investment. The new owner is doing exactly what I have recommended all investors do in this new environment: Buy genuine unimpaired cash flows. It would hard to name something that has more genuine demand than sewage services in the US. Now that the debt is defaulted on the entity is no longer impaired by debt. And, the cash flows, though not certain, are likely to be manageable. Prices for sewage services in that county will rise but probably not by as much as the previous debt-laden owners were demanding. Thus the public ability and willingness to pay is likely to be high.
The Federal Reserve remains on the increased inflation trajectory, in spite of their denials. Recent events are frustrating for the doves on the board and for the Treasury, all of whom would like to do more to ease the impact of a potential slowdown and the rise in uncertainty. But, the best they can do is to permit or even encourage the acceptable rate of inflation to drift up. And this is exactly why we see Chairman Bernanke making it crystal clear that the “Fed has latitude to set inflation goal”. You can be sure that the inflation goal will be higher than expected and that it will be raised over time.
The greatest policy mistake now building in the system is this: policymakers will confuse the temporary fall in commodity prices with a permanent reduction of inflation pressures: China, India, Australia come to mind. I think the opposite will turn out to be true. The recent crisis caused commodity prices to fall somewhat but the production constraints are now worse than ever due to lack of bank lending and working capital. So, commodity prices jump back up again very fast. This means central banks especially in emerging markets may start easing way too soon. I bet inflation pressures worldwide are barely beginning.
About the Author
Dr. Philippa Malmgren is the President and founder of Principalis Asset Management, a financial firm based in London. In short, she helps fund managers better understand how politics, policy and geopolitics will impact the financial markets. Investors use her insights to manage their portfolios more profitably. Her clients include many investment banks, fund managers and hedge funds as well as Sovereign Wealth Funds, pension funds and corporations. She founded the Canonbury Symposia, which brings together high level experts on strategic security, defense and intelligence matters to meet with experts from the financial markets. Click on photo for larger picture.
She is a frequent guest on the BBC’s Today Program, Newsnight, a guest presenter on CNBC’s Squawk Box (UK) and is a speaker at conferences. She has a column on the markets in Investment Week and has written for The International Economy, International Fund Investment Magazine and Institutional Investor Magazine. Dr. Malmgren has been a visiting lecturer at Tsinghua University in Beijing and an occasional lecturer for the Duke Fuqua Global Executive MBA Program.
She serves on the International Advisory Board for the School of Oriental and African Studies in London and Indiana University School of Public and Environmental Affairs. She is a Governor of the Ditchley Foundation in the UK.
She served as financial market advisor in the White House and on the National Economic Council from 2001-2002, where she was responsible for financial market issues. She founded Malmgren and Company, in London, England on 2000 and was previously the Deputy Head of Global Strategy at UBS and the Chief Currency Strategist for Bankers Trust. She headed the Global Investment Management business for Bankers Trust in Asia. She has a B.A. from Mount Vernon College and an M.Sc. and Ph.D. from the London School of Economics. She completed the Harvard Program on National Security. The World Economic Forum named Dr. Malmgren a Global Leader for Tomorrow in 2000. She is also a member of the Council on Foreign Relations, Chatham House, the Economic Club of New York and the Institute for International Strategic Security.