Monday, July 11, 2011

Greece is the Word

Investors may be feeling a sense of déjà vu this year as a familiar cast of permanently pessimistic public figures has been rolled out in various publications and on news broadcasts to rehash the Euro Zone issues that came to the center stage of world public policy debate in early 2010. Recent international headlines and news broadcasts have been dominated once again by news of Greek austerity and debt restructuring, and the possibility of other countries following them down this painful path.  The wild market gyrations of recent weeks seem to indicate - depending on the day - either that there will be a complete global financial meltdown or that the situation will happily resolve itself.

There are essentially two possible equilibrium outcomes of the ongoing crisis, 1) a move toward far greater fiscal unity, labor mobility, and centralized government authority (a "United States of Europe" of sorts), or 2) a separation of some countries from the euro monetary union and return to their original currencies.  Neither of these solutions is politically desirable or easy to accomplish under existing laws and institutions, however it is our view that market forces have been and will continue to push the Euro Zone to one or the other, willingly or not.  To date, key events seem to indicate broadly that option 1 is somewhat more probable than option 2, however very little can be safely ruled out given the wide range of human variables going into each decision.

In contrast to conventional wisdom, the problems of the Euro Zone have been caused primarily by Germany’s strength as an export powerhouse rather than by laziness and greed on the part of the periphery countries.  German wages have been kept flat for the past decade due to massive off-shoring efforts to Russia and the Ukraine, while wages in Greece, Spain, and Italy have risen by about 35% and the Euro Zone as a whole has risen by about 20%.  In a floating currency regime such as the one that existed in Europe prior to 1999, this productivity growth would be balanced by an appreciating German mark and declining drachma, pesata, and lira.  However with the euro pegged at a fixed level across its member countries it has been impossible for the periphery to remain cost competitive, and as a result their respective current account deficits have grown to the current unsustainable levels.

The impact of this disequilibrium is more clearly illustrated through a sectoral balances analysis of the debts and deficits in the Euro Zone (shown below – graphic courtesy of the Financial Times March 9 2010).  Double-entry accounting requires that incomes and spending between the private sector, public sector, and export sector must sum to zero - in other words if one of these entities saves then another must run a deficit (borrow) and vice versa.

As shown, before the financial crisis of 2008/2009 the large private sector balances in Germany, Austria, France, Belgium, and the Netherlands were offset by large private sector deficits (borrowing) in Slovakia, Portugal, Ireland, Greece, and Spain.  Thus the spending in the periphery countries was in a sense “financed” by the high private savings rates in the productive core countries, even as fiscal positions appeared strong across the board in accordance with the Maastricht treaty governing the Euro Zone.  These structural imbalances were an inevitable outcome of the weak competitive position of workers in the periphery countries and the inability of individual country currencies to float to offset this weakness.  Because wages in the periphery countries were too high, they were unable to compete in the labor markets with the core countries and needed to borrow to increase their consumption to grow the economy over time.

From this analysis it is clear that the austerity experiment has not been and will not be an effective solution to the problems of the Euro Zone.  In fact the results of austerity speak for themselves: as the chart above shows both Ireland and Spain ran a fiscal surplus in 2006.  Additionally both Ireland and Portugal aggressively cut expenditures early in 2010 to attempt to avert a confidence crisis.  Clearly none of these countries has been helped by their attempts at fiscal discipline, and in fact the sectoral balances analysis implies that paradoxically the opposite has occurred as the contraction in aggregate demand from withdrawn public spending has worsened the debt/GDP ratios of the Euro Zone countries in question.

Given this backdrop of a poorly planned currency union and failed austerity measures, the “end game” is particularly difficult to predict.  To this point, EU officials have shown a desire to move more toward fiscal consolidation rather than to push countries out of the union.  The formation of the European Financial Stability Facility last year, increased intervention by the European Central Bank, and expressed political will not to let the Euro collapse all are steps toward greater consolidation.  In fact, while the proposed solutions have frequently been criticized as “patchwork”, “kicking the can down the road”, etc., they have nevertheless successfully bought time for systemic risk to the global economy to be reduced.  As shown in the chart below, 25% of Greek debt is now owned by the EU and IMF, and only two non-Greek banks (FMS and BNP) have exposure of over $5B.

This illustrates two key points.  First, banks have been able to substantially lower their exposure to Greek debt over the past year, making a systemic event less probable.  Second, the EU has already taken on a great deal of the risk of a Greek default, which makes fiscal consolidation of the region more likely.  An analogy is that of a rock climber:  upon reaching a particularly treacherous section of a cliff, the worst thing one can do is to look down at how far the fall is to the bottom.   The best course of action is to continue to push through toward the summit.

For balance to return to the Euro Zone, there must be either an opportunity for the individual member currencies to float in order to restore reasonable current account levels, or the region must become more of a single fiscal entity so that it can enjoy labor mobility and an increased role of the European Central Bank, a treasury, and crisis resolution mechanism.  In the meantime the region will likely continue to “muddle through” its problems with patchwork solutions.  Investors will be well-served in attempting to understand the true dynamics of what is happening globally and focusing on making investment decisions that maximize the probability of a solid long run risk-adjusted return while ignoring the rhetoric and sales pitches from various parties serving their own agendas.