Wednesday, June 27, 2012

What Will Germany Do?

Julien Toyer and Thorsten Severin of Reuters report, Europe's leaders at odds before summit:

European leaders sound unusually divided before a high-stakes summit, with Germany's Angela Merkel saying total debt liability would not be shared in her lifetime and giving little support to Italian and Spanish pleas for immediate crisis action.

Rome and Madrid have seen their borrowing costs spiral to a level which for Spain at least would not be sustainable as it battles to recapitalize banks ravaged by a burst property bubble and cut a towering government deficit.

Spanish Prime Minister Mariano Rajoy said on Wednesday he would ask other European Union leaders to allow the bloc's bailout funds or the European Central Bank to stabilize financial markets.

Speaking in parliament before a meeting of European heads in Brussels on Thursday and Friday, Rajoy warned that Spain would not be able to finance itself indefinitely with 10-year bond yields near seven percent.

"The most urgent issue is the one of financing. We can't keep funding ourselves for a long time at the prices we're currently funding ourselves," he told parliament.

Even when there are profound disagreements, EU leaders have been burned by the markets enough times to generally make sure they sound united before major gatherings.

But divisions have been exposed by the ousting of Nicolas Sarkozy by socialist Francois Hollande as French president and the fact that Rome and Madrid have muscled into the traditional Franco-German axis.

The leaders held an unusually discordant news conference in Rome on Friday. Hollande said there must be more solidarity in Europe before countries hand over more sovereignty over their national budgets, while Merkel said she would not accept extra liabilities without overarching budget control.

The pair will have a working dinner in Paris on Thursday evening, an opportunity to repair the damage. An initial attempt to smooth over differences came at a meeting of the four countries' finance ministers late on Tuesday after which nothing was said.

In Rome, Italian Prime Minister Mario Monti said he would not simply rubber stamp conclusions at the EU summit and said he was ready to go on negotiating into Sunday evening if necessary to agree on measures to calm markets.

With Hollande's support, Monti is pushing for the euro zone's rescue funds to be used to help limit the spreads over German Bunds on bonds issued by countries that respect EU budget rules. Rajoy would settle for that or the European Central Bank doing the same job by reviving its bond-buying program.

The proposal has run into stiff opposition from Germany, the largest economy in the European Union and the bloc's effective paymaster, and has been rejected by Jens Weidmann, the powerful head of the German central bank, the Bundesbank.

Stock markets perked up last week on the hope that the 20th EU summit since the bloc's debt crisis exploded into the open in Greece would come up with dramatic measures. Investors have since thought better of that view.

European shares edged up on Wednesday and the euro was flat, with many investors out of the markets before the Brussels meeting.

"People are waiting for the inevitable - which is that policymakers will probably fail to do what is necessary," said Neil Mellor, currency analyst at Bank of New York Mellon.

BORROWING COSTS

Merkel stomped on the idea of mutualising debt - favored by France, Italy and Spain - at a meeting of lawmakers from her Free Democratic coalition partners in Berlin on Tuesday, according to people who attended the closed-door session.

"I don't see total debt liability as long as I live," she was quoted as saying, a day after branding the idea of euro bonds "economically wrong and counterproductive".

The words may have been carefully chosen and do not at face value rule out mutualising some portion of euro zone members' debts as the end point of a drive towards fiscal union.

Merkel find herself in a dwindling minority but holds the euro zone's purse strings and therefore nearly all the cards.

German opposition SPD leader Sigmar Gabriel told the Financial Times that urgent measures were needed to lower euro zone sovereign borrowing costs otherwise the currency bloc could "simply explode".

Italy and Spain argue that they are stretching every sinew to cut their debt mountains and need some support from their currency area peers to keep the markets at bay.

Monti won the first two of four confidence votes on Tuesday called to accelerate the passage of his labor reform that has been criticized by both by labor unions and the business establishment. The final two votes, and definitive approval, are due on Wednesday.

Spain, which has been offered loans of up to 100 billion euros to recapitalize its banks but which is determined not to ask for a sovereign bailout, is considering raising consumer, energy and property taxes.

Spanish Economy Minister Luis de Guindos said he had talked with the finance ministers of Germany, France and Italy already on Wednesday with further discussions planned.

Euro zone finance ministers will also hold a conference call on the bailout of Spanish banks and this week's request for aid from Cyprus, EU officials said. The request made Cyprus the fifth of the euro zone's 17 states to seek aid from EU rescue funds, after Greece, Ireland, Portugal and Spain.

Underlining the parlous state of Spanish finances, figures showed the central government's deficit had already reached 3.41 percent of annual gross domestic product through just the first five months of the year, close to its target for the whole year of 3.5 percent.

Spain's central bank said on Wednesday it expected recession to deepen in the second quarter of the year.

The Brussels summit is expected to agree on a growth package pushed by France worth around 130 billion euros ($162 billion) in infrastructure project bonds, reallocated regional aid funds and European Investment Bank loans.

Leaders will also discuss proposals for a banking union, but while they are likely to agree to give the ECB power to supervise big cross-border banks, Merkel is resisting any joint deposit guarantee or common bank resolution fund.

You might be asking yourself, why is Merkel resisting? John Mauldin shares some excellent insights into this very topic in his latest Outside the Box comment, What Will Germany Do?.

Mauldin begins by setting the background:

This week all eyes are on Germany, and the question is "What will Germany do?" We are going to look at four quite-short essays. Two are from GaveKal, one is from Dennis Gartman, and the last is from Kiron Sarkar – all on this very topic.

One of the reasons I really like to read the research from GaveKal is that they are very public when their analysts disagree, and you get to listen to the back and forth. Some of the best analysis I see is when Charles and Louis Gave (father and son) and Anatole Kaletsky do email battle with each other while they are on three different continents. This time it is Anatole and one of their analysts, Francois Chauchat (whom I have not had the pleasure of meeting), differing on whether Germany should (or even can!) leave the eurozone.

I should note that it is not unusual for there to be intense debates in serious research houses. Happens every day, and perhaps often during the day. When you are playing an "A"-level game at one of the best research houses, you are typically not a shy, retiring type. What is less than usual is for that debate to be played out in public for clients to see. While a strong, useful consensus may be reached, I find the sturm and drang of the debate to ofttimes be just as instructive.

Anatole thinks Germany should leave, and you find yourself nodding your head, and then you read Francois and you sit back. This is a very complicated issue.

I continue to believe that Europe in general and Germany in particular have no good choices. They can only choose between Disaster A, which is keeping the eurozone together, and Disaster B, which is breaking the eurozone apart. Either will cost trillions of euros and mean much pain. It is not a choice of pain or no pain. It is simply a decision as to what type of pain you want and in what doses you want to take it. Choose wisely.

Then Dennis Gartman weighs in this morning. For those who know Dennis, he is never shy about voicing his opinions when he writes every market day at 3 AM Eastern Time, from wherever in the world he is. But he is not married to any positions. His favorite quote seems to be from Keynes, which is (loosely), "When the facts change then so do my opinions." And then he tells everyone about the change and why. You have to love that.

But this morning he was exceptionally strong in his opening piece about Europe and Germany. After reading the notes from GaveKal, absorb Dennis's pithy analysis.

And finally there is a one-page summary note from Kiron Sarkar, which he sent me while we were exchanging emails today. (With m on my iPad 3 in Tuscany. There is an Italian company that sells a SIM card for the iPad that gives unlimited monthly data for €20. Awesome! Pay attention, AT&T).

This is a real feast for those who love to think about what's behind the headlines. I love it.
Indeed it is which is why I love reading Mauldin's comments which you can find here. Here are the comments on What Will Germany Do?:

What Will Germany Do?

By Anatole Kaletsky

Now that the Greek election is over, with the pro-bailout parties gaining enough seats for a slim majority, Europe can return to the regular cycle of panic, relief, disappointment and renewed panic, that we have observed for the past two years.

This time, however, the relief rally may be even shorter than usual, since the market's attention will soon shift from Athens to Madrid, Paris and, above all, Berlin.

Since Greece has no chance of meeting its financial targets, the new government will soon need significant new concessions from the troika. Assuming that Germany resists such concessions, as well as the much larger ones that will soon be required by Spain, the fundamental contradiction of the euro project will again be brought into focus. A single currency can only be sustained within a fiscal and political union that can mutualise and monetize the debt— something that Germany refuses even to discuss.

If this situation persists, then one of two things could happen. The debtor countries could resign themselves to permanent depression and bankruptcy as they sink further into debt traps and Greek-style crises which will ultimately push them out of the euro one by one. Or they could turn the tables on Germany. Instead of letting Germany impose its economic and political philosophy on Greece, Ireland and Portugal—and in the near future on Spain, Italy and probably France—the Club Med countries could unite and impose their economic philosophy on Germany.

With every day that passes, and especially since the French election, it is becoming clearer that the problem country for the euro—the odd man out in terms of economic structure and the chief obstacle to any political resolution of the euro crisis—is not Greece, Spain or Italy. It is Germany.

It is Germany that refuses even to talk about mutual debt and banking guarantees. It is Germany that insists on self-defeating fiscal austerity and intolerable political conditions for the debtor countries. It is Germany that vetoes quantitative easing by the ECB, which could cap bond yields and relieve deflationary debt traps. And it is Germany that makes the other euro countries uncompetitive, discourages devaluation of the euro against the dollar and refuses even to relax its own domestic fiscal policies to reduce its trade surplus and support growth.

Suppose then that Angela Merkel refuses to make any compromise on debt mutualisation or ECB monetisation when a political or market crisis next strikes one of the debtor countries, as it surely will. The obvious answer would be for the Club Med governments to point out that Germany has become the obstacle to a resolution of the euro crisis. Mrs Merkel could then be asked, one last time, to abide by majority decisions that are necessary for the survival of the euro and in the interests of all its members. If she refused to do this, Germany could be politely asked to leave. And if Mrs Merkel refused to fall in line or voluntarily leave the euro, the other countries could easily call her bluff by creating conditions that would be unacceptable to the German public. The obvious way to do this would be to force a vote in the ECB for unlimited quantitative easing to monetise government debts.

German public opinion would surely oppose this, but they could not prevent it because Germany has just two votes on the Council of the ECB —and even assuming support from Austria, Finland, the Netherlands and Slovakia, the German faction would command only 6 votes out of 23. If the two German ECB representatives were forced to resign in protest (again!), it is easy to imagine German public opinion demanding immediate withdrawal. A new Deutschemarks could rapidly be issued by the Bundesbank and, while the German banks and insurance companies would suffer large losses because of a mismatch between their euro assets and their New D-Mark liabilities, they could be readily recapitalised by a government suddenly freed of the contingent liabilities imposed by the rest of the eurozone.

This kind of euro break-up triggered by German revaluation would be much less disruptive than a "break-down" caused by devaluation in Greece or Spain. In the case of a German revaluation, there would be no contagion or capital flight, as there would be if Greece, then Spain, then Italy and France were knocked out of the euro one by one. There would be no lawsuits by disgruntled creditors.

Best of all, from both the legal and the economic standpoint, the legacy euro created by a German withdrawal would survive as a more viable common currency for the remaining countries of the eurozone. With Germany outside the euro, France, Italy and Spain could rapidly devalue their way back to competitiveness within Europe—and also internationally, by encouraging the new euro to devalue rapidly against the dollar, yen and RMB.

Without German opposition, the ECB could imitate the Fed and the Bank of England, buying bonds without limit so as to slash long-term interest rates. And if quantitative easing produced an even weaker euro or higher inflation, so much the better, since the Club Med countries have always relied on devaluation to promote export growth and inflation to eliminate debts.

A break-up of the euro caused by Germany's departure would be very bullish for practically all global risk assets, with the obvious exception of German export and bank stocks. German bonds would also suffer huge losses, since the German government could decide to repay its bonds in legacy euros, rather than redenominating all its obligations into appreciating new Deutschemarks.

For a government that had just spent hundreds of billions on recapitalising its banks for the losses they suffered in France, Spain and Italy, it would be tempting to burn foreign bondholders, rather than offering them a further currency windfall.

Germany Has To Stay: A Riposte

By Francois Chauchat

In his Reuters column last week (see here), and his recent Daily, Anatole argues that it may be more logical for Germany to leave the eurozone, rather than Spain or Italy. Germany is indeed the main outlier in economic terms; if it were removed, intra-euro zone economic dispersion would be much lower. However a scenario where Germany is the only country that exits is not just improbable—it is also undesirable:

  • Germany has long been considered by the other Europeans as the main vector of reforms, and a catalyst for change in France and Southern Europe. While Germany hardly fits the Anglo-Saxon ideal of a flexible, free-market economy (although more so since the inception of Gerhard Schroeder's reforms), the country is a more acceptable model for Europe's laggards than that provided by the US or the UK. If Germany leaves, which textbook would guide the economic policy of the South? Mao's red book? Economic history, as well as simple logic, shows that lasting growth cannot be achieved on the sole basis of devaluation and money-printing. Without supply-side and welfare state reforms, a Latin Union would have no economic viability. In this respect, we had a foretasteof how things "work" in the south when Germany was weak and busy fixing its own problems during the counter-shock years of the unification (1995-2005). The cost of capital plunged in Europe, and instead of taking this opportunity to reform their economies at a lower cost, France and Southern Europe did exactly the opposite: vested interests largely dictated stupid economic policies of social-clientelism. I do not want to see what would happen if the debt problems of these countries are fixed through devaluation and quantitative easing.
  • Politically, the consistency of any Latin Union would not be superior to that of the current eurozone. A Latin Union would be led by France. Just writing or reading this sentence, you have lost the Spaniards. Spain is a proud country, which historically sought alliances with the North againstFrance almost each time there were power redistributions in Europe. Moreover, most French and even many Italians would be extremely uncomfortable participating in a union that has lost its bad cop. If the French and others today agree, reluctantly, to pay for the Greeks, it is because they know that the Germans and the Dutch pay too! And finally, what do we make of Belgium? I doubt that even the Walloons would be enthusiastic about a Latin Union.
  • Germany would lose too much. First, its financial sector would see hundreds of billions disappear on the devaluation of the euro versus the revived Deutschemark. Most banks would thus have to be nationalized. And it would do no good to lighten its exit cost by paying its external debt in euros rather than its new currency. This would just push the DM even higher, and so German banks would lose even more on their €500bn exposure to Southern Europe, France and Belgium. In addition, the Bundesbank would have to bear an even higher cost on the unwinding of its €700bn claim on the Target2 interbank liquidity system. Indeed, when you add these two claims together, you get €1.2trn, which is more than the €1trn of German public debt held by non-resident investors. All the potential gains of keeping external debt in euros rather than denominating it in DEM would be eaten up by the losses in the banking sector. And on top of these direct losses would need to be added indirect financial losses, the economic costs of litigation, and, last but not least, the collapse of the profitability of the export industry in a country where exports accounts for 45% of GDP.
  • Most people outside continental Europe do not realize how deeply national laws, regulations and political projects are permeated with European directives. Breaking up the euro would thus be like unscrambling an omelet, and this is not just a monetary omelet. Even an exit of Germany alone would still call into question the viability of many legal, economic and political aspects of the European Union. The disruption would be considerable.
  • Finally, Germany would feel both guilty and orphaned to leave the most ambitious European project ever conceived.

Theoretically and practically, the only scenario in which a euro break-up could be done at an acceptable cost would be a clean, general and well-organized break-up where all euro members would have secretly pre-agreed on the terms, and that would keep the project of European integration alive (see An Alternative Euro End Game [subscribers only]). The probability of this ideal scenario is, unfortunately, not much higher than the one we have just discussed.

Ill News

By Dennis Gartman

Concerning the EUR, the week begins with some ill news, as the "troika" officials that were to visit Athens have chosen to "postpone" their meeting scheduled for today with the new Greek government. Further, it appears that when the pan-European Summit meeting begins later this week (and the debate in the media and in TGL for the next several days shall be about this impending meeting, rest assured of that), any hopes that Ms. Merkel will accede to the demands of Mr. Hollande that more financing be made available and for the advent of EUR-bonds will be dashed. Hollande has been pushing, for example, that the EUR-zone's bailout funds be allowed to buy sovereign debt on the secondary market, without having to invoke so-called "emergency borrowing procedures." Mr. Hollande wants the ECB to have the day-to-day ability to buy such debt as is necessary; Ms. Merkel is openly opposed to even considering such action. To this point, Ms. Merkel won't even debate it, much less move to allow it, leaving Mr. Hollande rather openly ... and embarrassingly ... flailing in the economic and political wind. As one anonymous French economist at a leading French bank said over the weekend,

"There is a real conflict here and the future of Europe is at stake. Mr. Hollande has exerted the maximum pressure on Merkel but if she remains intransigent and only agrees to the growth pact, I believe he will cave in and give her wants she wants."

What Ms. Merkel wants is nothing short of German oversight and ultimately dominion over all future sovereign debt issuance, oversight of the European banks themselves, and German supremacy on nearly all fronts economic and political. In Ms. Merkel's world ... and here she is merely reflecting the general philosophy of the German people themselves ... if Germany's checkbook is going to be relied upon, then German oversight shall be demanded by the German government, as demanded by the German people.

We found it interesting and exemplary of the problems attendant to Europe when, at a meeting last week of Merkel, Hollande, Monti, and Rajoy, Ms. Merkel sat on one side of the table, faced by the French, Italian, and Spanish prime ministers on the other.

One side has the "gold," the other side has the debts and, as is always the case, he who has the "gold" has the power. Even Tony Montana understood that simple fact when he said, in his famous soliloquy in Scarface,that "In this country, you gotta' make the money first. Then when you get the money, you get the power. Then when you get the power, then you get the women." In Europe, we've come to this: Germany has the money and it has the power and that, simply, is that.

Germany's finance minister, Mr. Schaeuble, was busy over the weekend ahead of the meetings he will be attending later this week, appearing on television and speaking with the press. He said in an interview with the German TV network ZDF that Greece simply hasn't done enough to make good on promises regarding fiscal austerity and meeting certain debt/GDP ratios that it made in exchange for bailout funds. Mr. Schaeuble said that the process goes far deeper and that the root causes of Greece's problems have to be resolved. He said,

"We have to fight the causes.... [and] anyone who believes that money alone or bailouts or any other solutions, or monetary policy at the ECB – that will never resolve the problem. The causes have to be resolved.

"It's not going to help to take money to it. The decisive thing is to credibly fight the causes of the crisis. It's succeeding very well in Ireland and Portugal. It's not succeeding very well in Greece. But it must succeed in Greece. There's no other way to do this.

"Greece hasn't tried enough so far, that has to be said quite clearly. That has to be said with respect for the domestic political difficulties. But no one on earth who has followed this issue would think that Greece has fulfilled what it has promised ... [however] Italy and Spain are different on this question. They're making great reform efforts."

At this point we should remember that Mr. Schaeuble has played, is playing, and in the future shall play the "bad cop" in the usual "good cop/bad cop" tandems that so often develop in situations like this. Ms. Merkel ofttimes looks to be the "good cop" in relation to Schaeuble.

Mr. Soros is "bad copping" this morning, too, as he has made it clear in one press conference after another in the past several days that he believes Europe is truly at risk of collapsing unless something material and timely is done to allow the ECB to buy pan-European debt in the open market. He has called upon Europe's leaders to swiftly create a "European Fiscal Authority" that would have the ability and the authority to buy Italian and Spanish debt, but only following actions by the Italian and Spanish governments to achieve credible material budget cuts. Mr. Soros has said that unless this authority is created and announced before the impending European Summit ... which begins on the 28th, by the way ... the result "could be fatal" for the EUR. Ms. Merkel has made it clear that she is not willing to agree to such a proposal until such time as full fiscal union is established; and that, as we understand it, would require major changes to Maastricht and the other treaties that are at the very heart of "Europe" as we know it presently.

And finally, this note from Kiron Sarkar, who I think is in Ireland today:

In addition to the existing monetary union, the Germans want fiscal union, leading to political union – in that order.

Political Union is the clear goal. They understand that the EU (and not even Germany), cannot compete with emerging countries such as China, India or developed countries such the US, in the future, given their natural strengths, without a political union. In addition, they do not want any more EU fudges, fixes or compromises, so common within the EU in the past.

Germany also understands that the EU/EZ, as currently structured, is flawed and that Europe needs true political union. Indeed, the Germans are increasingly suspicious of the EU bureaucracy, as they believe it is a bloated, overpaid and incompetent organisation – totally true and very much the views of the UK, for a very long time. The EU leaders were previously selected by EU heads of state on the basis that there were the least effective (and therefore would pose the least problem to them), so why should anyone be surprised. Why did the Germans take so long to understand you could well ask.

The Germans (Mrs Merkel) are prepared to open up their cheque book (though you must understand that it is not unlimited), but only if they believe that EZ countries will stick to pre agreed fiscal targets ie their money will make a difference. France, designed the EU to suit itself, but essentially it created an intergovernmental club, rather than a supranational organisation as today's WSJ very rightly says. In addition, the French ensured that they "parked" their people in the senior most positions possible.

The French, on the other hand, do not want to transfer sovereignty to another organisation, but, in my view, will have to. They are relatively weak and getting weaker. President Hollande's promises are unaffordable. Just today, the French minister of finance admitted that France needs to find between E7bn to E12bn of savings to reach its agreed budget target this year. How can Hollande's wild (and expensive) promises be accommodated. They cant. However, the French are known to take to the streets, which could make this issue explosive. Unlike Sarkozy, Hollande at the end of the day, will give in, though the domestic political pressure he will face will be enormous. Changes to the French constitution, which will be necessary if there is to be political union, will be particularly difficult. Most of the other EZ countries will be more amenable.

Mrs Merkel is facing increasing anti EU/EZ pressure at home– the only good news is that her main opposition is very much more pro EU/EZ. For her to act like the "Iron Lady" will play well with the voters in Germany – not a minor issue for politician who is seeking reelection in late 2013.

In regards to Gartman's comments above, a friend of mine shared this with me:

Although I have much respect for Mr. Gartman, I disagree with a few things that he said.

First, there is one myth that needs to be put into context. Germany's financial strength is based on economies of scale not only on the competitiveness of the individual German worker.

There are many countries that have equally competitive workforces but are nowhere near as successful as Germany at generating wealth.

So where do the economies of scale come from? Exports or, more specifically, access to foreign markets.

If Germany loses access to foreign markets either by being alienated from the rest of Europe or having to sell in Euro and manufacture in Deutschmarks, their "pot of gold" will quickly evaporate.

In addition to the above, I direct your attention to an excellent comment written by Patrick Artus of Natixis, What kind of economy would the euro zone be without Germany?. Artus concludes:

The euro zone excluding Germany is characterised, as a whole, by:
  • competitiveness and foreign trade problems;
  • low potential growth;
  • low corporate profitability;
  • Public finances in a bad state.
If the euro zone were to become a federal monetary union, with solidarity between countries and pooling of certain investments (recapitalisation of banks, for example) and risks, could the situation of the euro zone excluding Germany be anything other than:
  • benefiting from transfers from Germany;
  • benefiting from Germany's credibility in the markets;
  • benefiting from Germany's guarantee;
or could it share this burden with Germany? Probably, the burden on Germany would be very heavy.
I've already weighed in on this important topic. Let me be clear: Germany is screwed either way but in the end, Frau Merkel will cave to demands on eurobonds and fiscal union, not because her European counterparts are asking her to, but because the bond market will crack her like a Chinese fortune cookie.

It's time that Germany puts an end to its illusions. Yes, Germany is footing the bill for this eurozone mess but they benefited the most from this imperfect union. Schnell, Frau Merkel, your time is up. If you continue dithering, you will sink the eurozone and rest of the world, ensuring a protracted period of nasty global deflation (not the benign kind the Japanese experienced).

Below, Marc Lasry, Managing Partner and founder at Avenue Capital management, talks with Bloomberg's Stephanie Ruhle about the buying opportunities in Europe if you invest on a long-term basis. He speaks on Bloomberg Television's "Market Makers."

And renowned academic David Harvey asks if it is time to look beyond capitalism towards a new social order that would allow us to live within a system that really could be responsible, just, and humane (h/t, Sam Noumoff). It's two years old but brilliant. Nothing like a Marxist to expose the deficiencies of capitalism (unfortunately, they have no real long-term remedies).

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