Friday, September 23, 2011

Europe: No one left to lie to

“Europe” has exhausted its credibility with the credit markets. The corrosion began in the Anglosphere, where there is very little investment in the “European idea” (see: euroscepticism). Over time disbelief has slowly spread not only around the world, but more recently into the heart of Europe itself.

Why is this? I would advance three reasons: (1) Europe has no leadership. (2) Credit market participants can do arithmetic. (3) Every statement issued by the European authorities has been not only a lie, but a conscious lie, and has been proven to be such.

Who runs Europe? The Council? The Commission? France? Germany? The ECB? It’s like asking who runs MLB, or FIFA. Nobody. How can a political entity with no authoritative spokesman have any credibility?

When Greece, Portugal and Ireland lose capital market access, and when Spain and Italy appear in danger of losing access, it is difficult to say with any credibility “Nothing to see here folks; move along”. Anyone with calculator can plot how long it will take for these countries to run out of euros, given the scale of their maturing debt and their ongoing budget deficits. (Yes, countries with balanced budgets can still go bankrupt if they can’t refinance their maturing debt.)

The European party line for the last two years has been: “We have everything under control. This is Europe. Default by a eurozone member is unthinkable, so don’t think about it or, God forbid, talk about it.” OK, so that means that in the end, Europe will bail out the South, right?
Except that (1) this doesn’t apply to Southern banks; and (2) further sovereign bailouts will include “private sector participation”.

This means that “Europe” does not guarantee the PIIGS’s banks, and that there is no risk of a sovereign default, aside from “private sector participation”.

If “Europe” had the courage to tell the truth, they would say that “We will help the PIIGS and their banks, but we expect you (the bondholder) to help out too.” In other words, there is considerable credit risk with respect to the PIIGS and their banks. Which is why credit is being withdrawn and why credit spreads are rising to the point that Italy and Spain are steadily losing market access.

Europe must choose now, not next month, whether they will protect the bondholder in PIIGS sovereign and bank debt or whether they won’t. If they will, they need to publish a credible plan, such as a massively expanded EFSM with joint and several guarantees and a AAA rating from Moody’s and S&P. Or, if not, they must publish a credible scheme to recapitalize the Northern banks in the event of massive Southern defaults.

In the absence of a credible bailout plan, and in the absence of emergency recaps of BNP, SoGen, Credit Agricole, and the Landesbanken, why would any Credit Committee refrain from ordering a steady reduction in concentration limits for every bank in the eurozone?

The PIIGS problem is no longer central. What is happening now is systemic:  a run on the eurozone’s banking system that could make Lehman look like a slip-and-fall. This run must be met with two tools at once: (1) unlimited euro and dollar liquidity from the ECB so that liquidity is not an issue; and (2) a massive shock-and-awe recapitalization in order to facilitate an eventual return to the credit markets.

There are two ways to achieve this. The easiest is to simultaneously recapitalize the banks while stating that, if further capital is needed, it will be forthcoming (i.e., an implicit state guarantee). The other (currently popular) way is to contribute enough capital to allow re-entry while piously stating that this is the “last bailout”. This approach requires an enormous amount of capital in order to be remotely credible. From the FT:

The EU internal markets commissioner, Michel Barnier, said the 16 banks that nearly failed the stress tests “are judged to be fragile and must also be strengthened further. We want the recapitalisation for these banks to be by private means. The era of bailing out banks must end.”
Very helpful, M. Barnier.

Now that “Europe” has lost all credibility in the credit markets, further Wizard of Oz-like statements will prove not merely useless, but frightening. ("They have no clue!")
The time for soothing statements has passed, and the time for decisive and credible action is rapidly running out. 
My prediction? Catastrophe, of course. My best analogy to what is going on in Brussels today is the Imperial Cabinet in the summer of 1945. Denying the obvious, awaiting the inevitable.

Tuesday, September 20, 2011

Greece's bluff is about to be called

Here is the immediate state of play for Greece. Greece runs out of money next month, and lacks capital market access. The only way to avoid default is a further EUR 8 billion tranche from the Troika (IMF, EFSM, and the ECB).

In the past, Greece has played chicken with the Troika, by failing to comply with its agreements and saying  “if you don’t give us the money, we’ll default and you’ll regret it”. (As Donald Trump used to say to his bankers, “I’ve got a guy at the court house ready to file at any time.”

The “northern league” (Germany, Netherlands, Austria, Finland) have wearied of this game. They have decided to use this tranche to force Greece to comply 100% with their diktat, which includes a reduction in nominal wages, public sector layoffs, pension reform, privatizations, and tax compliance enforcement. And they want these demands to be certified by “inspectors” from the Troika.

These demands are perfectly reasonable and in fact inevitable. But they are politically impossible for both the ruling socialist and the opposition populist party because they represent political suicide. This is a pill that Greece cannot swallow. They can pretend; they can sign all sorts of agreements; but they can't actually do it.

One of two things will happen over the next two weeks: (1) Papandreou will force his cabinet and party to swallow the pill and, much more critically, convince the inspectors that this is not another scam; or (2) the northern league will say no, and Greece will default.

The northern league wants Greece to default, but it doesn’t want to be seen as wanting it, so they have disguised this desire behind a list of demands that Greece can’t meet. (Shades of Austria’s 1914 ultimatum to Serbia.) No matter what Papandreou does, it will never be enough.

I am confident that Greece has a Plan B to default and redenominate quickly (over a long weekend). Somewhere deep in the vaults under the Bank of Greece is an old drachma printing press that they can fire up. The New Drachma will float--downward.

The challenge is what to do about all that defaulted debt denominated in euro. There are two choice: unilaterally redenominate all debts foreign and domestic into drachma, or else redeem all foreign debts with long-term, low interest euro bonds.

This situation will crystallize quickly, because there is a deadline looming. As I said, I expect that Greece will be denied the next tranche and will then default by the end of October.

Sunday, September 18, 2011

Greece will restructure next month

The Easter Bunny and Europe were locked in a room until one emerged victorious. Who won? The Easter Bunny, of course, since there is no such thing as Europe.

"Europe" has about as much political meaning as the Western Hemishphere, Southeast Asia or the Arab League.

The American republics belong to the OAS; Southeast Asian countries belong to ASEAN; Arab states belong to the Arab League; European states belong to the EU.

None of these organizations has sovereignty or control over its members. Lenin described sovereignty as “ the monopoly of violence”. There is no doubt that the United States has the monopoly of violence over its members, as was demonstrated by Lincoln. 

Imagine if the US federal government lacked taxing power and relied on voluntary "contributions" from the member states? That's how it operated from 1777 until 1789 and it didn't work, just as Europe isn't working. Voluntary contributions don't work. Taxes do.

Brussels has no such control over its members. (Who’s going to invade Germany if they don't sign up for the bailout?)

Every communique coming out of Brussels demonstrates that no one is in charge. Not the European Commission, not the Council, not the ECB and not the rotating "president". The EU is a club, not a state. The member states are democracies, subject to the will of their peoples, not the EU.

Greece is the current case in point. Greece will run out of money next month. Either Greece is allowed to default, triggering a larger eurozone crisis, or else the “rejectionist front” consisting of Germany, Netherlands, Austria and Finland (all AAA by the way) will have to cave and sign on for donating their taxpayer's wealth to Greece for the indefinite future. No one can force the rejectionists to do this, and I think they won’t. (And if they do ultimately do donate money, it won’t be to Greece.)

The reason is this: whether it is via the EFSM bonds or via a eurobond, in either case a AAA rating is required. The EU has no balance sheet and can’t issue debt. 

The AAA bond rating can only be achieved by a joint and several guarantee by the eurozone’s member states. If such guarantees were issued, each member country would now have a large but unquantifiable contingent liability that in all likelihood will called upon in the end. And when the bill comes due, will Portugal pay it's prorata amount? What if they can't--or won't? And who will make them?

As the guarantee is several, that means Germany is potentially on the hook for the whole tab. Germany is not going to buy this plan, and has already said so, more than once. Merkel has had it with Sarkozy and his endless schemes (all intended to pin the tail on Germany). France is terrified of a eurozone breakup; Germany is not.

As commentators have been noting, Germany’s and France’s AAA ratings are not ironclad. If they staple on a few hundred more billion euros, there would be downward pressure. Personally, I expect France to lose its AAA in any case, based on its fiscal trajectory. But Germany will never give up its AAA, no matter how much it despises the ratings agencies.

Therefore, I expect a Greek “restructuring” next month, followed by eurozonal bank guarantees and/or nationalisations. Either way, the problems will be fiscalised at the national level. (Forget an ECB bailout; the ECB won't budge.)

Saturday, September 10, 2011

What is driving the US equity market?

The stock market did not tank on Friday because of Obama’s “jobs” speech. That’s because his speech provided the stock market with no new information (other than that he will never pivot to the center, but that’s actually good news for capitalism). Obama himself is now irrelevant to the stock market, aside from his poll ratings (capitalists want him to lose).

At present, there are only two people in the world to whom equity investors are paying attention: the German Chancellor and the Chairman of the Board of Governors.

Greece needs to be on an eternal and unlimited IV drip from “Europe” which means Germany. The chancellor is under enormous pressure from Sarkozy and Trichet for Germany to become Europe’s unending sugar-daddy. But Europe’s problem is German demography: the WW2 generation is dead, and their descendents see the Federal Republic not only as a normal country, but also as a very responsible country, with nothing to apologize for. “We are Europeans in good standing, and we are no longer suckers for guilt-games.”

The German taxpayer is unwilling to take his credit card and hand it to Greek cigarette-smoking marxists lounging at their  grandfather’s ouzo cafe. Greece represents everything that Germans hate about Europe and the eurozone. The eurozone was the price that Germany had to pay for reunification, a bad bargain. (And one they can now revoke.)

So, if the CDU/CSU/FDP coalition is to survive, at some point Merkel will have to pull the plug on Greece, or on the euro. Sarko won’t like it, but it isn’t his money. And if Germany becomes the guarantor of the eurozone’s debt, it won’t keep its AAA, which is something that no German could ever accept. So whatever happens to be going on in Berlin at the moment (i.e., Juergen Stark resigning from the ECB), is market information, as opposed to Obama's daily speech.

Why does the S&P 500 care about Greece? Because an unravelling of the eurozone would be (a) uncontrolled; (b) deflationary; (c) bad for global growth and trade; and (d) calling into question European financial and political stability. In other words, a reduction in global demand.

The other focus of the stock market’s attention is the FOMC, chaired by Ben Bernanke. Will there or won’t there be QE3? If the answer is no, very bad for stocks (and Obama). If the answer is yes, the reverse. Hence Rick Perry’s schoolyard threats to Bernanke about "playing politics" with monetary policy. Gov Perry thinks that Bernanke should continue to keep 15 million people out of work, in order to help the GOP. Their wives and kids? Who cares?

The GOP opposes QE3, because (a) it is as economically ignorant as Obama/Pelosi; and (b) it would help Obama by reducing unemployment and causing more of the horrendous “hyperinflation” we have recently been experiencing. (Can anyone remember 1980?). This kind of politics is cheap, cruel, and unpatriotic, and bad politics in the long-run. The GOP should want the economy to prosper no matter who is president. A nation of state dependents is a nation of Democrats. Hello Belarus.

Here is my prediction: Greece can’t comply with the austerity package, Germany and the ECB pull the plug, game over for Greece. Greece will have to go cold turkey and implode upon itself. That means redrachmaization, hunger and social unrest. (Greece has no exports, bulk shipping rates are in the tank, and strikes and riots don’t help tourism.)

After Greek default, contagion spreads ( it’s spreading now), but Greece is arguably a special case, and Europe may (may) be able to erect a firewall around it. Ireland, Spain and Portugal are not basket cases. Italy still has a short window in which to demonstrate that it is not the rich man’s Greece. Mario Draghi should be PM instead of the unserious Berlusconi. It will come to that, and hopefully soon. If Italy defaults, Houston we have a problem.

Any such dire European scenario would inevitably mean that the US will need to have as many QEs as we need to prevent deflation and to sustain nominal demand. If Perry is elected, intimidates the Fed, and causes deflation and negative nominal growth, he will be a one-term president, and maybe our last president.  
But isn’t it curious how, when hard money guys (e.g.,Nixon) become president, they become inflationists overnight. I promise you that President Perry will have a revelation from God that nominal growth is holy and sacred, and will play golf weekly with Bernanke.