The Greek New Year

While Europe relaxed during their Christmas holidays, Greek MPs were unable to elect a new President and a general election has been called for January 25. The opinion polls show Syriza the radical left party with a 3% lead. The Greek parliament has 300 MPs, 250 of whom are elected on a proportional representation basis, but the other 50 are awarded to the party which wins the greatest share of the vote.

In recent weeks Syriza have been toning down their aggressive rhetoric about unilaterally defaulting on Greek government debt, possibly in a bid to gain more moderate votes. In addition if the current polls are correct, Syriza will not achieve a majority of 151 MPs and will thus need to enter into a coalition with a more moderate party. Markets have thus become a little more hopeful another Greek financial crisis will be avoided.

Syriza’s economic policy has 3 strands:

  • A restructuring or forgiveness of much of the €370bn debt owed by the Greek government
  • An end to the austerity measures,  an end to the Troika (the IMF, ECB and EU) oversight of Greek economic policy and increases in wages, pensions and benefits throughout Greece, and

3)      Remaining in the euro

The first could be easily conceded on pragmatic grounds. 80% of the debt is owed to the Troika and it is generally accepted that most of it is unlikely to ever be repaid. However politically, any formal restructuring agreement would set a precedent that Ireland and Portugal might be keen to emulate, and thus be unappealing to the Troika (and Germany in particular who have effective veto power here).

The second and third demands are, however,  not acceptable (to the Troika) as a pair. If Greece wishes to remain in the euro (and polls show over 70% of Greeks wish to stay in the euro) then limits to government spending and deficits are part of what is required of all countries.

In recent days senior German politicians have made it clear that they would not be unhappy if Greece decides to leave the euro. Documents from the 2010-11 crisis that have recently become public show that many in Germany would have been quite happy not to rescue Greece and force it out of the euro then, but it was Angela Merkel that ultimately decided the contagion risks of a Greek exit were too high. This time around the contagion risks are generally believed to be very much lower and that the Eurozone could let Greece go without a wider crisis.

So the end of January and early February are likely to see negotiations to form a Syriza-led government and the end of the March is the deadline by which a new agreement with the Troika over Greek austerity is due. Either Syriza or the Germans will have to blink first!

A Stagnant Europe

The outlook for returns from European shares for the next few years is not exciting, though the level of dividend yields is likely to support current prices, thereby limiting the downside risk in these markets.   The investment implications are to remain VERY LIGHT in European equities, where domestic growth is expected to be disappointing and exports outside of the Eurozone are likely to remain under pressure from a strong Euro.

As in the US market, the earnings growth in the Eurozone for 2014 (that is already expected by analysts) is strong, despite the lack of revenue growth expected from most companies. Further, again as in the US, the valuations on these optimistic earnings forecasts are at the high end of the normal range. Core European bond yields are likely to remain low but risks certainly remain in peripheral bond markets.   Political developments need to be monitored closely for any indications that the rise of the anti-EU factions in the peripheral countries begins to change the current support within them to stay in the Euro.

The EU parliamentary elections – According to the opinion polls, the anti-EU, UK Independence Party (UKIP) could emerge with the most votes in the UK’s forthcoming elections to the European Parliament. This apparent rise in nationalist sentiment is not just a UK phenomenon, with the French National Front, Italy’s Forza Italia, Greece’s Golden Dawn, and the Freedom parties in Holland and Austria all scoring highly in opinion polls. Though these disparate parties do not all get on with each other, it is possible that they could, between them, win about 20% of the seats in the new Parliament. This is not likely to be enough to change the path towards greater integration within Europe, but is enough to be a very vocal nuisance within European politics.

Austerity – The peripheral economies (generally understood to be Spain, Portugal, Greece, Cyprus and Italy) have undergone harsh austerity in recent years, leading to very high levels of unemployment (and youth unemployment in particular), in the cause of remaining in the Euro and receiving support from EU bailouts and the ECB. It is perhaps surprising that anti-EU sentiment is not even greater in these countries, but there appears to be a grudging acceptance that the German-prescribed policies of economic orthodoxy must be adopted. These are (i) lower government spending and (ii) smaller budget deficits together with (iii) lower wage levels to regain competitiveness. The stark alternative for these economies is to come out of the Euro and allow currency depreciation to ease their problems, by creating inflation and reducing living standards. Even France, led by a Socialist president, has now succumbed to German orthodoxy on its budget, acknowledging that its levels of taxation and budget deficit cannot be allowed to go any higher, and that spending cuts are necessary.

There are however, two problems with extending the German approach to economic policy to the whole of the Eurozone. First, most of the Eurozone’s exports are to other Eurozone countries, so reducing domestic demand through austerity in one part of the Eurozone merely reduces export demand for the rest of the Eurozone. Second, the peripheral countries’ greatest need is to regain competitiveness against Germany. This would be much easier to achieve if Germany were prepared to become a little less competitive, by having some price and wage inflation. A few years of German inflation at 4% with 0% inflation in the periphery would ease the Eurozone’s problems considerably. However, if German inflation remains at 2%, then inflation at –2% might be required in the periphery; economically such deflation is particularly harmful, keeping unemployment and budget deficits high.   There are few signs that Germany would be prepared to tolerate a 4% inflation rate.

Following the Japanese – The Eurozone is currently edging towards deflation, with the current inflation rate at 0.8%. With its other issues of ageing populations, high levels of government debt and high welfare spending, it shares many similarities with the Japanese economy of a decade ago. There, the economy has, until very recently, been mired in a long period of economic stagnation in which the nominal size of the economy has not changed – there has been some real growth, but this has been offset by falling prices and wages.

Stagnation – Our concern is very much that the Eurozone, following orthodox German policies, with an absence of stimulus from fiscal policy or from monetary policy and with an ECB extremely reluctant to implement QE, may have entered a period of structural economic stagnation, with high levels of unemployment, similar to the experience of Japan. This would be negative for economic activity and indeed for social cohesion in the weaker economies, and, in time, the support for the anti-EU parties may be strong enough to lead to more radical change than the forthcoming elections are likely to create. This might mean a change to policies that were incompatible with continued membership of the Euro.

Just as the UK’s exit from the Exchange Rate Mechanism in 1992 and sharp fall in Sterling marked the start of a new period of growth in the economy and a new bull market in stocks, any country that did exit the Euro would be likely to derive the same benefits. However, for now, continued adherence to the orthodoxy of German economic policy ideas is expected to lead to a period of economic stagnation for the Eurozone economy.

UK economy – green shoots

Over the last ten quarters to March 2013, the UK economy has produced essentially zero growth due to a combination of (i) the UK government’s austerity plans encompassing both spending cuts and tax increases, (ii) severe economic weakness in the Eurozone, the UK’s largest trading partner, (iii) weakness in North Sea oil production due to essential maintenance work,  (iv) a large banking sector engulfed in a series of scandals, which have damaged their profitability, and (v) declining consumer real incomes

During this period the UK economy has consistently disappointed the expectations of the Bank of England, the Office of Budget Responsibility and the IMF, as well as many private sector forecasters.  In recent weeks however, this trend of disappointing expectations has come to an end, and the Bank of England, in Mervyn King’s last presentation of the state of the UK economy, upgraded its growth forecast for the UK in 2013 from 1.0% to 1.2%.

Beneath the headline figure of zero growth, there have however been two important improvements in the UK economy, which give encouragement to longer term recovery prospects as follows:

  1.  The structural budget deficit (that is after allowing for the extra government spending and lower tax revenues that arise from a weaker economy) has been reduced by over 4% of GDP in just 3 years (or 1.3% per annum) .Given that state spending is about 40% of the economy, it has required the other 60% (the private sector) to grow at about 1% per annum over this period, merely to offset the public sector weakness and achieve zero growth for the economy as a whole.  This 1% growth from the private sector is quite an achievement in the face of so many headwinds for consumer and government spending.  Though the structural budget deficit remains too high, there has been good progress in reducing it.
  2. The flexibility of the UK labour market has surprised many.   Despite the economic weakness, unemployment has stabilised at around 2.5m rather than the 3m that many commentators expected to see when the crisis first hit.  The major reason for this has been workers preparedness to take pay cuts or not demand pay rises to preserve their jobs – UK wages are only growing at about 1% currently, and have been well below the rate of inflation for four years. By contrast, French unemployment (France has essentially the same population and size of economy as the UK) has gone through 3m and is still rising.

The weather has played a surprisingly key role in the UK economy over the last twelve months – last summer was extremely wet (excepting the period of the Olympics) and both of the last two winters have been very cold and wet.  This has had a very serious effect on the construction industry, which had already been extremely weak over the life of this government, first from a cutback in government investment programmes, and secondly from weakness in UK housebuilding.  Just a return to normal weather over the summer and next winter should see a sharp improvement in construction spending, and with it the demand for construction workers, and the prospects for an improvement in overall economic growth.

There are other reasons though for being more confident. The electoral clock is now audibly ticking, and though the government will not reverse course on their austerity programme, they will be more sympathetic to ideas, which boost economic growth in the shorter term, particularly if they can be labelled as “investment”.  Importantly too, the new Governor of the Bank of England has been selected because he is an activist who believes that monetary policy can make a difference to the real economy. He has already been granted a more flexible mandate than just the control of inflation. Growth is now almost as important, and more emphasis on getting funds into the hands of industrial borrowers can be expected.

In the run-up to the 2015 election, there will be a more marked policy bias to boosting growth, and with the underlying improvements that can already be seen in the UK economy, it is likely that growth will exceed the (very low) expectations that currently exist. Note though that this is a forecast of modest improvement rather than of a boom.

The investment implications of beating the low expectations that exist for the UK economy are that, after two decades of performing much worse than either large or mid-sized companies, smaller companies in the UK, who are most exposed to the strength of the UK domestic economy, may be about to benefit most from the improving economic trends.  Where client portfolios do not have specific smaller companies exposure, we will be seeking to include it in any recommendations, as appropriate.



For the last quarter of a century, Germany has been open to monetary union with the rest of Europe, provided that three conditions were satisfied.  These are (i) no bailouts of other countries who were also in such a monetary union, (ii) the Central Bank that sat at the centre of this union was heavily modelled on the Bundesbank and its operation of monetary policy and (iii) all participating were subject to clear rules with regard to budget deficits and total government debt.  With all three conditions in place, then Germany felt that all other countries in the monetary union would be forced to manage their economies in the same way that the German economy was managed.

Since the crisis, all three of these conditions are being severely tested, causing increasing angst to many in Germany.  With regard to the first condition, it is currently true that no country has been bailed out by transfers from the other countries. However, Greece has stretched this interpretation to the very limit.  Huge amounts of money have been lent to Greece by the IMF, the EU and the ECB (and so not directly by other countries), which are officially repayable.  All non-official holders of Greek debt have had their arms twisted to agree to their holdings being substantially written off.  Most investors expect the official holders also to agree to write-offs (at which point the money is no longer lent but in reality given), but this will not occur until 2014, after this year’s German elections.  Germany’s first condition (no bail outs) will be breached next year.

Under its first two Presidents, Duisenberg and Trichet, the ECB did, in fact, model itself heavily on the Bundesbank in its operation of monetary policy. Draghi, however, took over at the height of the crisis.  His first act was to provide a trillion euros of extra liquidity for weak banks from the peripheral countries, in exchange for collateral of very dubious quality, a tactic which drew criticism from the Bundesbank, but great acclaim from most other quarters.  Then last summer, as Spain appeared to have lost the confidence of markets to issue its debt, Draghi invented the concept of Outright Monetary Transactions, which permitted the ECB to intervene in government bond markets to an unlimited extent. The Bundesbank, saw this (rightly) as tantamount to the printing of money, as was being practised in the US, Japan and the UK, but was the lone vote against within the ECB Council.  Crucially for Draghi, Merkel decided to over-rule the Bundesbank and gave Germany’s blessing to this very un-Bundesbank action.  Germany’s second condition has already been breached.

The third condition is the one which matters most, and which Germany will least be prepared to see breached.  To emphasise the point, Germany has brought forward its draft of the 2014 budget, demonstrating that it continues to cut government spending to meet its target of a balanced budget in 2015.  The message to the rest of the eurozone is unambiguous – they too must meet their promises of cutting government spending to achieve balanced budgets in the medium term.

The forthcoming EU summit will contain no Italian government, following the post-election stalemate in which over half of the voters voted for parties which explicitly rejected the EU-led austerity programme initiated by Monti.  The French government has just announced that it now expects a deficit of 3.8% of GDP this year, compared with its EU target of 3.0% – it seems unlikely that President Hollande will make any great attempt at further government spending cuts.  In Greece, the latest tranche of official loans is dependent upon clear plans for Greece to cut 150,000 civil servants from its headcount in the next eighteen months. Greek politicians are very reluctant to agree and even more reluctant to implement such plans.  Both the Spanish and Portugese have promised their people that they have had the last round of cuts, but their budget deficits remain too high due to the continuing recession in these countries.

Austerity in the Mediterranean countries is reaching its political limits.  If Germany continues to insist on its third condition (the control of budget deficits) as Merkel will want to be seen to be doing ahead of her election in October, then the possibility of a country falling out of the euro in the short term is once more very real.  In the longer term, even if Germany gives a little ground now, it will continue to insist on governments reducing their budget deficits at a rapid pace that will mean little or negative growth in many eurozone countries for years to come.  This price will prove too high for some economies.

The investment implications of this are to maintain low exposure to euro-denominated assets until more reflationary policies are being actively pursued in the euro area – if Germany continues to stand on its principles, this may be never.

Eurocalm before the Eurostorm

That the Eurozone ends 2012 in an apparently stable condition is mainly down to the work of two people. The first is Mario Draghi with his promise of potentially unlimited intervention in sovereign bond markets.  The second is Angela Merkel’s with her summer policy decision that forcing Greece from the Eurozone would be more damaging than keeping it in.

Mrs Merkel over-ruled the Bundesbank on both of these issues, and her steady approach to crisis management leaves her as one of the most popular European leaders within her own party and country.  She has now clearly grasped that, for the Eurozone to survive in the long term, it is necessary to have a much deeper integration of Eurozone countries, which extends ultimately to national government finances, common banking supervision and control, and joint liability for debt. In short banking, fiscal and political union is required to complete the economic and monetary union.  These are not particularly popular positions to adopt, either with the German people or with the other European nations, but they are the logical steps required to ensure the long term existence of the single currency.

She understands that for this to happen, Germany will have to dip into its pockets and provide substantial assistance to the poorer countries in the transition. However, she has not been as explicit with the German people that the financial costs of such policies to them will be very great.  The German people are not in favour of lending more money in bailouts to their Southern neighbours, and they are not in favour of accepting losses on previous bailout monies already granted.  Next autumn there is a Federal election in Germany in which Mrs Merkel would like to be re-elected as Chancellor.  So ideally, from her perspective, there would not be any more Eurozone bailouts before the German elections.

The recent agreement on the next tranche of Greek aid was farcical.  Everyone (Greece, the IMF, the EU and the ECB) is pretending that Greece is not insolvent, merely illiquid and that (based on optimistic assumptions) all will be well a decade from now.  Significantly, Germany has agreed that should Greece be doing well by 2015 in delivering on its budget deficit targets, then they would be prepared to forgive some of their debt.  The truth is that if Greece does not achieve its targets the Germans will be forced to forgive the debt because it cannot be repaid.  The point though is that any debt forgiveness happens after the German elections, when European priorities may once again be more important than domestic German ones..

Southern Europe is now very close to the limits of its tolerance for austerity. The Greek, Spanish and Portugese governments have all told their people that they are on the last round of austerity measures.  With youth unemployment close to 50% in these countries, anti-euro, anti-austerity political ideas are beginning to gain ground.  German leaders still consistently state that austerity in these economies will be necessary if further bailout funds are to be provided, and this rhetoric will not be watered down ahead of the elections.

The other major Eurozone election due by April 2013 is in Italy.  Mr Berlusconi’s withdrawal of support for the technocratic Monti government and his announcement that he will fight the elections on an anti-austerity, anti-German platform are not helpful for the euro. However, it is the honest debate to be having.

The Eurozone begins 2013 in recession, and fiscal policy is being tightened further, except in Germany.  A weak European economy will mean larger budget deficits than planned, and more pressure from the southern economies for bailouts.  This will produce more demands for austerity from the northern economies, with the rapidly fading ability to deliver either.

The stability of current financial markets in the Eurozone will not survive very long into 2013 without a dramatic improvement in economic growth, which is very hard to envisage.  Ultimately, the only solution for the weaker economies is inflation. This can come about either through leaving the single currency or through overturning the Germanic culture, which controls Eurozone economic policy. The former is the more likely solution, and the investment conclusion is to remain very wary of all euro-denominated investments until a more sustainable monetary system is in place in Europe.


The single currency – making Germany more European or Europe more German?

Following the fall of the Berlin Wall when Kohl wanted to press ahead with the reunification of Germany, the price of Mitterand’s acceptance of this was to demand that Germany share the power of its currency with the rest of Europe (or more particularly France) in a monetary union. Germany agreed provided that the guardian of the currency, the ECB, was made in the image of the Bundesbank, with its rigorous implementation of policies to control inflation. Both were happy because Mitterand believed he was making Germany more European, Kohl believed he was making Europe more German and the Bundesbank believed that it had the right to criticise and have a special influence over the policies of the ECB.

Until last year, the ECB did indeed operate in much the same way as the Bundesbank would have done, tending to be quick to raise interest rates and rather slow to cut them. After a Dutchman and a Frenchman, it was to have been a German, Axel Weber, who was expected to take over the ECB Presidency. However, he resigned following the introduction of the ECB policy of limited buying of the bonds of troubled peripheral governments, which in retrospect was a fairly minor breach of Bundesbank monetary orthodoxy. The man selected to take over the Presidency was Mario Draghi, an Italian and a former investment banker.

By the time Draghi took over as President in November, Europe was in deep crisis, and the ability of the politicians to respond with bailout money funded by the other governments was almost nil. If the Euro were to survive it would require extraordinary monetary policy measures. Draghi understood this and introduced two Long Term Repurchase Operations, lending unlimited money to any Eurozone bank at 1% for 3 years. Much of this was used by the Spanish and Italian banks to buy their own government bonds trading at much higher yields. For the Bundesbank this was pretty close to the direct funding of government deficits, which is illegal – they were unhappy but did not oppose it.

The crisis has worsened during this year and Spain has become close to joining the ranks of those on the bailout list. Doing so would use up most the capacity of the bailout funds (which were designed to be so big that they would never need to be used). Over the summer, Draghi has come out with a new bond-buying plan for which he has garnered substantial support. Under the plan, if the politicians agree to a sovereign bail-out with conditions, and use some of the bail-out funds set up for the purpose, then the ECB will buy bonds of those countries to maintain their deficit financing costs at a reasonable level, in potentially unlimited amounts.

Rather neatly, everyone, except the Bundesbank is happy with this. The German politicians can claim that any bail-out requires German approval and will be subject to strict conditions, thus making Europeans more German, whilst the rest of Europe sees the ECB being publicly prepared to print large quantities of money to support the weaker European economies even though this creates the risk of inflation in Germany, making Germany more European! The Bundesbank reject it because the ECB is now no longer operating in the Bundesbank’s image.

The history of the crisis in Europe is that at each step Germany talks tough and finally gives in and pays up to keep the Euro alive. It has reached the end of contributing to bail-out funds with taxpayer funds and future bail-outs need the money to be printed by the ECB. Draghi’s plan allows this to happen, once the politicians agree to a bail-out. Despite their talk, German politicians always do seem to agree to them, and so, ineluctably, the Germans are giving up on the sound money orthodoxy, which has served them so well over the last 50 years. It is the Germans who are becoming more European rather than the Europeans becoming more German.

The implication for markets is that the pattern of markets is set to continue on a loop: creating crises in the bond markets of weaker countries, followed by those counties requesting assistance from Germany and Germany demanding more austerity from them before acquiescing, leading to a rally in markets before the cycle starts again. Draghi’s plan is a good solution for today but doesn’t solve the fundamental problems. However, if German politicians continue to become more European, the clearest market implication is to sell German government bonds, because Germany will either take on the debts of the rest of Europe in some way or the money printed by the ECB will create inflation in Germany.

UK Economic Policy – Sticking to Plan A (plus a bit)

Last week as investors worried about the Greek elections, the Spanish bank bailout and the Federal Reserve meeting, George Osborne and Mervyn King made significant announcements about UK economic policy. Since coming to power, the UK’s approach to managing the economy can be described as a slow but steady tightening of fiscal policy over the medium term, to avoid an austerity-driven recession as seen in parts of Europe, combined with an extremely easy monetary policy.

The complicating factor to this logical response to the UK’s problems was capital requirements that had been placed on UK banks following the banking crisis – much more exacting prudential requirements with regard both to capital and to liquidity risks had forced the banks into buying large amounts of gilts (UK government bonds). Whilst one side of this coin meant that banks’ balance sheets were better protected, the other side of that coin is a reduced emphasis on the attractions of lending to small and medium sized businesses, which is a vital but nonetheless risky activity for banks.

Mr. Osborne announced a scheme to offer both government guarantees and cheap funding for banks that lend to the domestic personal and small business sectors – at £80bn this is approximately 5% of total existing lending to these sectors. Mr. King announced that going forward banks would not have to hold such large amounts of liquid gilts on their balance sheets, and thus would be able to make more loans (which are less-liquid assets) to business. There are few details yet but assessments of how much this might mean are around £150bn.

These announcements are clearly aimed at allowing the QE policy to work more effectively, which until now has worked to inject lots of money into the financial system. However, little of it has found its way into the real economy – thus financial asset prices (in particular the price of gilts) have been supported but with only a small impact on growth. The banks are receiving very strong guidance that they should be lending.

There remain though both demand and supply problems with this new approach, which are likely to mean that it will have only limited success. First, with regard to the demand for bank loans, the banks consistently report subdued demand to borrow. Certainly the housing market is slow (apart from Central London, which is beset with Greek, Russian and Middle Eastern investors seeking a safe home for part of their wealth) – falling house prices is not an incentive to borrow heavily and a lack of confidence in employment prospects or future pay increases is endemic. Similarly the subdued state of demand that many small businesses face will mean that very few are seeking to borrow to expand. Where there is demand to borrow from small businesses, it is usually to cover slow trading (or poorer credit risks). On the supply side, the credit boom conditions of 2002-2007 is now over and banks are not prepared to lend on the optimism-fuelled terms that were available then. Instead, they are reverting to lending terms similar to those on before 2002, which feel now much more restrictive to businesses.

Osborne and King are sticking with Plan A, but trying to make sure more liquidity gets into the real economy. It will help at the margin to boost private sector growth as the public sector continues to be cut back, but the general desire of most people and companies is to reduce their debt rather than increase it. This combined with the major uncertainties within the European economies, will prevent a rapid recovery. There are risks to gilt prices since the banks are being told that they do not need to own so many gilts, but the prospects for UK equity prices are positive given their very low valuations and the (minor) benefits to growth of this adjustment in policy.

An open letter to the voters in Greece

Congratulations! Your votes in the general election last week have humiliated the two main parties which have dominated Greek politics over the last 30 years. Traditionally they have between them garnered 2/3 of your votes which has meant that one or other of them has always been in power. They have failed you miserably, by i) permitting many of your fellow citizens not to pay the taxes levied by government, ii) making up for it by creating swathes of public-sector jobs where everyone receives two extra months pay each year to compensate for the fact that they do have to pay taxes, iii) tolerating corruption across most parts of the economy, iv) persistently running large budget deficits and borrowing heavily from anyone who will lend to them, and v) fiddling the figures to hide this from you.

Pasok and New Democracy, the two parties which signed up to the bailout package with its attendant further austerity, between them only managed 1/3 of the vote this time round and so even together they do not have a majority in parliament, under the system which so favoured them. 2/3 of your votes went to small parties which said they would not accept more austerity. Sadly, I have to tell you that these other political parties are not explaining the reality to you either. In recent weeks opinion polls have shown that around 70% of you want an end to austerity and to remain as members of the Eurozone, and so this is what these parties have had as their campaign platforms. Clearly this would be a good outcome for you if it could be brought about, but unfortunately this is not an option that is available.

The harsh truth that no one seems to have told you yet is that you have to choose between further austerity whilst staying in the euro and coming out of the euro with only a bit more austerity. The euro is a club for economies which wish to organise themselves along German lines – it requires real control of public finances and does not tolerate desires for pay increases which have not been earned through productivity improvements. Your economy, whilst it has been straitjacketed within the euro, has become hopelessly uncompetitive. This now requires that you go through a devaluation process and your only choice is whether this devaluation is internal or external.

The internal devaluation process means that you can stay in the euro but that you regain competitiveness via cutting the costs in your economy. This means reducing both the quantity and price of labour and in quite significant terms, both in the public and private sectors. This is difficult and very painful and will take several years, but that is the price you will have to pay if you wish to remain as part of the euro. Latvia is a recent model of how this approach can work.

The external devaluation process means that you come out of the euro, and bring in a New Drachma as your currency, which is then allowed to float freely. Many economists estimate that it would immediately fall by about 50%, which would double the value of all your euro-denominated debts, so it would make sense to default on all such debts. You will become poorer but competitive overnight and you can start to rebuild your economy from a lower base –  you will still require a little austerity as even without paying interest on all its debt, your government is still running a deficit, and there will be no one prepared to lend to them, so some further cuts are required. In the first year or two there will also be very high inflation, which will reduce your real standard of living as the costs of imported goods soar. Iceland is a good recent example of this approach.

It appears that you will soon get another chance to vote – I hope that this is the clear choice presented to you by your politicians. The second option is I believe, by far the better of the two.

With best wishes,


Democracy – the antidote to Eurozone austerity

Over the last twelve months of Eurozone crisis, the politicians in Europe have in the main been talking to each other rather than their electorates. In fact the conversations have involved Northern Europeans (mostly from Germany) telling Southern Europeans to slash government spending and find ways to collect more tax revenues and the Southern Europeans promising very solemnly that they have always intended to and will do so just as soon as they receive some extra money from the Northern Europeans. The voters have never been asked their opinion either in the North as to whether they want to commit funds to support those in the South, or in the South as to whether they want to go through with the austerity measures their politicians have agreed to. Over the next 18 months there are important votes in France, Greece, Holland and Germany, when the politicians will be courting votes and saying things that are odds with current policy settings.

It is said that in the French presidential elections, in the first round the French vote with their hearts and in the second round with their heads. Well, 30% of the electorate voted for the extreme left or the extreme right in the first round; both reject entirely the idea of deeper European integration and the economic policy of austerity. Further, the centrepiece of Francois Hollande’s platform is the rewriting of the fiscal compact set out in the new treaty to pursue a much more aggressive growth strategy and greater powers to the ECB to lend directly to countries. In this he is on a collision course with Angela Merkel and impact is likely to occur very soon after the May 6 run-off election. The received wisdom is that he will not seek dramatic change to what has already been agreed, and will be satisfied with language that has an aspiration for greater growth without meaningful measures – this would probably the best he would get from Merkel and Germany. The key though is that a clear majority of the French electorate rejected the current policies of austerity.

May 6 is also the date of the Greek general election. The technocrat Papademos who was put into power as the head of a coalition government of the 4 major parties in order to agree the terms and conditions of the Greek bailout, has completed his job and is stepping back to allow normal politics to resume. Northern Europe insisted that all 4 parties in the coalition individually signed up to the terms and conditions of the bailout, in order to prevent any backsliding after the agreement, but there are already problems. Recent polls indicate that 67% of Greeks want to stay in the euro but don’t want the austerity, which can be interpreted as wishful thinking, economic ignorance or that their politicians are allowing them to believe that such a choice exists. It is not clear that those 4 parties would command 50% of the seats in the new parliament, even if they could be persuaded. Already Venizelos, the head of the Socialist party has been floating the idea of Greece going back to the drachma as an alternative to austerity.

The Dutch too are struggling despite being seen as part of the Northern European bloc. The coalition government fell over the weekend because the far right party refused to accept the austerity measures necessary for the Netherlands to get their budget deficit in line with the Eurozone targets. An election now looks likely in Holland.

Once these elections are settled, attention will begin to shift to Germany’s election in September 2013. Here though the politics is reversed, what is popular with the Germans is the notion that the rest of Europe should engage in the austerity necessary to get their public finances in order as Germany has had to earlier this century, so that no further calls on the German purse are made from bankrupt Eurozone nations.

Exposure to the votes of their peoples is going to cause politicians to say and do things that make continued agreement on austerity and bailouts increasingly hard to do.

Spain – sliding down the Greece-y pole

A condensed version of the Greek tragedy in recent years: 1) A new government comes to power and finds that the true state of the public finances is much worse than the previous government admitted to. 2) They want to stay in the Eurozone because their people finally have a currency they trust, and so they solemnly promise their European partners that they will do whatever it takes to ensure this occurs. 3) An eye-wateringly aggressive fiscal austerity package is announced by the new government. 4) The sharp fall in expected public sector demand in the economy leads to a significant recession, unemployment rises sharply, welfare spending rises more than expected, tax revenues come in lower than expected and the fiscal deficit does not improve. 5) The government finds that foreigners no longer want to buy the debt it needs to sell in order to finance the deficit, so it forces its bank and insurance companies to buy the debt. 6) They are not keen despite high yields and so will only buy short-dated Treasury Bills of less than one year rather than bonds with longer maturities. 7) Yields on government bonds rise to levels at which it becomes impossible for the government to issue any more bonds and the deteriorating creditworthiness of the government debt means that the sovereign debt crisis is now also an existential crisis for the domestic banking sector. 8) The rest of Europe provides funds for a bailout, not to help out the distressed sovereign but to help out their own banking sectors who have massive exposures to both government and banks of the affected country. 9) This bailout from Europe comes with a price of even greater and more immediate austerity. 10) Youth unemployment soars to tragic levels as recession bites even deeper. 11) The country is bust.

Spain’s recent history is putting it on the same road to misery that Greece has travelled in recent years. 1, 2, 3 and 4 have already occurred and 5 is coming into sight, although Spain has taken advantage of the recent period of positive sentiment surrounding the ECB’s LTRO announcements to raise a good part of this year’s debt requirements. However 10-year yields of over 6% for an economy that is likely to show barely any nominal economic growth in the next few years, are not sustainable for very long, and foreign investors are likely not to want to commit more funds to Spain. The LTROs did however facilitate a move towards 6 as the 3-year fixed-rate financing allowed the Spanish banks to make arbitrage profits by buying debt with less than 3 years to maturity – the data suggest many Spanish banks did this.

Spain’s problems are different to Greece in two ways. First, whilst the initial Greek problem was a massive under-estimate of how much debt was owed by the government due to creative accounting, Spain’s problem is that the regional governments in the country have been busily running up debts which are seen effectively as debts of the national government, even though the national government has little political or financial control over the regions. Secondly much of the Spanish banking system has urgent solvency problems following the boom and bust in Spanish house prices over the last decade – the banks need more external capital and it probably has to be the government which has to supply it. The worse the austerity-induced recession, the lower house prices will fall, the worse is the solvency position of the Spanish banking system, and it becomes even more impossible for the Spanish economy to grow its way out of its problems. A move to 7 in Spain could happen faster than many think.

Moving to 8 – a bailout for Spain would be the critical moment for Europe. Greece, Ireland and Portugal together account for about 6% of the Eurozone economy, but Spain accounts for about 12%, so the scale of bailout assistance would triple. For Northern European countries this could well be a bailout too far.

As has always been the case since the crisis started, the solution depends on which of the 3 bad options Germany decides to opt for – either a full political and fiscal union, or inflation caused by the ECB printing money or Germany leaves the euro.