A hard Brexit please

This week the government made clear its decision regarding the sort of Brexit it will be seeking. The red lines of control of immigration and withdrawal from the European Court of Justice’s jurisdiction represent the “taking back control” that the Leave campaign promised.

The other 27 countries in the EU have made abundantly clear that the price of Britain denying freedom of movement is that it cannot continue to be inside the single market –  the working definition of a hard Brexit. Thus some sort of agreement on how trade will be conducted between Britain and the EU will be required.

There appear to be two key areas to be negotiated before Britain actually leaves – (i) a transitional trade agreement pending a more permanent agreement which might take many years to conclude and (ii) an agreement on the financial services sector and the current passporting system.

It is interesting to note that the red lines regarding “taking back control” do not include the subject of the UK’s net contributions to the EU budget and it seems that Britain may be prepared to pay (financially) for a transitional trade agreement and agreement over continued financial services passporting. Whether this would be acceptable to the EU countries is not clear – the current payment from the UK of £18bn per year (which would presumably be the maximum that Britain would be prepared to pay), does not go very far when spread around 27 countries.

Whilst now is the time of maximum pessimism about Brexit negotiations -before formal talks have even begun and with each side setting out their red lines – Britain has lost goodwill in Europe over the last week following policy ideas announced at the Conservative Party ‘s regarding foreign-born workers.

Both Merkel and Hollande have made clear that it is important for them that Britain should be not be seen as having won anything by deciding to leave the EU, and though it is quite possible neither will be around to have much influence over the negotiations, their fellow-countrymen are unlikely to have very different ideas.

With important votes and elections in Italy, Spain, France, Netherlands and Germany over the next 12 months, little progress should be expected in the Brexit talks in that time period. This will prove negative to the world’s view of Britain – the pound has continued its post-referendum decline this week, and gilt yields have risen in anticipation of the higher inflation this is likely to create in the British economy.

International investors will at best defer further investment into the country and at worst begin making adjustments to their factory and office locations to reflect a Britain outside the single market. Any good news regarding the benefits of new trade agreements with other non-EU countries will have to await the outcome of talks to agree our relationship with the EU.

By announcing when it expects Article 50 to be triggered and its red lines, Britain has now entered a period of massive vulnerability for its economy. Maintaining the goodwill of the other EU countries should now be a key objective of foreign policy.

A badly-timed referendum

David Cameron never really envisaged losing the referendum, hence he paid no attention to the timing of it should he lose it. However, the state of national politics across many European countries is febrile and within twelve months it is quite conceivable that the four largest countries in the EU will all have different leaders and potentially these new leaders will all be from different parties than rule today. This will have a major effect on the outcome of the exit negotiations.

In Germany the next general election is set for September next year. Ahead of the 2013 election Angela Merkel indicated that she would step down before the next election – this promise has not been repeated since that election but she is yet to confirm that she will stand for re-election next year. She is one of the most experienced and highly regarded politicians globally but her stance over the migrant crisis, being happy to accept over 1 million migrants into Germany over the last year or so, has damaged the standing of her and her CDU party in Germany. Should she decide to stand down, the EU will lose its most powerful politician and Germany’s influence within Europe will decline; should she decide to stand again she might find that her CDU party garners less seats than the centre-left SPD party, her current coalition partner. Recent local and regional elections have been notable for the surge in popularity of AfD, a party that began life on an anti-euro platform but which in recent times has shifted right to become firmly anti-immigrant and anti-Muslim. The proportional voting system in Germany means they are likely to gain seats in the new Parliament and become a meaningful force in German politics

In France, there will be a Presidential election in April. The two-stage process, where the two candidates with the highest number of votes in the first round are the only ones on the ballot for the second round, combined with a large number of potential candidates make for a lot of uncertainty. Currently Marine Le Pen of the Front Nationale, whose major policy is firmly anti-euro and anti-immigration, looks set to gain the most first round votes and be in the final ballot where she would be expected to lose against most others, but it is very unclear who the other candidate might be. From the centre-right of French politics Alain Juppe, a former prime minister and Nicholas Sarkozy the previous President are the two leading candidates, whilst from the left President Hollande is very unpopular and has yet to decide if he will stand again – two members of his government, Manuel Valls and Emmanuel Macron have already announced they are candidates. The current polls indicate that should Hollande stand he would fail to reach the second round, which would be a huge political embarrassment for him.

In Italy, the current prime minister Matteo Renzi has called a referendum on some constitutional changes to reduce the powers of the Upper House and regional governments, that he feels are necessary to deliver structural reforms to the Italian economy. The referendum result is likely to be close – it will be held between November 20 and December 4. He has repeatedly said that he will resign as prime minister and leave politics if his reforms are rejected. On current polling the anti-EU and anti-establishment Five Star Movement is leading though their leader, Beppe Griilo is himself not permitted to be elected to parliament due to a previous conviction

In Spain, there was an election in December 2015 but this produced an inconclusive result and it had not proven possible for any combination of parties to agree on a forming a government with a parliamentary majority. Mariano Rajoy the prime minister before the election has continued in office without sufficient votes in parliament to pursue his policies. Nine months of inter-party talks have failed to resolve the situation and the most likely outcome is another election soon. However current polling indicates that the likely outcome would remain very unclear.

With these four large Eurozone economies facing such political uncertainty, in terms of who will lead and what their policies will be, it seems unlikely that Brexit discussions / negotiations will achieve much forward momentum for some time. For markets, European economic policy will remain dependent on ECB decisions as little progress from fiscal policy or structural reforms can be expected either.

The German dilemma

Within the Eurozone, Germany is coming under increasing pressure to approve and adopt policies designed to stimulate the Eurozone economy. This is because (i) Germany is the largest economy in the Eurozone, (ii) since the global financial crisis, Germany has enjoyed the strongest performance within the Eurozone based mainly on exports, which has led to a very substantial trade surplus, (iii) German public finances are in a very healthy state compared with most in the Eurozone and (iv) they are rich and have the policy flexibility to act.

Many in the rest of Europe are calling on the German government to launch a large debt-financed fiscal boost through public investment spending, creating, it is hoped, jobs and demand throughout the Eurozone. The Germans are resisting this strongly because they have worked very hard in recent years to get their government finances back onto a solid footing, and are expected to get close to a balanced budget in 2014. German politicians are stoutly resisting European calls for them to spend more and move back into deficit.

It is though in monetary policy where the greater controversy is being generated. Through his public utterances over the last six months, Mario Draghi has sought, to maintain market confidence by positioning the ECB as about to introduce a US- or UK-style QE programme in its efforts to boost demand and inflation. However the actual policy steps agreed at ECB meetings have not lived up his words – QE is always just a few months away. It is clear that, behind the scenes, the Bundesbank and several ECB members are fiercely opposed to such a policy, with many in Germany believing it to be illegal. They are angry at the way that Draghi has sought to bounce them into such a policy by his public statements.

To many in Europe (and indeed the world), the Germans are the bad guys, doggedly blocking any moves to boost the moribund Eurozone economy due to their particular economic ideological fixations around sound government finances, conservative monetary policy and a strong currency. Being so out of step with their Western allies is not a position in which post-war German governments have wished to find themselves, and in any other field than economic policy, they would have made adjustments to their position and found a compromise.

It should however be recalled that Germany never asked for the single currency, and when it became inevitable, did their best to restrict membership only to those economies that were happy to embrace German economic orthodoxies, for precisely the reasons that are now being played out within the Eurozone.

In 1990, Mitterand’s price for accepting the re-unification of Germany was monetary union. In permitting Germany to become a much larger, and thus more powerful nation, he sought to maintain France’s significance by sharing the all-powerful Deutschemark. Kohl accepted this provided that all those involved in monetary union were prepared to manage their economies according to German orthodoxy. Thus the ECB’s mandate was constructed along very similar lines to that of the Bundesbank – very independent of politicians, with a mandate of low inflation delivered through conservative monetary policy. Similarly, the Maastricht Treaty constrained the size of government deficits and public debt that individual countries would be permitted. With these in place, the only economic solution for countries finding themselves in economic difficulties is for export-led growth, with the private sector becoming more competitive in global markets through cost control, innovation and structural reform. There would be no room for short-tem fixes generated by lower interest rates, weaker currencies and debt-financed government spending.

The criteria for membership of the euro were deliberately designed to exclude what are now known as the peripheral economies. Only the “core” European economies were expected to qualify, who understood and were prepared to accept German economic thinking. However everyone wanted to qualify and through a combination of the long economic boom of the 1990s and some very creative accounting, the euro began life both with many more members than Germany had ever intended, and with much weaker (though disguised) public finances than Germany would have countenanced.

Since 2008, the Germans have continued to espouse the policies that they believe were written into the monetary union. Thus they expect countries to embrace public sector austerity to reduce budget deficits and bring their giddy debt levels back under control, they expect their Central Bank to adhere to policies of sound money by control of money supply growth and they have a particular fear of Central Banks who buy government debt with newly-printed money. This is the economic and monetary union Germany insisted on, signed up to and has always believed that others had agreed to.

To date they have not relented on these principles, but it is leading to great pain and bad will across Europe, where the peripheral economies which previously resorted to policies of devaluation and government spending to boost their economies in times of trouble, cannot understand why these should not be adopted now. Germany now faces its greatest dilemma – whether to abandon the economic principles which have been the foundation of its economic success since 1945 and remain on good terms with the rest of Europe, or, remain true to its economic ideals and be the cause of the break-up of the monetary union as weaker economies are forced to leave.

In 2012, Angela Merkel opted to bail out Greece rather than risk the break-up of the euro, though by all accounts the decision was close and arrived at only after months of consideration. When the ECB finally votes to adopt QE (almost certainly sometime in early 2015), there will be vigorous opposition within Germany including legal challenges. Once again Mrs Merkel’s leadership will be key in determining the future for Germany and for Europe.

Nippon Europe?

Angela Merkel’s favourite set of facts about Europe are that it represents 7% of the world’s population, 25% of the world’s GDP and 50% of the world’s social spending. It is this that informs Germany’s insistence that the rest of the Eurozone meet their budget deficit targets.  In recent years, through harsh austerity, the peripheral economies have made good progress in reducing their budget deficits.  Progress has been very disappointing at the core of Europe and in particular France and Italy, which together represent almost 37% of the Eurozone economy.  These countries still have much painful restructuring to come, which will continue to depress demand in the Eurozone as a whole: Europe’s economy is likely to continue to stagnate and it increasingly resembles the Japanese economy of 10 – 15 years ago in terms of high levels of public debt, poor demographics and weak policy action.  We believe Europe offers few opportunities for profitable investment in the next few years, and therefore remain VERY LIGHT in Europe in our model portfolios.

The second quarter data for Eurozone growth was disappointing, showing zero growth for the Eurozone as a whole, and of great concern for the health of the core, all of the three largest economies (Germany, France and Italy) reported negative growth:

  • Growth in Germany has been hurt by the switch and slowdown in spending in China, away from investment and infrastructure spending towards consumer spending, and also by the sanctions imposed on Russia – two trends that seem likely to persist for some time;
  • The French Government has been forced to admit that their economy will not grow this year, and they expect only 1% GDP growth in 2015, with the result that France will not be able to meet the EU targets for budget deficit reduction, which have already been extended by two years from the original target dates. Though Francois Hollande accepts the need for French austerity and reform, many of his Socialist Party colleagues are opposed to the necessary measures and are unlikely to vote for them in parliament. The recent dissolution of the cabinet highlights the growing division within the Socialist Party;
  • In Italy the economy has already endured a lost decade. The size of the economy in real terms has not grown since Q1 2000, and in nominal terms has not grown since Q3 2007. The budget deficit remains large, but Prime Minister Matteo Renzi has effectively warned his Eurozone partners that he will seek to ignore the EU budget and fiscal rules designed to reduce Italy’s debt/GDP ratio. Italy’s finances would be in far healthier shape but for the interest that has to be paid on Italy’s €2 trillion government debt.

The stage is now set for a major argument within the Eurozone between Germany and the Northern economies (mainly Finland, the Netherlands and Austria) who are currently demanding that France and Italy reduce their deficits and the countries themselves, which appear very reluctant to take the necessary measures. This is likely to lead to a long period of drift amongst the leaders of the Eurozone, and create uncertainty about the future direction of European economic policy.

Meanwhile, clear evidence of progress in the periphery can be seen in the record of both Ireland and Spain’s private sectors, which have been at the forefront of efforts to make their industries more competitive with Germany since 2008.  From 1998 to 2008, Irish and Spanish Unit Labour Costs (“ULCs”), which represent the average cost of labour per unit of output, rose steadily while German ULCs were unchanged, and so the former became increasingly uncompetitive. Since 2008, German ULCs have risen but Irish and Spanish ULCs have fallen back, bringing their economies back to the competitiveness relative to Germany last seen in in 2005.

In France and Italy, in contrast to Ireland and Spain, ULCs have continued to rise since 2008 – there has been no improvement in competitiveness relative to Germany. The core of the Eurozone economy is steadily becoming less able to compete in global markets, which has negative implications for the potential for these economies to grow.  Both France and Italy need the austerity in both public and private sectors that the peripheral economies have been undergoing in the last few years.

Europe’s economic problems – (i) excessive public sector debt, (ii) poor demographics and (iii) a banking system suspected to be hiding considerable bad debts, leaving banks unwilling to lend – are eerily similar to those of Japan over the last two decades, an economy which has seen zero nominal GDP growth over that period, and is now embarking on one of the most extraordinary policies of money-printing ever seen in a developed economy. There is also a fourth problem, which is the existence of the Euro with its flawed construction that seeks to deliver a monetary union without a political union.  For many countries, remaining in the Euro requires strong deflationary policies, while coming out of the Euro would be seen as a hugely negative political loss of face.

The peripheral economies have taken their medicine, with frightening results in terms of youth unemployment and living standards in recent years. The same, however, cannot be said of France and Italy, and when the dose is taken, given the size of their economies it will lead to far greater repercussions on the European economy, than was seen with the peripheral economies.  With a strong currency, high unemployment and weak wage growth, the medium term outlook for the Eurozone economy is bleak, and returns to investors will be challenging to find.  The ECB is the one institution that could break the logjam, but to do so would require a QE programme on such an enormous scale that Germany could never accept it.  If the ECB does resort to a policy of QE, it will likely be too small to be effective, and will merely lead to disappointed financial markets.   We therefore remain VERY LIGHT in Europe in our model portfolios.

 

 

 

The German dilemma

Since the drama of the Italian election in the spring, European politics have been remarkably quiet.  This has been by design – the countries who would like Germany to provide money or ease policy to support their beleaguered economies have understood that it is very important not to scare the German voters ahead of their general election on September 22.  There was a fear that “bailout fatigue” amongst Germany’s electorate might force the politicians to make promises not to provide further support to weaker economies.

In two senses, the result is not in doubt – (i) Mrs Merkel seems sure to remain as Chancellor following the election, as her party is odds on to have the largest share of the votes and (ii) in that event, she will have to lead a coalition to form a government.  What is uncertain is that this coalition will either be a continuation of the current coalition (of Merkel’s centre-right Christian Democrats with the Free Democrats should they reach the 5% threshold of the total vote required to get any seats in the Bundestag), or, if they don’t, there will be a “grand” coalition with the Social Democrats, the large centre-left party.

Whatever the shape of the resulting coalition, the next German government faces a huge dilemma between its two major policy objectives.  It can choose to do all that it can to keep the Euro intact, which will achieve its foreign policy objective of being at the heart of an ever-closer European Union, but at the expense of its economic policy objectives of low and stable inflation and balanced budgets.  Or it can choose to insist that Europe’s economic policies reflect those of Germany and watch as the rest of Europe suffers from economic stagnation until the option of withdrawing from the Euro becomes impossible to resist for some, threatening the survival of the Euro.

To achieve both of Germany’s key policy objectives, the optimal solution is a continuation of the current German stance where they provide the minimum in bail-outs to prevent a default,  in return for a commitment to continued austerity at an agreed pace.  This achieves their dual goals of keeping the Eurozone together, whilst maintaining a German –style attitude to fiscal policy and thus low inflation and a sound currency.  It delivers the “stability” that is so prized by German politicians.  However, this is an inherently risky policy for most of the rest of Europe, delivering a graveyard type of stability.  It will ensure near zero growth, high unemployment and weak banking systems across the Eurozone, for a long time to come.  It is eerily similar to the policy adopted by Japan which led to two decades of stagnation.

To escape this stagnation, countries in the Eurozone have three options: (i) leave the eurozone and repay their euro-denominated debt in their new (and devalued) currency – this would dramatically improve their trade competitiveness and reduce their national debt, but badly damage their relationships with their European neighbours; (ii) persuade the ECB to engage in Quantitative Easing in an effort to create inflation, which would reduce the real value of their debts and might also encourage some growth; or (iii) construct the necessary  banking, fiscal and political unions to go alongside and support the existing monetary union.  At an aggregate level the economy of the Eurozone does not have great budget and trade deficits.  It is only at a national level that the problems appear, which implies that a deep and real economic union between the countries can be successful.

Of these three options, the first is seen as suicidal by incumbent politicians, not only for their prospects for domestic re-election but also for their chances of any future European roles in Brussels.  The second is hard to imagine, since it would require both the ECB and the Germans to support a higher inflation objective.  The third is very complicated to achieve – in 2011 the German Constitutional Court pronounced that the German constitution does not permit further significant political integration without a German referendum.  It would also probably require referenda in several other Eurozone states.  This is though the most logical solution to the Eurozone’s problems.

The banking systems across the Eurozone remain very weak, with the OECD recently estimating that since the crisis began, Eurozone banks have reduced the size of their balance sheets by €2.8tr but have a further €3.0tr still to go, from total balance sheets of approximately €32tr. The banks, particularly in the peripheral countries are in no position to support growth by increasing their lending.  The outlook for economic growth in the Eurozone is thus very restrained, meaning that unemployment will remain very high and that governments will continue to struggle to deliver deficit reductions.

The implications for investors are that Eurozone growth will be very sluggish (even though in the short term growth may be improving), and will remain so as long as Germany’s preferred policy approach continues to hold, since no further fiscal or monetary stimulus will be supplied to the eurozone economy.  We remain very cautious on European equities, which do appear cheap, but that cheapness is concentrated in banking shares and in the markets of the peripheral economies whose prospects remain very challenging.

Eur-out

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.

 

Eurozone poker – Monti calls Merkel’s bluff

At last week’s EU summit, Mr Monti refused to agree to anything until Germany made a key concession. He wanted the bailout monies for the Spanish banking system not to be structured as debt of the Spanish government.  In the end, Mrs Merkel gave in although this will not occur until a European banking supervisor has been established for the Eurozone banking system.

This concession is hugely significant in terms of a principle to which Germany has long held fast, in that it appears to contravene the Maastricht “no bailout” clause – recapitalising a banking system requires equity capital not debt capital. Europe will now use its emergency funds to inject new equity into the Spanish banks. This cannot be portrayed as emergency lending to fellow European sovereigns as all previous rescue loans have been. Providing equity capital to bankrupt institutions is inherently a far riskier proposition than lending to a sovereign state, and so it is impossible now to maintain the facade that German taxpayer money is not being put at risk.

As time moves on, Germany and others will find themselves facing the classic sunk cost problem – if more money is required to keep these banks afloat, then the capital provider feels under greater pressure to do so, to avoid writing off the previous investment. This is the first step down a slippery slope – the second step will come when a more rigorous and independent audit reveals that Spain’s banks require far more than the E62bn currently mooted in order to recapitalise. Next Ireland and Greece have already made clear that they want to get (retroactively) the same terms as Spain for their banking recapitalisations, and finally the Italian and French banks will be looking enviously at the cheap equity capital Spanish banks have now secured.

Mrs. Merkel does have a cooling-off period though. The principle has been conceded subject to agreement within 6 months of a new European banking supervisor. This leaves many vital areas of disagreement over details and, probably, ratification in all 27 EU states. Key areas still to be resolved are which banks fall under the direct supervision of the European regulator, what will  be the role of the current national banking supervisors, and most importantly of all, who has responsibility for deposit guarantee insurance. It would seem obvious that any deposit guarantee scheme would have to fall under the auspices of the European banking regulator, but it is not clear where the money would come from. Most politicians do not wish to provide their own taxpayers money to bail out bank depositors in other countries – instead they are hoping it will be funded by the banking system itself via a Financial Transactions Tax. In the long term this may be a viable solution, but in the short term the fund would be empty for several years and the potential demands on it huge given the fragility of European banks.

One further factor which should not be ignored is that in September 2013, Mrs Merkel faces re-election. Should she concede too much to the rest of Europe over the next 12 months, she faces huge domestic political problems. There is talk that a possible way out of her dilemmas is for Germany to hold a referendum on whether it should continue to support its European partners to enable them to remain in the single currency. German public opinion is currently split on this and such a referendum would leave European financial markets paralysed until the matter was resolved.

The markets have rallied strongly on the abandonment of the Maastricht “no-bailout” clause, and the first move towards more integrated European institutions. However history suggests that there are many more late-night summits and games of brinkmanship to come while negotiating the details of what has been only agreed in principle. Investors can afford to wait and see before concluding that Europe is solving its problems.

Dear Diary – possible reflections of some of those at the G8 meeting

The G8 meeting achieved nothing, despite the sense of crisis in the markets. The communiqué was bland and meant different things to different people. Below are what the leaders may well have really thought  about the summit.

Barack.  Re-election chances continue to drop – only 6 months to go. Have to say that Angela has some backbone, kept going with the German Nein all weekend long despite all of us ganging upon her to open her wallet. Played at being best buddies with Francois, the new boy in our club – it keeps David and Angela on their toes. Anyway he and I do have a lot in common, the rich should be paying a whole lot more towards getting us out of this mess, and it shouldn’t be the ordinary Joe who takes the hits all the time. Europe really worries me though – if it all blows up this summer, it could send our economy back into recession just about election time and I’ll be a very young ex-President.

Angela.  Re-election chances continue to drop – only 16 months to go. Well, that goes down as one of the most miserable weekends of my life. I know I’m still at the top of Barack’s European speed-dial, but it was horrible to watch him buttering up Francois. At heart though neither of them believe in balanced budgets and sound money like I do; they just want the money and public expenditure to keep on flowing and keep their supporters sweet. I am now only really left with David as a true right-of-centre ally in Europe; at least he is backing our drive for a political union as the best option to save the monetary union. Even so, he joined in with the others that Germany must spend lots of money we don’t have and let the ECB print and cause inflation – I was totally alone on this but stood my ground.

I thought it was a pretty smart idea to take 3 hours off from our discussions to watch the Champions League Final – it would be 3 hours not having to defend sound economic principles and a chance for Germans to show the football world how good we are (again) – but it didn’t work out. Bayern lost (on penalties – Germans never do that) and the symbolism was so awful – a team of foreign imports on huge salaries from the part of London inhabited by investment bankers, managed to overcome the bulk of the German national team, who were so strong, courageous and disciplined, and from Munich, the most successful centre of the German export industry. Worst of all that photo of us all watching the game has gone viral thanks to Twitter.

David. Re-election chances starting to drop – though still have 36 months to go. Politics is a rum old game. Who would have thought that a British Conservative Prime Minister would be telling the nations of Europe that their best (and only) hope was to move toward a full-on political union led by Germany? Yet George keeps on telling me that really is the best hope for our economy until the next election. Maybe, but it would be terrible for Britain’s influence with the US and China if Europe was truly one country with an elected President. I really can’t see it happening though, but I just don’t know if that is a good or a bad thing. That photo should do me the world of good with all the ordinary footy supporters in the country though – not many Posh Boys really like association football. Like Angela I had to be grovel a bit to Francois.

Francois. Chances in the parliamentary elections in 4 weeks definitely on the up. Life is amazing right now. Two weeks I was M. Normal, a French Socialist leader that had never had responsibility for anything in my life except for other Socialists, and now the President of the United States of America is telling me and the others what wonderfully interesting ideas I have. Also quite a nice feeling for Angela and David to have to be extra nice to me right now – I shall make good use of that back home in the next few weeks ahead of the elections.

Mario. Politicians are so transparent, always worrying about their election prospects.

Vladimir. Why are these guys so afraid of elections? Everyone’s beating up on Angela. I reckon she needs a good friend like me, and then just maybe we can get Germany to see Russia as their best European ally, instead of always looking westward.

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.