The Money Principle

The immediate response of the markets last week was quite muted.  They assumed that with Germany in charge of the Euro and Merkel in charge of Germany, the austerity programmes will continue to the bitter end.  Simpletons.

Faced with changes in France and another election in Greece, people then started falling over themselves talking about growth.  Voters have also spoken in Germany where Merkel’s hard line approach seems to be losing touch.   Merkel herself has to go to the polls next year.  In Spain a large banking bailout will be required to accommodate all the duff mortgages and construction loans.

Contradictions

People are now openly talking about two things which are contradictory – Greece leaving the Euro and growth pacts.   If Greece leaves the Euro, there will be such a flight of money from all Club Med countries that the Euro will find it difficult to work at all.  There will be no growth.  Investors have already had a ‘haircut’ with the Greek debt and won’t want to go there again.  Don’t imagine it will be a civilised divorce, whatever the contractual obligations and treaties.

Apart from the inevitable poverty and chaos that will happen in Greece, the real big losers will be France and Germany, which have invested most in Greece and other Club Med countries.  Companies have already started putting money in ‘safe havens’ overnight.  There is no guarantee that the money will come back.  Remember what happened with Lehman Bros?

If Greece does exit – or is evicted – then while physical Euros currently in Greece will be OK, accounts will be empty because the other banks will not lend to Greek banks at all.  Contagion will occur in the other indebted countries.  The abyss.

While Greece must bear some responsibility, the banks which lent them money are also at fault.   Some of this debt was actually to fund exports to Greece – of military hardware!  Both Germany and France are the main suppliers of such goods and have, to some extent, been competing with each other.  Presumably these exports were ‘guaranteed’ by the respective governments so if Greece does default it will be German and French taxpayers that will take the largest hit.

Forseeing this possibility, the Euro has weakened and stock markets round the world have taken a trip south.   Unless the principles I outlined last week are adopted and the European Central Bank starts behaving like a proper central bank – with all its implications not the least for the redundant national banks – the market will start to view the Euro as not as a stateless currency but a currency working under diverse and incoherent jurisdictions, which it is.  Expect then more than a few countries,  Euro-denominated bonds and instruments  to lose their credit ratings.

It is against this background that Francois Hollande is being baptised in Berlin.  He will be aware of the consequences of failing to persuade Germany that its best interests lie in growth and renegotiation.  So let’s assume that he succeeds.

Hollande succeeds …

The immediate effect is that the Euro will lose a little more value but if as a result the Eurozone economy picks up, that will be good news all round.  Changes will have to be subtle not seismic but a move from austerity to growth will bode well for the Eurozone internally.  Investors will be more realistic and accept that to get out of the mess that the Euro finds itself, they will have to be rather more patient.

It will need considerable time and, for fiscal union, political agreement which will need a new Agreement post Lisbon and not be easy.  Most importantly, something must be offered now to the innocent people while this re-orientation is going on.   There has to be hope.

As far as the consumer is concerned, it will be carry on as before.  Some countries may have painful re-orientation, property prices in Spain and Ireland will remain low and a Eurobond with the ECB as banker of last resort will drastically cut the interest payments for all.  Maybe not honey and cream but at least some jam.

… or fails

On the other hand, if there is no progress, all hell will break loose.  It is likely that social unrest in southern Europe will become a major issue; none of the countries has a passive history.  Of course, it may be that a passive and broken population of southern Europe will bow down and accept their fate but it is also possible that pigs will fly.  When people are driven to the wall with five years of constant cuts while others walk away with millions, don’t expect acquiesence.

Many people in Greece are already starving and it may soon come to Spain, Portugal and Italy.  The only one of the PIIGS which is likely to escape is Ireland because their problems were not in tax collection or overspend but in an overheated property market.   It is Club Med that will suffer I’m afraid.  Get out now while you can – there may be investment opportunities once everything has settled down but that could be years away.

There will have to be a lots more haircuts.  Investors stand to loose many billions or even trillions of Euros which will depress the world economy affecting not only Europe but also the US and China.  Therefore it behoves these countries not to rock the boat.  Europe needs some re-alignment for sure because the world does not owe it a living.  But it has many good things, not only culture but also innovation, science and a certain civilisation that has been exported all over the world.

The UK will suffer.  If our major trading partner is not purchasing, our economy will nose-dive as well and it will be impossible to square Osborne’s fiscal circle.  There is no room for schadenfreude here.

So what for the rest of the world? Pretty dire for the next 10 years or so.  While there are havens and not all countries will be affected, severe recession in Europe will take many years to recover and depress the world economy by many points.

It is in all our interests therefore that Hollande succeeds.

The people have spoken in France and Greece.  They do not like this austerity business one little bit.  Can you blame them?  After all it was not the people who caused the problem so why should they suffer while the banks get off scot-free?

But what are the implications?  What could happen and how best can you insulate yourself?  In this series of two posts, I will tell you what I believe should be done at a Euro level, what are the implications for various countries and what you can do in this context.

After last Sunday’s elections in France and Greece the markets have remained stable so far because they expected the results.  The Euro has hardly moved. Good – we can breathe.

France is central to the whole issue so I start there.

Having discounted his victory, the markets will give Francois Hollande the benefit of the doubt for a short time and be fairly relaxed, thinking perhaps that ultimately Germany rules the Euro anyway.  But it may come that, should his policies not bear fruit, the markets will react and set French yields substantially up.  Remember that in their enthusiasm, French banks are the most exposed to Greek and other southern Eurozone debt.`

Hollande’s economic position is in some respects closer to Obama’s than was Sarkozy’s who hitched himself to the rigid German approach and paid for it at the polls.  We have seen that the US has created jobs and grown its economy but France has one of the most regulated labour markets.  How easy will it be for a Socialist government to relax labour laws?  Not at all, I suggest so don’t expect a smooth road ahead.  In his election campaign, Hollande was promising to tax the rich and somehow this was to pay for loads more teachers and so on.  All good stuff but the rich are pretty nifty at evading tax and Switzerland is not far away.

This is all of course from a conventional economic viewpoint.  Maybe Hollande can repeat the success of President Roosevelt’s New Deal although this would be very difficult to do in a very different world.  We will see.  But before then two serious problems need to be tackled.

The big questions

The issues that require Hollande’s persuasive skills are:

1. The European Central Bank is not a central bank like the Bank of England or the Federal Reserve.  It is not a lender of last resort and this is a fundamental weakness in a currency where there is no central control over spending.  This is deliberate of course because all countries should hold to the Maastricht criteria, shouldn’t they?  So it would not be needed.   But they don’t behave and the markets cannot be sure that if one country or another runs out of money, the ECB will step in and avoid a liquidity crisis – ie the investors will lose all their money.  Hence the current high yields being demanded by the markets – 7% is not far short of an unsecured personal loan from your listening bank.

Unfortunately the markets didn’t realise this so lent money as if there was no tomorrow, which just shows how stupid banks can be.  The ECB must become a lender of last resort and issue Eurobonds on behalf of all Eurozone members.  Otherwise bond yields will remain high, particularly for southern Eurozone members, and that is a massive cost to the individual governments.

This means that fiscal union and budgets set centrally (at least in percentage terms) will be essential, as foretold by Oscar LaFontaine back in 1998.  As a quid pro quo all members would then pay the same low interest rate to service their debt.   So far the Eurozone countries have been trying to have their sovereign cake and eat it but with appointed technocratic governments in some countries, there is a de facto loss of sovereignty anyway so what’s the difference?  OK Greeks have just chucked their government out but more about that later.

In addition the ECB will need to be persuaded that a little inflation in the north would not be a bad thing either and could help promote growth.  The macho inflation target of 1% ±1% has always seemed to me to be deflationary and nothing is worse than deflation as anyone with fixed costs will know.  The BoE’s  2% ±1% target seems much more sensible.

2.  The other problem is the German attitude. Will Chancellor Merkel change her position against the national view that Germany is propping everyone else up?  Will Germany drop its opposition to Eurobonds with its (by now) irrational fear of inflation?  It may be that the pfennig will drop and the German people will understand that being in the Euro gives them enormous benefits with an open market and full employment.  It is not a zero-sum game and supporting the likes of Greece is a small price to pay, particularly as they end up buying Greece as an extended holiday home.  Austerity measures on the other hand throughout the Eurozone will become self-defeating and harm Germany exports.

France as the Eurozone number 2, is the only country that can do this.  There are clear benefits in cutting the enormous risk to French banks and as a socialist, Hollande could pull it off where Sarkozy would have had no hope.  To be fair, this was something like the policy of the late departed President Bling but I hope Hollande will have no problem in pursuing it.

This is part 2 of the Great European Project and I do wonder whether the initial formation of the Euro was deliberately vague, expecting at some time these problems to arise but hoping it would be later rather than sooner!

Why should the ECB and Germany comply? 

Let’s think of the consequences of them leaving their collective heads in the sand.

It would not be a good idea for the southern European states to end up in anarchy and unrest.  You cannot carry on cutting jobs and expecting things not to blow up.  People have lives and when pensioners start committing suicide in public, not just the national politicians should notice but also the international paymasters.  Free will and history shows that they have considerable power, albeit passive, which has been enhanced in this internet age as the Arab Spring has demonstrated only too clearly last year.  Brussels beware – it is a short flight from Athens, Madrid, Lisbon and Rome.

Politicians in the north need to heed this lesson and stop strutting the stage with macho mutterings about cuts, cuts and more cuts.  Things are balanced on a knife edge and the big question is therefore will Hollande manage to persuade both the ECB and Merkel?

I will discuss the consequences next time and implications for the UK ….