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Subject: Current Thinking Date: 6/14/2012 11:59 PM
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I’m back to pound the table again, more bearish after that weak attempt at a Spanish bank rescue. Here follows a gathering my most current thinking on the euro, and while much of it is rehash, there is a bit more than just a change in tone.

If you have the screen real estate, please open the charts in a separate window so you can refer to them while you read. In case you don’t have the screen real estate, here’s a word doc version of the post, with the charts inlined:

Short Euro, Long Dollar

That configuration that we had with us by and large for ten years which was considered sustainable, I should add, in a perhaps myopic way, has been shown to be unsustainable unless further steps are taken. – Mario Draghi

All that prevents the euro from disappearing is the idea of a complete fiscal union, and while that is not a new problem, the hopes for fiscal union appear to be increasingly thin, fading as fast as Ebenezer’s Ghost of Christmas Past. Perhaps it has already left the stage, and now we watch the Ghost of Christmas Present, in a European depression heralded by unemployment that has crossed 10% in France and Italy, and 24% in Spain, and by a stalling growth in the broad money supply well below its 5-year average growth rate, and other indicators. In this act we could well see the euro abandoned.

Of course, the Ghost of Christmas Future is the most frightening, but redemption will come in the end. First the weight of existing debts needs to be reduced through much larger defaults, currency devaluation, or likely a mix of both.

The euro, if managed to match the anti-inflation rhetoric surrounding it, may be worse than the gold standard. At least with gold there have been occasional new discoveries that could support increasing reserves. With the euro we have 17 countries that trade using a currency that they ostensibly want to not grow, without any system of transfers to keep some money in weaker regions.

Germany and a few much smaller countries run chronic trade surpluses that require the steady accumulation of the currency. Had they separate currencies there could be adjustments to exchange rates. As is, the mechanism that prevents less competitive Eurozone countries from being starved of the very coin of commerce is an ever-increasing mountain of loans from Germany to the less competitive, and now that the Germans are worried about getting paid back, the cycle ends.


The euro is a flawed construct, which has lashed 17 sovereign countries to a single currency, and therefor a single set of monetary policies, without a centralized fiscal policy and its attendant fiscal transfers.

This creates major structural problems:
1) Currency rate adjustments are unavailable as a release valve to temper current account imbalances. As is, while Germany exports more to France, Spain, and Italy than these countries can hope to export to Germany, the natural course is for debts to pile up in the less competitive countries. Temporarily restoring a semblance of competitiveness requires cuts in the face value of paychecks in the debtor nations. But, due to cultural differences, this restoration of competitiveness is necessarily short-lived, and upward pressure on debts as well as downward pressure on nominal wages continues.
2) Monetary policy is unavailable to temper recession in the countries that most need help. Here we have Spain stuck with monetary policy found suitable to Germany, when for 2010 and 2011, Spain averaged 3% less in GDP growth than Germany, and 14% more in unemployment.
3) The availability of fiscal policy to temper recession is also severely limited if government deficit spending has been more than negligible prior to the onset of recession. Having given up its ability to create money, Spain has little room to run deficits now, and it is in this pickle in spite of its moderate use of debt pre-crisis, when it was more compliant with Eurozone debt limits than Germany.

Ideally, a fiscal union would be joined to this monetary union, and with it a steady stream of taxes would flow from Germany to Spain, etc., partially offsetting the imbalances. This may still happen, but the crisis management has been abysmal to date, and with this poor performance Eurozone leadership has been squandering the euro’s goodwill, and increasing doubt amongst the euro using population.

While the European Union was being created, the leadership was in the forefront of further integration; but after the outbreak of the financial crisis the authorities became wedded to preserving the status quo. This has forced all those who consider the status quo unsustainable or intolerable into an anti-European posture. That is the political dynamic that makes the disintegration of the European Union just as self-reinforcing as its creation has been. – George Soros

Most immediately, the Eurozone has a bank run to head off. Ironically, the single currency provides a mechanism to accelerate bank runs. Fearful depositors in Spain or Italy can easily move the bulk of their savings to German banks, and that has been happening in a steady stream since the middle of last year.

At first the money was also flowing to the Netherlands, but as the government budget came into question there, that flow has reversed.

Following the stabilization of the banks, there is urgent need of pro-growth, countercyclical policies to help the worst-off member countries, including support for their debt burdens. This can be provided through an easing of deficit restrictions during recession combined with a sharing of the debt burden, and these are steps that are even being discussed at present in Germany. Given the track record to date, it seems unlikely that either form of assistance will be offered on a large enough scale to buy adequate respite.

The recent Spanish bank rescue illustrates the scale of the support needed, the scale of the support offered, and the apparent exhaustion of everybody involved. Looking at only the housing component of Spain’s real estate bubble, The Brussels-based Center for European Policy Studies (CEPS) estimates the resources wasted and rough attendant banks losses as being on the order of 380 billion euros. This is compatible with my own calculations based on gross value added in the construction sector during the bubble. Combining housing and commercial construction, I think it likely the Spanish banks face losses on the order of 500 billion euros. Spain begrudgingly said it would ask for up to a maximum of 100 billion euros to help its banks.

If the bank run can be stopped, and Spain and other struggling countries can be supported for the interim, and if additionally a full and credible roadmap to the fiscal union can be agreed upon, then there will be reason to treat the euro with a good deal of respect. Anything less, and it looks like a failed experiment.

Getting a handle on the twin crises in banking and sovereign debt looks like it will require a huge amount of money. Providing partial rescues to Greece and smaller economies like Ireland had already tapped most of the funds raised for rescuing troubled EU member states. Now Spain is accepting rescue loans, yes it is all more debt, as well. By 2010 GDP, the economy of Spain was already more than 4 times larger than that of Greece, and Italy’s was even larger, and France’s larger yet again. Rescue funds are due to be doubled very soon, but that won’t be enough to take care of these larger countries, and comically, Spain, Italy, and France are all supposed make large contributions to these rescue funds.

Only the European Central Bank has the firepower to credibly backstop the banks and the sovereigns, and yet the ECB still hasn’t stepped up to fill the roll. They made an attempt with a couple rounds of LTRO, their Long-Term Refinancing Operation, whereby banks were able to borrow almost unlimited quantities from the ECB on the cheap and buy distressed sovereign debt to profit off it. By the second round of the LTRO, observing the easing of sovereign debt yields, I thought the ECB was possibly on to something, but then the ECB inexplicably stopped.

Now I can make a guess as to why the ECB stopped. Looking at the flow of money between the ECB and Eurozone national central banks, known as target2, the flow of money out of Spanish and Italian banks and into German banks continued rather steadily, unabated by the LTRO. With eroding deposits, the Spanish and Italian banks are unlikely to be able to earn their way to solvency regardless of how much leverage the ECB hands them.

A different vehicle is required for rescuing the banks. Still, only the ECB can provide enough money to fund the vehicle.

The US has its own problems, to be sure, but government expenditures, inclusive of state and local expenditures, have been averaging 40.5% of GDP for the US as compared to 49.2% for the top eleven economies within the Eurozone.

In the US some like a larger government and some like a smaller government. The same is true in Eurozone countries, but in the Eurozone what is generally thought of as small is considered large by US standards. European society is used to big government, and European labor views it as a kind of birthright. To handle the current debt crisis, Eurozone countries need more central bank support than the US does. I see the ECB’s hawkish public face as fundamentally incompatible with the societal fiber of the vast majority of the countries it serves.

If you’re still reading, from here I expand on a few details and even toss in some charts. At some point the extra detail can create overconfidence. Just because I’ve dug up a fair amount of supporting evidence doesn’t mean my thesis is correct. With that caveat, if you want more, here it is.


A credible bank rescue

The Spanish bank rescue is a farce, but what would be required for a credible bank rescue?

The odds we get on look thin, but non-zero. The ECB appears to be actively fighting the idea absent getting the full fiscal union first. I think they don't have the time to achieve the full fiscal union before the flow of deposits from Spain and Italy goes too far, and so the first obstacle is for the ECB to give up on getting the fiscal union before it funds a proper bank rescue.

Another problem is the scale of the fund. My estimate is Spain alone needs 500 billion euros for its banks. France, with its giant over-leveraged banks with business spread throughout southern Europe probably needs a similar amount. The only thing protecting German banks at the moment is the large influx of deposits. A credible bank rescue might reverse that flow. Expecting further defaults, at least private, probably also sovereign, a reversing of the deposit flow puts the German banks in trouble. The Netherlands, with large Eurozone exports relative to the size of their economy, probably hold large amounts of bad loans as well. Very roughly, it looks like a credible bank rescue fund needs clear access to a couple trillion euros, minimum.

With that much money on the line, it is easier to see Germany preferring to walk away and focus on saving its own banks. But, there is a big push going on right now in the Bundestag, the German legislature, to do something, even if it is on the scale of a couple trillion euros. Still, talk is of requiring all participating countries to pledge their sovereign gold reserves as collateral, which sounds like a very tough sell, and the purpose of this "redemption fund" is first to save the sovereigns through a one-time pooling of debts -- avoiding a full fiscal union -- and second to save the banks. In failing to address the core problems of fiscal union and current accounts, and instead cementing the status quo with an enormous band aid for current debts, such a plan is doomed to fail long-term.

What I see as a potentially viable bank rescue vehicle is for the ECB to step in and serve as the bank regulator for all Eurozone domiciled banks. The ECB has to be given full regulatory control, and national regulators must be either disbanded or subsumed into the ECB, losing all power to decide the fate of their own banks. Snap! You have all of the trillions required without even having to announce the size of any fund.

This solution is also difficult. The intertwining of banking and politics in Europe is extreme creating difficulties with the plan a the national level, and the ECB is balking at doing anything without getting a fiscal union first, creating difficulties at the EU level. But this is what I see as the most likely, credible bank rescue.

Even if we get a credible bank rescue, there remains some potential for the euro to fall in response to the rescue.

The ECB has to create a lot of money to rescue the banks, but it is money that is replacing money destroyed in piles of bad loans. Fundamentally, I see no need for the rescue to devalue the euro. So, it comes down to perceptions. Are people more encouraged that something so large is being done, or are they more discouraged that something so large is required? And, to what degree does the market see my angle in that the new money is just replacing old money instead of inflating the supply.

However, I think it is less than fifty-fifty that the credible solution entails a lower euro. I think China looms large here. I think they would like the solution, and would move early to diversify a little more of their reserves into euros. A little Chinese money could provide a big cushion on any euro downside.


German 2010 trade balances with other large Eurozone economies

The five largest Eurozone economies, by 2010 GDP, are Germany, France, Italy, Spain, and the Netherlands. Together they are responsible for 83% of the GDP of the entire Eurozone.

If we include the next four, Belgium, Austria, Greece, and Portugal, two of which have already been in rescue programs for a while, that would take the total up to 94% of the Eurozone GDP.

Merely looking at the top five economies can illustrate the core problem posed by the euro itself. Germany exports more to France than France does to Germany. The same goes for Germany and Italy, as well as Germany and Spain. Not until we get to the Netherlands does the pattern switch.

That surplus of exports from the Netherlands to Germany is only large enough to balance the smallest of German surpluses, that of Germany with Spain. Further, the Netherlands isn’t recycling any of its surplus through other Eurozone countries. The Netherlands, similar to Germany itself, is a broad exporter across the Eurozone, with the typical flow of extra imports from China and other developing countries.

The supply of money is piling up in Germany, and to a lesser extent the Netherlands, while the balance of the Eurozone gets starved.

Country to country exports, in billions of euros, for 2010


Data Source: The Observatory of Economic Complexity, MIT ( http://atlas.media.mit.edu/ ), which takes its data from UN COMTRADE and makes the numbers more accessible. I used the HS4 data.

These numbers represent exports reported by each country to the other. While I haven’t found any trade numbers wholly reliable, this is an improvement over the balance of trade numbers reported by each country. Countries have broad leeway to leave out of their trade reports anything deemed too strategically important, and it appears a lot of countries are understating their trade shortfalls. If you look at the trade balances reported at Eurostat for all EU members just for trade within the EU, instead of the balances summing to zero as they should, there is a net level of exports within this closed sample, impossible though that is, and the scale of this net export balance is similar to the scale of the German trade surplus within the group.

Eurostat’s Statistical Yearbook for External and Intra-EU Trade:


Target2 balances, showing how much each member country’s national bank is borrowing from or lending to the ECB


Chart source: The Institute of Empirical Economic Research, University of Osnabrueck, Germany ( http://www.iew.uni-osnabrueck.de/en/8959.htm )

When too many euros are withdrawn from a Spanish bank, that bank turns to the central bank of Spain for a loan, which in turn borrows from the ECB. If those euros are being deposited in a German bank that then has more euros than it can put to good use, it deposits the excess with the German central bank, which in turn loans the money to the ECB.

The two lines that slope sharply downward starting in the middle of last year show the rising negative balances for the central banks of Italy and Spain, as they borrow increasingly from the ECB.


Government expenditures as a percent of GDP


Data source: The International Monetary Fund ( http://www.imf.org/external/pubs/ft/weo/2012/01/weodata/weor... )

From 2007 through 2010, of the eleven largest economies within the Eurozone, as measured by 2010 GDP, only one, Ireland, had even a single year for which central, state, and local government expenditures added up to less than that of the US on a percentage of GDP basis. And, the 2007 result for Ireland was an anomaly driven by excessive bank lending that led shortly thereafter to the collapse of Ireland’s banking sector, which was an impressive failure in a world of shaky banks.

Note that Spain stands out as spending less than all 10 of the other large Eurozone countries. The notion that the current crisis is caused by overspending is misplaced, and the prescription of less spending as a cure has been far off the mark.


Eurozone unemployment


Data source: Eurostat ( http://appsso.eurostat.ec.europa.eu/nui/show.do?dataset=une_... )

This includes Germany’s current 5% unemployment, as well as 10% for both France and Italy, and 24% for Spain.


Eurozone broad monetary aggregate, M3, year-over-year growth


Data source: Eurostat ( http://appsso.eurostat.ec.europa.eu/nui/show.do?query=BOOKMA... )

I would have preferred to run this chart back a couple more years, but there is a big hole in Eurostat’s M3 data for 2005 that messes up the calculation for both 2005 and 2006.

Recall that the ECB recently used two rounds of Long-Term Refinancing Operations, one in December and another in February, to inject over a trillion euros total into the region’s banks with cheap loans.

As M3 totals up all of the currency in circulation, overnight deposits, term deposits of up to 2 years, repurchase agreements, money market funds, and bonds with a maturity of up to 2 years, if money is even slightly active in the system, it should show up here. Banks would have given longer-term instruments as collateral to get the LTRO loans, but they received cash in trade, and that cash would add to M3 unless it went into longer-term instruments.

No effect on the money supply was visible. It looks like either all of the LTRO funds went into the purchase of sovereign debt, or the portion that wasn’t spent on sovereign debt was entirely offset by contraction in bank lending to the private sector. To the degree the sovereign debt was bought, yields just enjoyed a brief respite. To the degree bank lending is contracting, Eurozone business should be seriously slowing.

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