Welcome to my first post in 2012. I hope to make regular contributions during the year to keep you updated with what is going on with the global economy and how it affects you. My aim is to do this on a basis that makes the financial markets and the politics of the same, easier to understand. So forget the convoluted language of your economists and commentators – here you will get the naked truth as frightening as it may be!
So we pick up in 2012 where we left off – that is, the Eurozone in crisis. In fact, the Eurozone has been the issue for most of 2010, 2011 and now indeed will remain so for the foreseeable future.
How did the Eurozone end up in such a apocalyptic situation? For those of you that haven’t heard, and I am sure there are not many who haven’t, Euro governments have borrowed too much money. This has come about as too many Europeans rely on their government to fund their lifestyle, either via employment (i.e. public servants) or by transfer payments (age pensions, unemployment benefits et al).
So how much can a government borrow? Milton Freidman, a renowned economist once said “Government will borrow whatever they can get away with, and a little bit more”, and I think that pretty much sums it up. The European situation is quite unique because Europe simply has so much history. The Europeans have been at war with each other for all of modern history and everything preceding that. So you have to understand that this constant fighting has left many Europeans pretty tired of confrontation. The 20th century saw two major conflicts WW1 and WW2 which resulted in complete destruction of parts of Europe and decimation of generations (incidentally, the Spanish Flu that spread throughout the world in 1918 killed more people then WW1).
So following WW2 (not withstanding the Cold War) Europe wanted to have closer economic ties to ensure that any future conflict would be decidedly less likely because they would all have too much to lose. So the European Union (EU) was born and then the Eurozone. Not all members of the EU are in the Eurozone (the Eurozone are the nations that have adopted the Eurodollar as their currency) the United Kingdom being a notable exception.
So everything went along grandly for some time. The Greek government was able to borrow money at the same rates as the German Government, the French workers demanded and got a 35 hour week, the Italians were able to continue to avoid paying tax but retire early on government pensions (Southern Italians I am told), the Europeans introduced taxes to make their manufacturing uncompetitive (ETS), so on and so forth. So everyone was happy because the increased government debt allowed more people to be paid more money and this translated into “economic growth” and the party kept going (sounds a bit like a Ponzi Scheme.................).
But then the music stopped. The US Sub Prime crisis blew up, creating a global credit crunch. When a credit crunch occurs everyone decides they don’t trust anyone anymore. People don’t want to lend money to other people and banks don’t want to lend to other banks. This drop in confidence and withdrawal of credit feeds on itself. This is because financial institutions are “highly geared”. They use a small amount of equity to lend a lot of money. If the financial institution suffers losses, this “equity” is quickly wiped out and the banks become insolvent. Insolvent banks require government support. In Iceland the banks simply had too much debt for the country to take over. They collapsed taking Iceland with it. In Ireland, the banks had too much debt as well, the government in Ireland has bailed them out, but this has forced Ireland into technical insolvency. In the UK, banks were bailed out to ensure credit kept flowing.
Credit crunches are very destructive. Banks stop lending to business and also individuals that want to buy houses. This negative feedback loop results in falling property prices, businesses cutting back on investment and job losses. Keynesian economics dictates that government must fill this gap and spend. This is of course what they did and borrow and spend is what they have done (Australia is no exception – Kevin Rudd went from a self proclaimed fiscal conservative to a social democrat in a matter of weeks!)
And now we have the hangover. Europe, the USA, the UK and many other developed countries have simply borrowed too much and the prospect of paying it back seems enormous.
So why is the Eurozone the current problem and not the USA or UK – given the USA and UK have massive amounts of public and private debt? It all comes down to the ability to use all the devices available to them. The USA and UK each control their own Central Bank and therefore currency. The Eurozone does not! The European Central Bank is effectively controlled by 17 different governments, some of which are reasonably healthy and others that are decidedly unhealthy.
What would normally occur in a situation where an economy is in strife is that the currency of that country would depreciate to make it workers and manufacturing more competitive (think Australia during the Asian Financial crisis in 1998 – our currency “plummeted” to 50 cents US and saved us from recession). The Eurozone, which has the Euro dollar, does not have this luxury. The Eurodollar as a currency reacts to the health of all of the 17 countries within it of which some are going OK and others are failing. So yes, the Eurodollar has depreciated, which has been of great benefit to exporting nations such as Germany, but by not nearly enough that would benefit Greece.
So ultimately, the Eurozone economies have a half baked system. They have monetary Union, but they also need Fiscal (government taxation and spending) union as well. Indeed, they probably require Political Union or “The United States of Europe”! They also need unified labour laws. Public servants in Greece are paid 30% more than public servants in Germany. Guess who probably works harder.....and you then realise that the system sure is broke.
On some levels, it shows how the culture of “entitlement” has now riddled the developed countries. By this, I mean that once a government “awards” an entitlement to a constituent, it is very hard to take that away. In Greece, it is high public service salaries or an Government Pension at age 55 , in Australia it is Family Tax benefits for middle class Australia. This is because people begin to establish their lifestyle on that increased entitlement and that allows them to spend more, borrow more, enjoy more. Taking that away is not easy for politicians who have to ensure they are re-elected at the next ballot.
At the other end of the scale, this entitlement culture also dominates board rooms in our listed companies. CEO’s earn multi-million dollar salaries and bonuses based on what is deemed “responsibility”. Even worse, some company boards actually reset performance hurdles when executives look like not achieving them to make the payment of bonuses more likely (see recently Wesfarmers and Bluescope). Not good and not healthy.
So Europe continues to lurch towards their solution. Essentially there is only one solution, and that is the write down of government debt to more sustainable levels. Simply put, Greece will never repay its debt and it will continue to grow in perpetuity unless it is written off. The holders of this debt which is mainly European banks will see a fall in their assets (equity) which will make them insolvent. The governments of each of these countries will then be required to prop up these banks by providing them with Capital (and I would suggest wiping out shareholders in the process) and this will of course require governments to borrow more....yes, I know this is insane – it will actually result in say Germany taking on more debt to effectively forgive Greek debt!
This increased debt load that will be the result of this exercise is unsustainable (as all developed countries have governments that spend too much to fund entitlements) and the final piece to the puzzle will be that the European Central Bank will begin the purchase of government bonds, or the fancy people call it Quantitative Easing – I just call it money printing. This exercise pushes additional money into the banking system to provide more money to buy more government debt. Although this sounds silly (OK, it is silly) it eventually results in inflation. Inflation is the great tool in a governments armoury as it is tax increases by stealth. Although the government does not announce an increase in taxation, taxation revenues increase as inflation makes people earn more in nominal terms but the level of debt stays the same as it is fixed. However, this is not a magic pudding because although peoples income and assets may rise in nominal terms, their “real” after inflation wealth is sure as hell going to decrease. Those with a long enough memory may remember the 1970’s and 1980’s when this similar policy was used......so we have been there before.
Make no mistake, this is going to be ugly. For Europe, it will be a tough decade or two. Investors will need to be highly disciplined and ensure that their portfolios are highly diversified and retain a structure to ensure they rebalance their holdings on a periodic predetermined basis. Remember, successful investors purchase assets when prices are low – not high. Do not be tempted to follow the herd. Also, be particularly wary of the doomsayers as they will provide some very enticing evidence for the end of the world as we know it (The Mayans may seem to be spot on – for Europe anyway!). Ultimately, Australians are extremely lucky that we are geographically located where we are, we sit in a dustbowl and brilliant economic management for the two decades preceding 2007 placed our government fiscal position well ahead of major developed economies. The bounce back in the Australian Share market is likely to be quick and impressive, although the timing of this is beyond my ability to predict!
Humans have an in seemingly intractable ability to adapt in the face of adversity. Assuming the politicians have the aptitude to face this reality, the light at the end of the tunnel may soon appear.
