Wednesday, August 20, 2014

Europe's Conundrum

Anyways, Europe has many (major) problems and upcoming hurdles. This post will detail the hurdles I find to be the most important hurdles. I will separate this post into various parts with the parts being:
1. Introduction
2. The Euro and the Gold Standard
3. The Question of Austerity
4. The European Banking System
5. Asset Bubbles in Northern Europe
6. The Question of Germany
7. European Demographics
8. Conclusion

Europe is in the middle of an economic crisis (if that isn't blatantly obvious). There is simply too much debt across Europe. The fundamental problem in Europe is that they tried to set up a unified currency when there's absolutely no reason for a unified currency for Europe. The bureaucrats/politicians in charge of the European Union (I'll refer to them as Eurocrats from now on) wanted to create a geopolitical alliance to merge Europe socially and politically. They thought the best way to do this was to create a unified currency and a unified monetary authority. Of course, they also decided to completely ignore a fiscal alliance between the countries, which now leaves all of Europe with a major problem.

The Euro and the Gold Standard:
I like the Euro today to the gold standard of the 1930's. We've got countries (Portugal, Italy, Ireland, Greece, and Spain) having debts denominated in currencies they can't control. These countries find themselves with very high levels of unemployment and absolutely no demand while they've got massive debt burdens in both the private and public sectors. Also note that their debts are assets of some financial institution. In the case of Europe today, the debts of the PIIGS (Portugal, Italy, Ireland, Greece, and Spain) are primarily held by German and French banks. So we've got countries with massive and unsustainable debt burdens on one side while we've got countries who hold those debts on the other side.

The problem for the PIIGS is that if they were to leave the Euro and devalue, their debts would remain denominated in Euros. So if Spain were to leave the Euro and return to Pesetas, the drop in the value of the Peseta would mean that the real debt burden for Spain would go up. If the Peseta dropped 50% overnight vs the Euro, that'd imply a 100% increase in the real debt burden for Spain. In other words, there's really nothing Spain can do to relieve its debt burden. However, some people would argue about the merits of austerity and say that the austerity taken up in these countries can fix their problems. This is nonsense.

The Question of Austerity:
AUSTERITY IS NOT THE PROBLEM OR THE SOLUTION! These countries are stuck in a situation where there is absolutely no demand for goods and services in the country. The reason the fiscal deficits in these countries are so large is primarily because the falling demand is putting a massive downward pressure on tax revenues. Trying to fix Europe's problems by trying to cut deficits is useless because deficit cutting reduces the turnover of money (and thus aggregate demand) in the private sector. The austerity proponents would argue that countries like the UK and (to a lesser extent) the US have been able to deal with austerity and they've been just fine. Of course, they completely miss that the US and the UK are sovereign currency issuers. In other words, the US and UK can simply have their central banks expand their balance sheets in order to prevent a bank run or simply increase the base money supply and provide cash as necessary for the private sector so that there isn't a total collapse in the financial system. None of the countries in Europe can do this and if there is a problem with the financial sector in Europe, they get screwed. Austerity clearly doesn't help reduce the public debt burdens of any of the PIIGS (as shown below).

The European Banking System:
Another major problem in Europe is the banking system. There's been much talk about how bad the situation is with the US banking system and how things were in 2008. Europe's situation is about 1000 times worse. First of all, the European banking system is much larger as a portion of GDP. Secondly, the European banking system is also much more leveraged with much lower capital standards (ex. the bank capital/assets ratio in Germany is 5.5%). The lower capital standards imply that there's less of a cushion for the potential losses of the banking system while the large size of the banking system as a whole imply that the risk of a fall in their assets has more potential downside. In other words, the risk of a loss in bank capital is much greater for the European banking system while the costs of recapitalizing the European banking system would be much greater on the sovereign governments involved.

So what does the European banking system have to do with the creation of the Euro? Well, the creation of the Euro meant that the banking system of all of the European countries effectively came together (monetary union). During the boom period, the spreads between German sovereign debt and the debt of the PIIGS collapsed, as shown in the chart below. In other words, the risk of holding German debt vs the debts of countries like Ireland and Greece was considered to be effectively the same. Also note that in the early to mid 2000's, it was the countries of Portugal, Italy, Ireland, Spain, and Greece that were booming while the German economy was in the doldrums. So we basically had economies that were booming see interest rates collapse which caused liquidity to expand. Naturally, this led to large, unsustainable asset bubbles where capital flew out of the European interior (primarily Germany and France) and into the periphery. During this process, German and French banks ended up acquiring the debts of various sovereign governments in the periphery. In other words, many of the assets of the German and French banks are the sovereign debts or other liabilities of the European periphery.

Note: All of the lines shown above are 10 year bond yield spreads between the PIIGS and Germany where Portugal is dark blue, Italy is brown, Ireland is green, Greece is purple, and Spain is light blue/turquoise.

Remember how I earlier stated that the debt burdens of the PIIGS are getting larger and larger while the budget cuts are having little effect on the debts and deficits of these countries. I do not think there's a way out for any of these countries unless a good portion of these debts are written down and the losses are taken. The problem is that while a debt restructuring would help the PIIGS, the holders of the assets of the PIIGS (primarily German and French banks) would be hurt more than anyone else. Also note that credit has effectively been socialized (ex. deposit insurance), which means that the losses of the banks of Germany and France are effectively the losses of the sovereign governments. So a debt restructuring (or even the PIIGS leaving the Euro) for the PIIGS would force Germany and France into recapitalizing their banking systems--a loss that will eventually show up in the debts of those sovereigns in one form or another. The cost of a default/devaluation of the PIIGS would end up being borne by the rest of the countries who remain in the Euro.

Also note that if the PIIGS started to leave the Euro, we'd likely see a strengthening of the Euro as all of the weaker countries drop out. In other words, the Euro will strengthen while newly issued currencies like the Peseta and Drachma would fall. It's important to notice that a Euro strengthening in such a scenario would imply that the real debt burdens of the PIIGS would soar much higher than expected.

Asset Bubbles in Northern Europe:
There's also a problem of asset bubbles in Europe. Countries like France, the Netherlands, the UK, along with Finland and a few other countries currently have asset bubbles as price/rent ratios (chart shown below) have surged and house prices haven't come back down to sustainable levels. Once house prices and private debts (in nominal levels) start to fall, the debt increases that were adding to growth and incomes will start to detract from growth and incomes.

Note: The chart above starts from Q1 of 1996 and goes to Q3 of 2012. The chart is (obviously) taken from The Economist and the app can be found here. A more recent app that details similar statistics can also be found here

In these countries, aggregate demand will start to fall and the fall in incomes will make it more difficult for people in these countries to be able to handle their large debt burdens. Unemployment will rise as tax revenues take a dive while government spending will increase (particularly towards automatic stabilizers). We're likely to see rising unemployment, rising public debts, and falling incomes and aggregate demand in much of Europe over the next 5-10 years. So while the periphery of the Eurozone is currently mired in a depression due to a lack of demand, much of the other half of Europe is stuck with excess capacity fueled by debt. When the excess capacity (asset bubbles) starts to fall, the demand in these regions will take a hit as well. In other words, we're likely to see falling demand in Europe as a whole and the Northern parts of Europe will end up with a major correction in asset markets. The falling capacity will worsen the demand problem in all of Europe since falling capacity and rising unemployment will imply less income, and thus demand, for all of Europe.

The Question of Germany:
When people talk about the positive aspects of Europe, they bring up Germany. Often, the argument goes that Germany is fiscally responsible and that Germany, by itself, can completely save all of Europe. This argument is complete bullshit. Germany has >80% government debt/GDP while the German banking system holds less capital than the US banking system, the assets of the German banking system are highly questionable with regards to their quality, and the German banking system is also much larger (with respect to income and production) than the banking system in the US. If we add in the cost of recapitalizing the German banking system into Germany's government debt, Germany's national debt could already be larger than the US by that single addition alone. Also note that Germany's track record of fiscal responsibility doesn't have very much behind it, particularly considering that Germany has defaulted on its own debt twice in the past 100 years.

Remember when I said that if the PIIGS left the Euro, the Euro would strengthen. Well, that's a very important point because Germany has been the largest benefactor of the Euro since its inception. The trade disadvantages of the PIIGS really ended up as trade advantages for Germany as Germany was working with an undervalued currency. When the PIIGS leave the Euro (they will end up leaving the Euro or suffer at least another 5-10 years of extremely high unemployment), they'll effectively force much of their unemployment towards Germany as Germany will end up losing its trade advantage from the Euro. So not only will Germany's banking system be on the hook for the losses on its debt ownership of the PIIGS, but Germany will also lose its trade advantages as the unemployment will eventually rise. The drop in capacity and rise in unemployment in Germany will decrease German demand and tax revenues while the German deficits and debt continue to increase. Germany is not, and will not, be the savior of Europe. The reality shows that Germany is one of the sickest countries in Europe, but the sickness is being hidden.

European Demographics:
In the developed world, we're starting to see population decline and Europe isn't the exception. Fertility rates in most of the European countries (particularly Western and Northern Europe) have plunged over the past 40 years. In almost all cases, the fertility rates are below 1.6 and, in some cases, have been <1.6 for over 40 years (a graph of European fertility rates is shown below). With the exception of the Scadinavian countries and a few others, most of Europe is in population decline. Obviously, less people means less future productive capacity and less people working. Also note that the worsening European population demography implies rising dependency rates as the elderly portion of the population surges relative while the population workforce size starts to fall. The falling dependency ratio implies less future growth and lower debt capacity for every single one of these countries. Also note that entitlement systems in many of these countries tend to be rather generous which just implies either higher future costs for a smaller workforce to bear or less benefits for future retirees from the governments.
Note: The chart shown above is the total fertility rate for selected European countries over the past 40 years. This data comes from the world bank and can be found here.

When I look at the economic factors and combine all of the upcoming hurdles of Europe, I find it difficult to find any solution other than massive debt writedowns. Even writing down all the debts will not fix Europe's problems and there is no real way against future pain. Since around the 17th century to until 50-60 years ago, the European powers were the ones to really rule the world. Now, those same European powers find themselves in secular decline and there's no real easy way out. The pain has to be taken and there's a good chance that European living standards could even drop over the next few decades. The current levels of (both public and private) debt in Europe also make war a realistic possibility, which would further weaken the geopolitical power of these countries.

The real problem in Europe has been the ideology that runs these countries. In many of these countries, the left side effectively consists of hardline self-described socialists on the left while the other side consists of fascists or similar ideologies. We see this political fault line starting to develop or already have developed in many European countries (ex. Front National in France, Golden Dawn in Greece). Over the next few decades, we're likely to see Europe lose power and influence on the world stage while there's a realistic chance of rapidly dropping living standards in these countries.

In the end, I believe the only solution is to completely wipe out the debts and start from scratch. I don't really see an easy way out and there's an increasing risk of Europe breaking into war (I'm NOT saying Europe will go to war, I'm just saying that the risk exists and the risk is getting larger and will continue to do so if this can-kicking continues). Unfortunately, there aren't any easy solutions or quick fixes for these countries.

1 comment:

  1. I believe the late Charles P. Kindleberger might argue that Germany is failing to act as the provider of "hegemonic stability" in the European Union. As a result, much of what Daniel Ellsberg would term as "ambiguity aversion" is manifesting itself quite nastily in the Euro Zone. I also agree with the historical parallel between the Euro and the Gold Standard in the Interwar Period in the 20th Century.