The Mario Bros and the Euro Savings Reality

What a lot of news lately - I was thinking recently that it's almost like watching a soap opera gone badly astray from the original plot!  So in this posting I want to pull together some thoughts on the European situation.

I am doing this because I am frankly tired of reading some of the "doom and gloom" commentaries that other (mostly "glitterati") economists are producing.  Roubini's comments (see here) on Italy potentially leaving the euro area were simply over the top and illustrate that some economists simply don't understand the European project (despite the fact that Roubini is from Italy) or appreciate optimal currency area theory.  And Roubini wasn't alone - just read Krugman's (here), Martin Wolf (here) and even George Soros (here).  This alarmist reaction to what is going on in Europe is not only unhelpful but (as noted by one response to Roubini's commentary) it is alarmist and almost hysterical.  Let's not forget that Italy has a very high savings rate compared to many countries and given the economic downturn their savings rate is likely higher than where it was back in 2009 when it stood at 14% of GDP. So the run up in Italian bond yields is not something to worry about, and this was amply illustrated when the market realized this and quickly shifted it's attention over to Spain when the latest auction of Italian bonds was successful. Italy is definitely not Greece, and Italy's debt, as I recall, was 112% of GDP when they joined the euro area back in 1999, so why should there suddenly be a "crisis" when Italy's debt to GDP ratio is now 118%? 

Here are the national savings rates for various countries as of 2007:

Economics also backs this up, in the form of analysis of savings and investment, along with the funding of public sector debt. Countries that have high domestic savings rates (like Japan, for example), have no trouble funding extremely large public (and private) debts. Countries like the US with relatively low savings rates have  much more reliance on external funding of their public debt, and therefore the international bond markets. Obviously the higher the debt and the lower the national savings rate (as well as other factors such as whether the country has defaulted before, as pointed out by Rheinhart and Rogoff), the more likely it is that difficulties will occur in funding debt. So where does this put Italy? Italy's savings rate is one of the highest in Europe, and although it has been falling, it is still a sizeable chunk of GDP, so that it is unlikely that the Italian government would ever default. Add to that the fact that Burlesconi is gone and has been replaced by a "technocrat" economist (Mario Monti) who was previously an EU Commissioner, with Monti having a cabinet of no less than 7 professors, and the fact that the new ECB President is an Italian (Mario Draghi) and I think you have the recipe for losing a lot of money in the bond markets if you take a bet that interests rates on Italian bonds will stay high.  Indeed, as I didn't manage to get this post up before leaving the US for Africa I have managed to get an overnight 15% return on my bet on Italian bond yields coming down by using the ETN ITLT.

But the main message I want to get across on Europe is that the euro is NOT going away anytime soon, as some commentators seem to think. Although member states should be free to, or forced to leave, Germany, France, Austria, Italy, the Netherlands, Belgium, Luxembourg and Finland do not seem to be pulling apart economically speaking, and if push comes to shove the ECB is not going to allow bond "vigilantes" to threaten its very existence. Collapse, in my opinion, is unimaginable in the current circumstances - but crisis and default are not. The Economist's commentary on Germany's rigidity (here) in seeking solutions to the euro area's problems was instructive but failed to point out that Germany has benefitted from the euro as if it had continued to adopt the Deutschmark it's exchange rate would likely have been higher than current levels of the euro and so their economy has been given a boost through their export sector.

Next post will deal with the perhaps more severe problem of the banking liquidity issue in Europe. 

Is a “Perfect Storm” heading our way?

The NYU economics professor, Nouriel Roubini just went on record in Singapore a few days ago about his long term prediction for world growth – and it wasn’t wonderful!  According to Bloomberg reporters he said that there was roughly a third chance of a perfect storm in 2013, where China slows down significantly because of lack of consumption and the unwinding of the real estate bubble there, the US also struggles to break free from its current headwinds of mounting debt and the housing malaise to return to historical levels of economic growth and the EU finds itself revisiting the PIGS (Portugal, Ireland, Greece and Spain) debt problems time and time again which slows that continent down as crowding out occurs from increases in interest rates.  According to Roubini by that time Japan would also have exhausted the extra fiscal stimulus given to the economy after the Tsunami from earlier this year, which adds the icing to a cake that clearly has refused to rise to the occasion. 

So what are the other two-thirds of Roubini's probabilities?  The second scenario with a weighting of roughly a third is a resumption to more usual levels of growth is one of them – clearly a soft landing in China, an upturn in growth in the US and better news from Europe plus a more permanent boost in growth in Japan could all combine to move things along faster than the pessimists expect.  And the third scenario with a weighting of a third again is an intermediate “anemic but OK” growth scenario where the factors in the “perfect storm” scenario are much less severe. 

Forecasting the global economy is, I would assert, harder than forecasting the weather.  At least with the weather you know there are going to be seasons – with the economy you don’t have any idea about when these “seasons” are going to occur. There is the “business cycle” of course, but the consensus for the length of the business cycle is anywhere between 3 and now 10 years.  Once you are 3 years beyond the end of the last recession (which ended in June 2009) which means we’re at June 2012, then it’s anyone’s guess when the next recession will occur. At the other extreme we’re pretty sure that something will happen by 2019, as we have never had a period of more than 10 years of uninterrupted economic growth in the US. 

If we look at the gap between recessions though, it has grown since the Second World War, and so the next recession is more likely to be later, rather than earlier. Given this, I would place less probability on Roubini’s “perfect storm” than the other two scenarios he came up with.  Also the rosy scenario is a little too “rosy” for my liking, in that not all policymakers get it right, and particularly in both China and Japan there is not much of a record of getting the correct mix of policies to really optimize economic growth, plus we now know that there is not a lot that policymakers can do once a bubble has really built up in an economy, so the Chinese might really have difficulties dealing with the aftermath of a popping of their property bubble.

So I would disagree with Professor Roubini’s main forecast, which is of a “perfect storm” brewing for 2013, and would predict that we are much more likely to see problems in one part of the world and growth in other parts over the next few years, but that the “perfect storm” in the form of the next recession is some way down the road, and rather unlikely, mainly because of business and growth cycle factors in 2013. My most likely scenario would consist of more of a divergence in growth around the world, which is not to say that I don't believe in an international business cycle, but more because each region of the world has a different focus and different views about the effectiveness of government policies. These perceptions, I believe, in and of themselves can produce different outcomes.

So a more interesting question from an investment standpoint is where there is most potential for a resumption in economic growth.  Although policymakers do not determine economic growth rates, they do, in my view, have a significant impact on setting the appropriate environment for growth to occur. The developing economies in the form of the emerging markets certainly have the most to gain, but if the US gets this mix of fiscal rectitude and continued modest monetary stimulus from the Fed right, then it too will also benefit. Non euro area European countries still have extremely bright prospects and of course the euro area, if it bites the bullet and develops a Euro area bond or decides to let Greece go, could also benefit. I, like several other commentators, am now bearish on China as their economic problems appear to presage a bursting bubble, and Japan, as I have already stated in this blog, might just be the biggest surprise of them all if they can only get their politicians to act sensibly.

Will the Greek crisis end in tragedy?

The glitterati of the economics profession have been out in full force to comment on the Greek crisis, what with Paul Krugman (http://www.nytimes.com/2010/05/07/opinion/07krugman.html?emc=eta1), Greg Mankiw (http://gregmankiw.blogspot.com/), and Nouriel Roubini (http://www.roubini.com/roubini-monitor) wading in to give their opinions.

OK, so things have erupted in Europe with the Greek debacle continuing to unfold - but the main question now revolves around 3 things: first, whether the EU bailout ( - I know Germany is contributing to this, but officially it is an EU initiative) is enough to "plug the dyke" in Greece's public finances; second, whether the EU measures will be enough to stop contagion taking place across Europe thereby threatening the euro area; and third whether Greece can remain in the euro area.

I pose these three questions separately on purpose, because as we all know, whether the actual bailout is big enough to stop financial panic is not how financial markets behave - they behave according to fear and irrationality as we saw in the Mexican peso crisis in the 1990s when panic swept across quite a few South American countries that were nowhere near to defaulting on their public debt obligations.  The last question is a matter of politics as well as economics, so I will also address that as it is now on the radar screens thanks to Paul Krugman.

But let's start at the beginning.  In the Maastricht Treaty, which was the original blueprint for the euro area, Article 104 specifies that "Overdraft facilities or any other type of credit facility with the ECB or with the
central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments."  This is known as the "no bailout" clause, and clearly states that the ECB cannot bailout Greece.  But in Article 103a it states that "Where a Member State is in difficulties or is seriously threatened with severe difficulties caused by exceptional occurrences beyond its control, the Council may, acting unanimously on a proposal from the Commission, grant, under certain conditions, Community financial assistance to the Member State concerned." 

So that is what is happening this weekend - the euro area finance ministers are huddled together to hammer out an agreement to effectively lend Greece €110bn through "Community financial assistance" over what is rumoured to be a 3 year period.  At the same time the Greek government has put in place austerity measures to try to reduce it's budget deficit, hence the riots in Athens.  But today there are also signs that the Finance ministers want to "ring fence" the Greek problem by providing an enhanced (€110bn) fund to get Greece, Portugal and Spain through what was the €60bn emergency facility that allowed Latvia, Hungary and Romania to get through their balance of payments difficulties last year.

Let's now go back to the key questions we asked at the beginning.  Is this enough to "plug the dyke" that is the mess with the Greek finances.  The answer is an unequivocal "yes".  First, remember that the Greek economy represents only roughly 3% of the euro area economy.  If you look at the Greek Finance Ministry's last report on public debt (see http://www.mof-glk.gr/en/publications/debt/56.pdf which rather mysteriously ends at the end of last year, and hasn't been updated yet for Q1 2010) you'll see the following chart (click on it to bring up a bigger version), which shows the redemption schedule and term structure of the public debt in Greece. 

As you can see, total Greek public debt at the end of last year was reportedly just under €300bn with only 10% rollover due to take place in 2010, and 50% rollover required more than 5 years away.  So all this talk about debt restructuring, while it will make it easier for Greece in the short term, is nowhere near the order of magnitude that the media is hyping it up to be.  Now I'm not denying that debt in Greece is high, but at 120% of GDP this really is not wholly exceptional - take a look at Japan, which has debt levels approaching 200%.  But the main point to be made is that the €30bn plus to be either paid off or rolled over in 2010 can be funded through EU borrowings, so the amount provided through the EU is definitely sufficient to avoid a default. 

So to the second question - whether this is enough to stop contagion to the other euro area member states.  Of course what the financial markets don't like is surprises, and the public debt figures are higher for Greece than reported above (as some of the debt wasn't reported and was "hidden") so that the figure of €300bn is actually €356bn  - that, in my opinion, is the main reason for the panic - the financial markets cannot trust the Greek government to report the debt figure honestly or accurately.  Is there a similar situation in Portugal and Spain?  No, there isn't.  So although bond yields have spiked for Portuguese and Spanish public debt, the problem is not qualitatively similar to Greece's, so the concern about contagion is overdone in my opinion. 

As an aside, I'm not saying that there is a linear relationship between debt/GDP levels and financial crisis either, as Rogoff commented a few days ago in the FT (see http://www.ft.com/cms/s/0/ecea426c-5877-11df-9921-00144feab49a.html). What matters is that you have not offended the markets recently, and of course a country like Japan (with public debt levels approaching 200% of GDP), even with anemic growth, can still make it's bond payments because of low interest rates due to market confidence. Even a speculator extraordinaire like George Soros doesn't see Greece defaulting on it's sovereign debt. And there is little reason to think that either Portugal or Spain would follow suit even if Greece did.  Of course that doesn't stop speculators speculating on it, and that's exactly what happened at the end of last week (see http://www.ft.com/cms/s/0/c56eeec6-5b4d-11df-85a3-00144feab49a.html).  Incidentally, I think this is exactly the time to start buying EU stocks as clearly the euro will bounce back once this crisis is over - certainly if I had millions of dollars that's what I'd be doing right now!

So the next question, is whether Greece will  leave the euro area.  Krugman even goes as far as to state, after going through 3 options that Greece would have to consider to stay in the euro area, that "What remains seems unthinkable: Greece leaving the euro. But when you’ve ruled out everything else, that’s what’s left."  I think Krugman underestimates the political will of the larger members of the euro area to keep the show on the road.  The EU has always risen to the occasion when crisis hits, and this time will be no exception.  And let's face it, this is not a crisis of confidence in the euro itself, just a crisis of confidence in the economic policies of one of it's member states, Greece, and in the Stability and Growth pact and it's ability to control public debt issuance in profligate euro area member states. 

So Greece, in my opinion, will remain in the euro area but will face some really dark years ahead, particularly if EU growth does not pick up soon.  The main point I would make though is that the EU needs to start thinking a little more strategically about how the institutional structure of its design can weather different economic scenarios rather than what is the most feasible solution from a political standpoint.  The Stability and Growth pact (see my previous post on this blog) is a perfect case in point. 

There will definitely be a period of deep reflection in EU circles after this crisis is over, and hopefully it will lead to some decisive action, otherwise the EU is doomed to lurch from crisis to crisis, making rushed decisions in response to market forces rather than constructing an EU that is resilient in the face of economic shocks and downturns.