"Europe Agonistes"

Sydney M. Williams

Thought of the Day

“Europe Agonistes”

November 15, 2011

The usual explanation for the struggle in Europe is that it was based on a common monetary system put in place without fiscal or political authorities or considerations. The fate of the Euro seems predetermined, absent addressing those other two factors. But at its essence, and the lesson for the United States (which does have political, fiscal and monetary authority), it is a struggle about the survivability of the massive social welfare states that grew from the ashes of a war-torn Europe sixty-six years ago.

According to J.P. Morgan strategist, Ken Landon, government spending, as a percentage of GDP, among the seventeen countries that constitute the Euro Zone is around 50%. With fully half of all economic activity passing through government, the financing needs of those states are enormous. Corporate and income taxes are levied, as one would expect. But, to pay for the benefits these countries have so generously ladled out, all of these countries use some version of a value added tax (VAT) – a euphemism for a sales tax. The VAT in those seventeen countries ranges from 15% in Cyprus and Luxembourg to 23% in Finland, Greece and Portugal. The VAT in most countries falls between 19% and 21%. Any sales tax, by whatever name one chooses to call it, is regressive, and it is rare, as we all know from our state sales taxes, for such a tax, once instituted, to be lowered or eliminated.

In 1945 Europe was devastated. Excluding the Soviet Union, more than twenty million Europeans were killed. Buildings, roads and bridges were destroyed. It is no surprise, after the two world wars, that Europeans would forego military arms and concentrate on building socialist states. For the three decades following the War, demographics worked – a large workforce supported a small number of retirees. An idyllic world was achieved – short work days, enough money to live comfortably, and early and easy retirement. No one bothered to compute the costs as demographics shifted and obligations mounted. Today, 20 percent of Italy’s population is over 65, and Italian women have on average 1.2 children. Italy’s population is both aging and shrinking.

Can Europe be saved without enormous dislocations? Analysts and commentators with far more expertise than I have published myriad articles on the Euro Zone, reflecting virtually all views on its potential success or failure. Their lack of consensus suggests nobody knows. Nevertheless, my read is that most people continue to be too optimistic as to the Euro’s survivability.

In his weekly market comment, John Hussman of the Hussman Funds notes that leverage ratios for most European banks exceed 40-to-1. Whether that is accurate or not, the price of many southern European country bonds suggest that a 50% write down, for example, of Greek debt has been inadequate. Ditto for Italian bonds. Italy’s government debt amounts to about $2.5 trillion (120% of GDP and the 3rd highest in the world), most of which is held in Italy. Have Italian banks sufficiently marked to market their country bond holdings? With three of the largest Italian financial institutions (Generali Group, Intesa Sanpaolo Bank and UniCredit Group) holding combined assets greater than the GDP of Italy, the question is not just academic.

But markets, as we all know, are discounting mechanisms. Markets and economies do not always move hand-in-hand. Over the past ten years, since shortly after the advent of the Euro, the Euro Stoxx 50 has declined 40%. Granted, prices ten years ago were elevated because of the tech/internet bubble, but even so, some discounting has to have been going on. The Index is down 22% over the past twelve months. Whenever you hear a market or economic seer speak of a lost decade to come, ask them about the lost decade we have left behind.

There are lessons in Europe’s “Appointment in Samarra” for the United States, lessons whose clarion calls we appear to be ignoring. For the forty years ending 2008, U.S. federal government spending, as a percent of GDP ranged from 18.2% in 2001 to 23.5% in 1983, when defense spending accelerated; outlays, over that time, averaged 20.5%. Receipts during those years ranged from 14.9% in 2010 to 20.6% in 2000 and averaged 18%. (For those who keep track of data like this, in 2007, four years after the Bush tax cuts of 2003, tax receipts rose to 18.5% of GDP from 16.2%. During those four years GDP rose cumulatively 14 percent, so tax revenues increased about 28%. Spending during those four years grew in line with GDP growth.) What concerns fiscal conservatives is that spending over the past three years implies a far bigger role for government going forward.

While we await the recommendations of the Super Committee on deficit reduction – the third such committee in the past year – questions come to mind: Congress needs to ask: How big do we want government to be? What do we want it to provide? If more entitlements, like the Affordable Care Act, are wanted, then a lot more revenues will have to be found. Questions need to be asked regarding the scoring of proposed legislation by the Congressional Budget Office (CBO). The CBO uses static accounting; in other words they assume that any proposed legislation will have no affect on people’s behavior. While allowing for behavioral changes could foster the fudging of results, both parties could express their version of any expected consequences. Additionally, the art of behavioral economics has greatly improved over the past several years.

In the past decade, the study of behavioral economics has gone from the margins of academia to the mainstream. In 2002, the psychologist Daniel Kahneman won the Nobel Prize in Economics. Economic professors, Richard Thaler and Cass Sunstein (who worked with Peter Orzag in the White House) authored the best seller Nudge in 2008. There are those, like Peter Orzag who practice a form of activist behavioral economics – economists who push people toward outcomes they have predetermined are in their or the country’s best interest. But there are also those like Malcolm Gladwell (Blink, in 2011) and Steven Levitt (Freakonomics, in 2005 and Super Freakonomics, in 2009) who simply demonstrate how people react to changing conditions, or different stimuli. Regardless, the time has come for the CBO to provide at least two scores regarding pending legislation – the current static response, and another based on probable changes in behavior. Pretending that changing the tax code or removing a regulatory barrier will have no consequences is absurd. We may not be able to accurately forecast what the effects will be, but Physics 101 teaches us that for every action there is an equal and opposite reaction.

Europe’s latest response has been to replace democratically elected leaders in Greece and Italy with “technocrats” appointed by the Presidents of the respective countries. (Presidents’ duties in Italy and Greece are largely ceremonial and are elected by the country’s parliaments.) Lucas Papademos, a central banker, has been asked to lead Greece, while Mario Monti, a former European Commissioner, will do the same in Italy. Their jobs are to restore confidence and implement austerity measures. However, there remain a number of unanswered questions. Will Italians, Greeks, Spaniards, Portuguese and even the French willingly give up their way of life? Would austerity measures simply make a tough economic environment worse? Can the authorities in these states address the culture of tax avoidance? Will banks address their balance sheet needs? How long will the people willingly accept a government that was not freely elected? Will riots in the street require a police-style response?

Europe’s struggles will continue. And, unfortunately for us, what happens in Europe will not stay in Europe.