"Europe - The Emperor's New Clothes"

Sydney M. Williams

Thought of the Day

“Europe – The Emperor’s New Clothes”

November 30, 2011

“Europe should leave the European Union.” So concluded Private Eye, the British satirical weekly, as reported in Monday’s New York Times. Or, put another way, in looking at Europe (or the United States Congress, for that matter) one could paraphrase Oscar Wilde: It is the hypocritical in defense of the irresponsible. The Euro cannot work without a common fiscal authority, which will require greater political union. Greece will have to default, yet the banks are not willing to write the loans down. Perhaps the December 9th European Summit will see progress in that regard, but we have been down the road toward hope before. Europe’s leaders are finding it difficult to admit what others can see. Boldness is needed. Timidity is being offered.

The concept of unified Europe makes sense. After all, the combined economies of the 27 states that comprise the European Union represent the world’s largest economy. The 17 nations that use the Euro represent the world’s second largest economy, a little less than the U.S and about 70% of the EU’s economy. What happens in Europe does impact the global economy. On Monday, the Organization for Economic and Co-operation Development (OECD) lowered their expectation for world growth from 4.6% in May to 3.4%, with most of the decline attributed to Europe (0.2% from 2.0%) and the U.S. where the forecast is now for 2.0% versus 3.1% in May.

The dilemma confronting the peoples of Europe is not unlike the situation in this country when, following the Declaration of Independence, the thirteen founding states were loosely organized under the Articles of Confederation. The Articles were drafted in 1776-7, ratified in 1781 and then replaced in 1789 with the Constitution. The Articles proved impractical as they did not provide for a centralized federal taxing authority, nor did they allow for a strong executive or a national judicial system. The states were suspicious of one another, especially between the commercial/trading north and the agrarian south. But, they had in common a legal system based on English common law, and a common language and heritage. While more than fifty languages were spoken in Pennsylvania in 1781, most of the people, at that time, could trace their roots to the British Isles. In spite of forging a centralized fiscal and political system, it wasn’t until 1863, in the midst of the Civil War, that a unified currency emerged. Two years later, in 1865, state bank notes were finally taxed out of existence.

The world today is far more complex and interrelated than it was two hundred years ago. Derivative instruments have permitted more precise hedging strategies that have diminished risk on the one hand, but those hedges have been offset by the increase use of leverage, with German banks allegedly levered 40:1. Additionally and perhaps more important, the differences between individual European states overwhelm their common needs. Their heritages reach back, in the case of the Mediterranean nations, more than two thousand years. The legal systems of the individual countries are different. For example, how will German courts adjudicate Greek bonds issued under Greek law, but held in German banks? While English has become the common language of business in Europe, it is not native to the 17 Euro Zone members.

In the end, the determination as to the future of the Euro must be tied to the outlook for economic growth. How best can their economies grow? For example, the Euro has benefited the Germans in providing them a currency that is cheaper than the Deutsch Mark would have been, while the Greeks are saddled with the same currency, but one that is more expensive than the Drachma would have been. German exports over the past decade have grown from just over one quarter of their GDP to just under fifty percent.

The possibility of a breakup of the Euro, and its implications, are being given serious consideration. On Monday, with one eye (or perhaps both eyes?) on next year’s election, President Obama met with European Council President Herman Van Rompuy and European Commission President Jose Manuel Barroso. Speaking of the debt situation in Europe, he said, “This is of huge importance to our economy.” “If Europe is contracting or if Europe is having difficulties, then it is much more difficult for us to create jobs at home.” Let’s hope that does not mean he will encourage the IMF to step up their loan guarantees to Europe, for that would be tantamount to the U.S. bailing out Europe. Yesterday, the Wall Street Journal reported that the U.K. Financial Services Authority “advised banks to make contingency plans.” Germany’s credit is considered impeccable, thus their inability to sell a full complement of 10-Year Bonds last week suggests the market is becoming wary of currency risk. Since early June, the Euro has declined 9% versus the Dollar.

European banks have used low-cost borrowings from the European Central Bank (ECB) to buy Sovereigns, which were considered risk-free, so were levered. As reality is beginning to sink in that Greek bonds are perhaps worth twenty-five to thirty-five cents on the dollar (and Italian, Spanish and Portuguese bonds are worth less than par), the banks want the ECB to buy the bonds back, something their charter would disallow. The ECB may try to circumvent its charter by lending to the IMF, but that road, as mentioned above, has risky implications for the U.S. It would have to print money, an anathema to Germany whose long memory has never forgotten the inflation of the post World War I Weimar Republic. If they don’t do so, banks will have to take the hit of writing down their Sovereign assets – a catch 22 situation.

It seems inevitable that the Euro is doomed. Niall Ferguson, professor of history at Harvard has long been a Euro skeptic, suggesting more than a year ago that it could not survive. The fear is that its collapse would create chaos. Currency unions have broken up before, “but,” as the Journal reported yesterday, “none with such complex inter-linkages both between countries and between governments and banks.” John Hussman, of Hussman funds, in a recent note, proposed that individual countries could issue bonds in Euros, but that are convertible into their legacy currencies. If they solve their problems, no conversion would be necessary. On the other hand, should they exit the system, it could be done without jeopardizing the system. When the United States went to a single currency, states and banks continued to issue their respective currencies for two years.

My guess is that the Euro cannot survive without a central political and fiscal structure, neither of which seems likely given the myriad cultures, languages and legal systems. Perhaps the summit meeting in Brussels on December 9th, at which the proposed European Monetary Fund will be highlighted, will provide promise. But, absent a politician with the courage and charisma of a Thatcher or a Reagan, it seems to me a mountain too high.

Why no one can forecast what would happen should the Euro Zone break up, my guess is that if it were done with advanced warning and with dual systems operating for a period of time it would be less painful than the Cassandra’s are predicting. It would require a bold leader with a clear agenda for growth. Man is capable of far more than people think. The men and women of the “Greatest Generation” were no different from people today. They lived during a time when great feats were required, and they responded with great bravery and determination; as people have always done throughout history. Those same characteristics, I am sure, are true of people today. Markets look through disruptions, when they sense that difficult decisions have been made in the long term interests of investors. Markets, though, are nervous and would likely react to any announcement of a breakup, but the transition may be less difficult, in my opinion.

With the introduction of the Euro a dozen years ago, the Germans rationalized their economy, while the Mediterranean nations largely saw the Euro as a vehicle that lowered their costs of borrowing, allowing them to continue living beyond their means. Today, the Greeks are bankrupt, and Europe has not yet admitted that fact. The situation cannot be resolved easily, but it increasingly seems likely that any answer is going to include some sort of a breakup of the Euro.