May 15, 2010

By John Mauldin

Europe Throws a Hail Mary Pass

In a 1975 playoff game, the Dallas Cowboys were nearly out of time and facing elimination from the playoffs, down 14-10 against a very good Minnesota Vikings team. The Cowboys future Hall of Fame quarterback Roger Staubach had no very good options. He later said he dropped back to pass, closed his eyes and, as a good Catholic, said a Hail Mary and threw the ball as far as he could. Wide receiver Drew Pearson had to come back for the ball and, in a very controversial play, managed to catch the ball on his hip and stumble into the end zone. Angry Vikings fans threw trash onto the field, and one threw a whiskey bottle that knocked a referee out. After that play, all last-minute desperation passes became known as Hail Mary passes. (That was a very thrilling game to watch!)

And that is what Europe did last weekend. They threw a Hail Mary pass in an attempt to avoid the loss of the eurozone. Jean-Claude Trichet blinked. Merkel capitulated. Today we consider what the consequences of this new European-styled TARP will be for Europe and the world. We do live in interesting times.

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Europe Throws a Hail Mary Pass
On Thursday of last week Jean-Claude Trichet, president of the European Central Bank, said three times “Non! Non! Non!” when asked in a press conference if the ECB would consider buying Greek bonds. His exclamation was accompanied by a forceful lecture on the need for eurozone countries to get their fiscal houses in order, some of which I quoted in last week’s letter. Trichet was remonstrating about the need for the ECB to remain independent, and was rather definite about it.

Then on Sunday he said, in effect, “Mais oui! Bring me your Greek bonds and we will buy them.” What happened in just three days?

Basically, the leaders of Europe marched to the edge of the abyss, looked over, decided it was a long way down, and did an about-face. It was no small move, as they shoved almost $1 trillion onto the table in an “all-in” bet.

Bailing out Greece is very unpopular in Germany. So why did Chancellor Merkel agree to do so? This is the story that has come out in the last few days.

“French President Nicolas Sarkozy threatened to pull out of the euro unless German Chancellor Angela Merkel agreed to back the European Union bailout plan at a summit last week in Brussels, El Pais newspaper said.

“According to El Pais, which didn’t say how it obtained the information, Spanish Prime Minister Jose Luis Rodriguez Zapatero said (in a private meeting of his Socialist politicians) that Sarkozy demanded ‘the commitment of everyone, that everyone should help Greece, everyone according to their means, or France would reconsider the situation of the euro.’

“Sarkozy banged his fist on the table and threatened to quit the euro, which forced Merkel to cave in, Zapatero told the Spanish politicians, according to the El Pais account.

” ‘If at this point, given how it’s falling, Europe isn’t capable of making a united response, then there is no point to the euro,’ the newspaper quoted the French President as saying.

“It wouldn’t be the first time Sarkozy linked the fate of the euro to a willingness to support Greece. On March 7, before meeting Greek Prime Minister George Papandreou in Paris, Sarkozy said: ‘If we created the euro, we cannot let a country in the eurozone fall. Otherwise there was no point in creating the euro. We must support Greece because they are making an effort.” (Bloomberg)


I find this interesting when I compare it to the analysis from my friends at Stratfor:

“Germany now senses the opportunity to reform the eurozone so that similar crises do not happen again. For starters, this will likely mean entrenching the European Central Bank’s ability to intervene in government debt as a long-term solution to Europe’s mounting fiscal problems. It will also mean establishing German-designed European institutions capable of monitoring national budgets and punishing profligate spenders in the future. Whether these institutions will work in the long term – or fail as attempts to enforce Europe’s rules on deficit levels and government debt have in the past – remains to be seen. But from Germany’s perspective, they must.”

Well, at least France and Germany are not looking at each other over the Maginot Line. But it is the age old-struggle: who will lead?

There are so many implications of this latest action, it is hard to know where to begin.

“What is the plan? First, European governments have committed e500bn (e440bn in loan guarantees to eurozone members in difficulties, and a e60bn increase in a balance of payments facility). Second, the International Monetary Fund will, it appears, put up an additional e250bn ($320bn, f215bn). Third, the European Central Bank has, to the chagrin of Axel Weber, president of the Bundesbank, decided to purchase the bonds of members under attack. Finally, the US Federal Reserve has reopened swap lines, to provide foreign banks with access to dollar funding. This is a panic-driven response to market panic. It reminds us of the autumn of 2008.” (Martin Wolf,

Above all, this is a move to buy time. There is enough in this fund to purchase all the expected debt of Greece, Portugal, and Spain for three years. The money could actually last a lot longer, as Spain might not need to tap the fund for some time.

There were clearly some other quid pro quos that came out of this weekend. Both Spain and Portugal announced new austerity moves, which will help them get back below the 3% deficit limit mandated by the Maastricht Treaty within (they hope) a few years. It was the usual combination of tax increases, some budget cuts, and across-the-board pay cuts for government workers. These are very left-wing socialist governments, and their announcements were not popular with their followers or the unions. But they are enacting these cuts before a durable recovery has come about. They are committing themselves to a very rough road.

But it is not just the PIIGS countries that are out of compliance in Europe. Look at the following chart from Note that France has a budget deficit of over 8%. There are going to have to be austerity measures enacted all over Europe.



Notice that Ireland has the largest deficit, at 14.7%. This is in spite of (or more aptly because of) the enactment of severe austerity measures, far beyond what Greece, Portugal, and Spain have contemplated. And what has that gotten them? An economy that has shrunk by almost 17% in the last two years, 14% unemployment, and a country in the grip of outright deflation. Property prices have fallen by 34% and are still falling. Their banks are in shambles.

And their debt-to-GDP is rising, because even as they borrow their GDP is falling. It is hard to cut that ratio when GDP is falling. If GDP falls 20%, then the debt-to-GDP ratio rises by 25%. And that means your interest-rate costs are an ever bigger chunk of your tax revenues.

Let’s be clear. These austerity measures are not growth plans. They are not designed to help countries grow their way out of the problem. There is no reason to think that if Greece enacts the measures that have been proposed, that what happened to Ireland will not happen to them. It almost certainly will. Credible estimates I have seen suggest that the Club Med countries will see their GDP drop at least 4% this year.

It is not just the PIIGS. All of Europe will be making cuts. And in the short term that is going to be a drag on growth and a headwind for the euro.

It’s More Than Just Government Debt
A recent study by Portuguese economist Ricardo Cabral [2] shows that the PIIGS have even deeper problems. With the exception of Italy, they have a large percentage of their debt owned by foreigners. (http://voxeu.org/index.php?q=node/5008 [3])

“Greece, for example, has approximately 79% of government gross debt held by non-residents and has a net international investment position of -82.2% of GDP. Interest payments on public debt represented nearly 40% of Greece’s already large 2009 budget deficit – and this is set to increase.”

These interest payments leave the country, making their already bad trade imbalances even worse. And the taxes that might be paid on the interest go to other countries, too.

Cabral looks at the average external debt during 16 debt crises over the past 30 years. On average, Greece, Spain, and Portugal are now 30% worse off than these other countries when they went into crisis and restructured debt.

Cabral notes (as I have done in past letters) that there are no good choices. Continuing to increase debt owed to foreign creditors just digs a deeper hole that they must dig out of. His conclusion is that some sort of debt restructuring will ultimately be required.

Martin Wolf writes this week of the problems facing the eurozone:

“… the story of the eurozone economy has, in consequence, been one of divergence, not convergence. The rough external balance masked the emergence of countries with huge current account surpluses and corresponding exports of capital, notably Germany, and of others with the opposite condition, notably Spain. In countries with weak domestic demand and low inflation, real interest rates were high; in countries with strong demand and higher inflation, the reverse was true. The result is not just huge fiscal deficits, now that private-sector spending has collapsed, but a need to regain lost competitiveness. But, inside the eurozone, this is possible only with falling wages, higher productivity growth than in Germany (and so soaring unemployment), or both.”

Take a look at the charts below from his column. The PIIGS have much higher labor costs per unit of production than Germany, as much as 50% higher! Germany runs large trade surpluses while the Club Med countries have large trade deficits.

A country may want to reduce its government debt, its businesses and individuals may want to reduce their debt, and they might like to run a trade deficit. However, the rules of accounting are such that you can only do two of the three.

The reality is that the coming austerity measures are going to reduce the ability of the PIIGS to buy products from outside their countries. Germany’s surplus will thereby suffer.



Let’s look at yet another set of graphs from to get a handle on the problem facing these countries. Their unemployment is already high and is going to get worse. They are not enacting pro-growth policies. Spain, for instance, has a rule that a company must pay a one-month severance fee for each year an employee has worked. Thus, if you have worked for ten years, you get a ten-month severance allowance if you are laid off. What that does is discourage new employment, and it means that newer workers are laid off first. That is one of the reason Spain has such a high unemployment rate among young people.



The Grand Misallocation
What this Euro-TARP does is take money from mostly good credit and give it to weak credit. It will crowd out private savings that go into private enterprise (which is where jobs come from) and put it to unproductive uses in the government debt of weak countries.

There are only two ways to grow an economy: you can grow your population or you can increase productivity. That’s it. The Club Med countries are not growing their populations appreciably, as their birth rates are low. And you increase productivity by investing private capital into businesses, the way the Germans have done, which is why their labor unit costs are so low compared to their competition.

Euro-TARP almost mandates that capital be misallocated into non-productivity-enhancing government programs and debt.

Europe is run by Keynesians (as is the US). They see everything as a liquidity problem. And sometimes it is. But the PIIGS have a debt problem. And you don’t cure a debt problem with more debt unless you have a clear path to grow your way out of the debt. But as I have demonstrated, there is no clear path to growth with the current policies. They will produce deflationary recessions, lower government tax receipts from reduced GDP, and higher unemployment.

At the end of the day, Greece will just have more debt. Perhaps Spain and Portugal can work through their problems, but that will be very difficult and will involve considerable economic pain. Italy can succeed if it decides to.

This new program simply buys time to try and figure things out. It is Germany saying, “Ok, I give you 3-4 years. But don’t come back asking for more.”

All this does is bridge to the middle of the decade, when the truly massive health and pension promises made all over Europe must be dealt with. The US has the option of raising taxes, reducing benefits, and means testing, should we so choose to do so to meet the demands of entitlement problems. Europe already has tax rates that are high and growth-inhibiting. The entitlement problems in many countries are more onerous, and their working populations are not growing.

This is just the beginning of their woes. They have a long way to go and a short time to get there. Can it be done? Yes, of course. But it is going to require a great deal of change. I hope they pull it off, I really do. I have been to most of Europe and love every bit I have seen. The world is better off with a united Europe.

That being said, I have my doubts that the European Union in its current form will exist in 5-7 years. I hope I am wrong.

One implication. The euro is on its way to parity with the dollar. So is the pound. That is going to help their exports vis-a-vis the US. Watch the yen fall rather sharply over the next few years. Senators Schumer and Graham gripe about China. What are they going to say about Europe, Britain, and Japan, all of which are on course to premeditated devaluation? This is going to be just one more challenge for businesses in countries with the world’s stronger currencies.

Another side bet? The ECB says it will sterilize those government bonds it buys (meaning, it will make sure it does not add to the money supply). My bet is that when deflation starts to run throughout Europe, the ECB will decide that maybe not so much sterilization is required after all.

New York, LA, and Italy
As I noted above, I have cleared my schedule to be at the Agora Financial Conference in Vancouver, July 19-23. They have a truly great line-up of speakers. I suggest you go to http://agorafinancial.com/vancouver2010/ [4] and look at the program and then go ahead and register.

This week, I had to lay over in Montreal due to bad weather in Chicago, which meant I had to get up at 2:45 am to make a flight to get me back to Dallas in time for a speech. Ugh. I am fairly used to travel, but I make a point not to push it. My body just needs my 8 hours’ sleep, and sadly I can’t sleep on planes, unlike Dennis Gartman, who can sleep anywhere. It really kicked my butt.

On Monday I fly to New York for a day, then two nights in Stamford, Connecticut, speaking to Pitney Bowes execs. I am looking forward to Monday night, when I get to have dinner with Art Cashin, Greg Weldon, and Cliff Draughn (coming up from Savannah) – we’ll hash over the problems of the world.

Then it’s a quick trip to LA the following week, to meet with a team of people who are helping us redesign our websites and services to you, gentle reader. We are in for a major upgrade and I think you are really going to like it.

And then home, where I will stay until June 3, when the whole family (seven kids and spouses, grand-babies) takes a two-week vacation to Italy. I am going to stay over and speak at the Global Interdependence Center Conference in Paris, June 17th and 18th, with my good friend (and euro-bull) David Kotok and other luminaries. There will be a lot of central banker types, and if you want to get a feel for what’s happening in Europe you should come. Information is at www.interdependence.org [5].

We have been planning (or Tiffani has) for the Italy trip. I really can’t wait, as it’s going to be a ton of fun. Thanks for all the suggestions as to where to go and what to see and where to eat! It has been over 25 years since I was in Italy, and that was just a few days in Rome and Venice. This time it’s two full weeks, with a week in Rome and Venice and then a week in Tuscany, then to Paris, and then back to Tuscany and Milan. And since we decided to go, the euro has fallen 25%. That helps a lot! I used miles to take everyone, but hotels are a real expense. Every little bit helps.

It is once again late and time to hit the send button. Enjoy your week.

Your still recovering from an early morning analyst,


John Mauldin