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Kyle Bass’ Analysis of the Macro Environment

http://www.youtube.com/watch?v=JUc8-GUC1hY&feature=player_embedded

I appreciate his fact-based thinking. Take the time to listen to his analysis, it’s worth it.

Some quotes:

  • Debt has grown with CAGR of 11% over the last 10 yrs.
  • We sit today at the largest accumulation of peacetime debt in world history
  • You know how this ends right?…..This ends through war…I don’t know between who and who…
  • War is just is just economic intrepid playing out to its logical conclusion….
  • Southern Europe and Japan is going to restructure
  • Social fabric of the world is going to be stretched or thorn within 2-3 yrs
  • But there is a general reluctance to admit we’ll have to go through this

On Germany…

  • The country is much riskier than perceived…
  • Germany defaulted twice last century
  • They have on-balance sheet sovereign debt of 82% of GDP
  • Their banks are 340% of GDP…

Japan:

  • There’s no chance Japan can ever repay its debt
  • Xenofobe society
  • Social security funding debt is the cancer on their income statement
  • more adult diapers sold than kids diapers
  • In the next 2-3 yrs they cannot hang on
  • the 10th finance minister in the last 6 yrs
  • from the Japanese budget plan: the pensions will be financed through future radical reform (!!)
  • they don’t know what to do and don’t know where to go…
  • retail ownership decreases from 5% to 3.5% because population is dissaving..
  • this it how it all ends

Macro Scenario: The Demise of Manufacturing Is the Real Problem of the World Economy

Enjoy and learn from this discussion between Prof. Bruce Greenwald and Richard Koo at the CIGI conference: The Great Recession: Structural and Cyclical Causes

While Richard Koo is sure weak balance sheets are the issue, Greenwald disagrees and further elaborates on his thesis, the underlying problem is the demise of manufacturing.

I am always interested in comprehensive macro scenarios which I can use to test the business model of my investments or clients.

Manufacturers Suffered More from the Crisis Than Debtors

Greenwald, says that balance sheets are the problem in any recession, however now balance sheets are repaired (US, UK) the recession still continues. Evidence shows the countries that suffered most from the worldwide crisis were not the countries with a large bubble (UK, US), but countries with relatively sounds balance sheets.

He mentions:

  • Japan suffered a 7% drop in GDP while Japanese companies had very healthy Balance Sheets (significant negative debt)
  • and Finland (a 13% drop in GDP from 2008-2010, my add.)
  • Natural Resources countries also suffered, like Canada (My add. GDP drop -13%)
  • US (-2%) and the UK (-6%)

Is Manufacturing the new Agriculture?

Greenwald draws the parallel with agriculture. This industry suffered enormous productivity gains and limited increase in worldwide demand.

This same development is now happening in manufacturing.

And growing in a dying industry is an extremely difficult thing to do…

Screen shot 2013-01-06 at 11.19.33 AM

Agriculture as % of GDP development since 1960. I’ve included the countries mentioned. Source: Google, Worldbank. 

Greenwald says: productivity increases annually with 5-7%, however worldwide demand merely grows at best 2-3%. Capital expenditures (robots, technology, software) have come down dramatically the last decade, and so productivity improvements become less capital intensive…

Screen shot 2013-01-06 at 11.25.28 AM Manufacturing as % of GDP development since 1980. I’ve included the countries mentioned. Source: Google, Worldbank. 

Ok, ok what’s new you might ask…manufacturing usually declines as a % of GDP as a country moves up the income ladder and more and more countries move up this ladder…

Well there is something new, remember the earlier post on Greenwald’s thesis? The way out of the crisis and sustaining/increasing employment for manufacturing economies like Germany is selling the production surplus through exports.

However exports are a zero sum game between surplus and deficit countries…

Especially countries with a strong manufacturing base (read: labor unions, industry lobbies) are resisting the decline in jobs and revenues as hard as they can through exports, helped by politicians that aim to keep unemployments at bay.

The Spender of Last Resort Ran Out of Cash!

Now, what changed? Greenwald tells us US households have been eating the world surpluses up to 2008. Unfortunately they cannot finance a net deficit any longer through rising house prices and a zero savings rate. And if there is nobody in the world to eat the net export surpluses of manufacturing countries, the world economy will continue to have problems to grow until manufacturing countries make the explicit choice to change into a more service based economy.

This development has a chronic deflationary pressure on manufactured goods…

So the Remedy is a Focus on Services?

The remedy according to Greenwald is changing the economic structure of manufacturing surplus economies like Germany, China and Japan to focused (non-financial) service sectors like medical care, education. However this takes focus from government and bold decision making (read: confronting labor unions and industry lobbies).

Corroborative Inquiry: McKinsey on Manufacturing

Now all this sounds like a solid storyline from a highly respected (also by me) professor. But can we check some facts?

Very conveniently McKinsey’s Global Institute recently published a report named: Manufacturing the future: The next era of global growth and innovation, full of interesting statistics actually supporting Greenwald’s thesis.

Where McKinsey and Greenwald grow apart is the storyline on the future… So even though McKinsey draws similar conclusions as Greenwald from economic data, their overall conclusion (and productivity growth estimate) sounds less dramatic.

McKinsey explicitly mentions: Manufacturing is entering a dynamic new phase. As a new global consuming class emerges in developing nations, and innovations spark additional demand, global manufacturers will have substantial new opportunities—but in a much more uncertain environment.

Actually this conclusion sounds like manufacturing is set for a new growth spurt….not decline! Well let’s just use their facts.

Screen shot 2012-12-30 at 8.40.35 PM

Source: McKinsey Global Institute

So how does McKinsey’s data support Greenwald’s thesis?

McKinsey: “Manufacturing contributes disproportionally to exports, innovation and productivity growth.” Which is supported by Exhibit E2 and 13 as per above and below.

Per above we can see only 14% of employment (in advanced economies) is in manufacturing, whereas 37% of productivity growth comes from manufacturing (EU-15).

Per below we see most exports are still manufactured goods. According to Greenwald high productivity and high exports have a negative impact on manufacturers and jobs in manufacturing.

Manufacturing drives two third of exprts

Source: McKinsey Global Institute

So How Does the Future Look?

According to McKinsey, up to 2025 about 1.8 bln. people will enter the consumer class, which is about 140 mln new consumers per year or a CAGR of 3.8%. Not bad! However this is similar to the last 20 years.

Furthermore McKinsey estimates consumption will rise 3.54% so consumption per capita will actually fall from 16k to 15k per capita. Did they forget inflation? Or does inflation offset a decrease in overall income due to growth coming mainly from low income countries? Let’s assume the latter…

As the 3.54% is slightly above Greenwald’s 3% estimate, but far below the 7% productivity gain in manufacturing, the deflationary pressure still makes sense…or am I missing something?

Demand Shift

Source: McKinsey Global Institute

Now for the Productivity Gains? Are they Supported by Historical Evidence?

McKinsey mentions productivity gains have been at an average of 2.7% p.a. which does not tie in with Greenwald’s 5-7%.

However from the graph we can see a spread between US productivity growth and real value added of 1 – 4%. If this spread persists, this will probably impact pricing of manufactured goods.

Screen shot 2013-01-16 at 12.15.47 AM

Source: McKinsey Global Institute

This conclusion could be supported by exhibit 15: productivity gains were passed on to consumers through lower prices of consumer durables (refrigerators, cars etc.).

Screen shot 2013-01-16 at 12.25.49 AM



Source: McKinsey Global Institute

So could Greenwald be right? I don’t know. It sounds like a logical explanation. More important is to me…What can I learn from this?

I will have to think about the consequences for employees, companies and investors. Next to job losses of the lower skilled due to productivity gains, the multiplier effect of manufacturing could turn into a serious negative force following manufacturing decline, which will impact also service sector jobs and revenues.

As an investor I will have to look more critical at service sector companies and try to find out, whether the companies aren’t built too much around manufacturing clients. Who are the key clients? What is their competitive position? Will they still be clients in different manufacturing landscape? Why? Why not?

If I am investing in a manufacturer…I will not expect productivity gains to be passed on to me, the shareholder, but most probably to the clients. Overcapacity will also lead to a landscape for high end and low costs producers (e.g. think fashion and furniture): will my producers be stuck in the middle or are they already well positioned? Will capital expenditures be also lower in the future (deflation will also impact capital goods) or will companies have to spend more frequently to keep up with the productivity race.

Please let me know if I made mistakes, whether you disagree, or want to add to the scenario. Also read: Worse Than the Great Depression:  What Experts Are Missing About American Manufacturing Decline by ATKINSON, STEWART, ANDES, AND EZELL

Screen shot 2013-01-16 at 1.00.16 AMSource: McKinsey Global Institute

Bruce Greenwald: Germany and the Netherlands should leave the Euro; The Global Demise of Manufacturing is the Real Economic Problem

Professor of Bruce C. Greenwald, Robert Heilbrunn Professor of Finance and Asset Management at Columbia Business School gave some very interesting interviews recently.

Prof. Greenwald is generally known for his value investing expertise, however in these interviews he offers us an different macro view on the euro-zone and the causes for the continuing world economy’s crises. I have made a limited transcript of the interviews.

International Trade Imbalances Are a Bigger Problem

Today there are some real problems in the world economy that have nothing to do with the financial crisis or unhealthy balance sheets.

The trade imbalances are at the heart of the economic decline and this is not a new phenomenon:

  • Japan: for 50 years a net exporter, managing their currency
  • China: grows through exports by keeping the Yuan at bay
  • Germany: stays in the euro-zone keeping its exports too cheap
  • Indonesia, Thailand, Malaysia and South Korea are since the Asian currency crisis (’97) running surpluses through a currency reduction of 50%

Adding up the surpluses of the oil exporters, there should be also various countries running deficits as all global trade accounts balance to 0.

A Short History of Deficits

Who runs these deficits then? Well after ’97 when Indonesia, Thailand, Malaysia and South Korea went from deficit to surplus, the deficits went to Mexico, Argentina, Brazil, Russia and we remember what happened to them around the turn of the century. They collapsed! Since then, they have all run surpluses.

During the 2000s the deficit running countries became the US and to a lesser extent the UK and the euro-zone. Financed by households living beyond their means, saving 0% and eating away household equity produced by the housing bubbles. Now the housing bubbles have deflated or stabilized and households are saving again, while demand has collapsed and everybody is adjusting.

The Difficulty in The Euro-Zone

Competitive Germany and the Netherlands are tied into the euro area with less competitive countries (Portugal, Spain, Italy, France etc.)

  1. When countries have significant deficits, it is extremely difficult to sustain full employment.
  2. Germany is in effect exporting any job problem it might have to less competitive countries in the euro area.
  3. These countries cannot protect themselves, because they cannot depreciate their currency

As long as Germany keeps running account surpluses, less competitive countries won’t have healthy demand growth. And as they cannot depreciate their currency they will have to make another fundamental change: lower real wages.

And Germany is not going to give away its economic power so easily. It has a very powerful manufacturing sector growing productivity at 5-7%. As domestic demand just grows 1% and globally it grows just 2-3%, they have to export. Otherwise manufacturing dies.

The Underlying Problem is The Decline of Manufacturing

The same goes for China, Japan, South-Korea etc. transmitting deflationary pressures overseas.

The underlying problem of global imbalances is the demise of manufacturing and the enormous vested interests in this economic sector. Governments try their best to protect manufacturing jobs by stimulating exports similar to the protection of agriculture in the depression years. However manufacturers are increasing productivity at a higher speed than global demand, leading to a significant deflationary pressure.

As long as the net exporters don’t find jobs in the service sector for their displaced manufacturing workers, there will be no solution for this crisis.

The other part of the problem is the dependency of deficit countries on external financing, where these countries are at the mercy of their external creditors. Living beyond their means becomes virtually impossible as long as they run a deficit and they have to become surplus countries without being able to depreciate their currencies.

So essentially, what is required from countries like Italy and Spain, is becoming more competitive than Germany through productivity gains. This is extremely difficult and probably not going to happen. The other painful way out is a decline in real wage rates which is a very difficult path, because households will feel real pain, losing their purchasing power.

The only way out is currency depreciation. This can be done the easy way or the hard way:

The easy way out:

  • Germany, the Netherlands and Denmark (maybe France) leave the euro and appreciate their currency.
  • The euro will fall, which will fix the problem for the uncompetitive countries.
  • As the debt of these countries is denominated in euros, the burden becomes more bearable.
  • Of course this scenario leads economic shocks for the leavers as exports will fall and their investments in euro will decline.

However prof. Greenwald sees this solution as the least painful and more orderly way to solve the problem as exits by the weaker countries will lead to defaults, serious recessions and even larger problems for German manufacturing.

http://www.youtube.com/watch?v=4rOqrmloRvQ

http://www.youtube.com/watch?v=jQE82yI5Ldk

Greenwald on Italy in Specific

http://www.youtube.com/watch?feature=player_embedded&v=lwNLoZBnRKE

Greenwald on the future of the US economy (But this could easily apply to Europe’s economy as well)

http://www.youtube.com/watch?v=9NfBVmSz0MI

The rich world should prepare to become poorer…

In an earlier article on this blog, I mentioned ageing is another ticking time bomb under economic recovery in Europe.

Yesterday the Economist has explained quite clearly why this is. Unfortunately they merely mention US data and leave up to imagination how the time bomb could explode, or better yet how it would look when rich world economies implode.

I will make an attempt to illustrate the consequences of reversion. But please remember:
– I am not clairvoyant
– the future could look much different
– no, my name is not Roubini
– and all the facts, data and graphs used are borrowed from the economist.com or other sources.

Baby-Boomers, a bubble deflating

Back to the issue at hand. The baby-boom generation has profited and is still profiting from the demographic dividend. As household and per capita income rose and spending per household decreased, more households were able to save up, invest in pension assets, purchase houses, companies and could stay debt free. Just think: income – spending = saving, and it will make more sense.

Less spending

Rising numbers of working age (and more work), making more hours and with women entering the labor force all led to higher household incomes. At the same time people had less children, so less household spending lead to more capital to save and invest.

More savings and higher asset prices

For their article, the Economist mentions research by Liu and Spiegel (2011) who found a close correlation between number of middle age cohort (40-49) to old age cohort (60-69) and P/E ratios of equities indicating a larger group of middle aged savers* led to higher P/E ratios. Simply translated: more people saving and investing led to higher stock market valuations…

*People under 35 are often indebted and invest in houses not the stock market.

Sizable political influence, less taxes

Various worrying facts on baby-boomers, profiting from political influence, are also mentioned:

  • 7% decline in US federal tax rates alone between 1980 and 2011, yet there was no halt in generous spending on health care leading to exploding deficits
  • Eschker estimates that Americans born in 1945 can expect almost $2.2 mln dollar in net transfers from the state
  • The IMF finds that Americans aged 65 in 2010 may receive $ 333 billion in net benefits. Source: IMF WP 2011 Intergenerational imbalances

Some anecdotal evidence exists that for European countries the problem is currently even larger. In Italy current workers will pay 14% more pension related taxes than current retirees have paid in their lifetime.

 

 

 

 

 

 

 

Reversion to the long-run mean

So how would a reversion process look as the demographic pyramid is turning into the shape of a mushroom?

A vicious cycle

Remember the simple equation: income – spending = saving.

As the ratio non-working to working quickly deteriorates, and if mere gradual changes are made to subsidies for the non-working, the workers will have to pay an increasing amount in taxes. This leaves less household income to save and spend.

Just imagine: in France, public sector workers are paid out of the current account. What will happen when 1 pensioner on 10 workers changes into 1 pensioner on 2 workers? Will they cut pensions or raise taxes? Or both? Either way it doesn’t look good for general household income and savings. And France is not the only country with this problem….

Hence my hypothesis that current across-the-board austerity measures (subsidy cuts on daycare, schooling and tax hikes) are the beginning, but certainly not the end.

Increasing taxes, higher current life costs and expected higher future life costs will be a major drag on consumption, depressing employment and company revenues.

In Portugal lowering salaries and cutting back on deductibility of schooling already lead to various families taking their children out of private school and assigning them to free public ones, putting even more strains on public finances.

Less savings, higher costs of capital, lower asset prices

With less savings by the young generations and baby-boomers consuming their savings, less funds are also left to be productively invested in the economy, limiting economic growth and increasing the cost of capital for companies, depressing asset prices.

As P/E ratio’s fall and do not move back to recent historical means, companies will be sold for lower prices than historically recorded leading to value destruction for current company owners and higher required returns on capital by new entrants to justify current prices.

Entrepreneurs currently buying companies should beware that historical valuations and transaction prices are not representative of future exit prices and the opportunity costs of waiting to buy a business are high.

Be careful buying a house now

House prices are just another asset that have changed hands for inflated prices in the last two decades. According to an analyses of the economist houseprices in the Netherlands France and Belgium are 33%, 38% and 42% above the normal rent-to-income ratio and thus still have a steep decline to come.

This indicates the over-indebted generation until 35 are about to become more indebted unless they start withdrawing a larger proportion of their income from consumption and start repaying their debt overhang.

Asset prices would be stable if the generational numbers are stable, however as the baby-boomers are retiring they could decide to move to smaller houses, elderly homes and put their houses up for sale. This is expected to put more pressure on houseprices rather than less.

Often I hear, this time it’s different arguments from real estate buyers or agents, however an illustration on the reversion to the mean in real Dutch houseprices over the centuries leaves nothing to imagination.

Anybody still wanting to buy a house should stop listening to the brokers and perform at least some form of fundamental value analysis (e.g. rental value) or add the expected loss of value to the cost of purchasing vs. renting.

Can economic growth be the answer?

Now back to the macro picture (and the Economist’s storyline).

Economic growth for Europe has become a problematically distant vision and with less savings available for productive investments, this vision is more dream than reality.

Contrary, as costs of capital run up and returns decrease, it is probably natural to expect a period of increased bankruptcies, less jobs like we are seeing now in Spain and Greece.

Also be careful with recent 30 years historical evidence on growth solutions (e.g. Sweden, Finland). They are distorted by EU subsidies, EU accession and a rich world credit boom. Without such a catalyst and even worse, with similar problems in neighboring countries, the recovery will take much longer than historical success stories indicate.

Furthermore as I wrote in an earlier post, economic growth is just not possible as long as Europe doesn’t get on with restructuring its debt and keeps on muddling to resolve a debt overhang and an uncompetitiveness problem at the same time.

Does Austerity help?

Again the babyboom generation is still an electorate of size. Politicians are normal people living from election to election searching for short term solutions and compromises instead of visionary long term solutions.

With Spain’s insiders (babyboomers with fixed contracts) and outsiders (50% unemployed youth) the people paying for the austerity bills are the young. Unable to generate income, they cannot spend, save and become productive members of society. Unfortunately as soon as they find work, they also will have to start paying for the baby-boom bills , higher health care costs and education tuition fees for their children.

In the Netherlands the government recently decided pension funds should calculate their present value of liabilities with an artificial investment rate (UFR), so pension cuts can be avoided at costs for the young. Another indication the balance of power tilts into the baby-boom direction and the bill of austerity will be paid later.

Politicians are almost understandable, let’s not forget, general austerity in Argentina led to overthrowing of various governments in two weeks and an eventual exit of the currency peg, a debt default and loss of savings and pensions. Who in her right mind would want that for her political career?

As long as the young are unorganized, don’t speak up and the pain is far away and spread out, the youngsters are just an easier target for austerity.

Inflation as a solution?

This looks like the easiest way out, decreasing the real value of debt (mostly of younger generations until 35) and decreasing the real value of savings and pensions of everyone, but to a larger proportion that of the elderly as they have accumulated more net assets in pensions, housing and savings.

With the political weight the baby-boomers still bring to the table the question is whether inflation will be accepted and will result in pension cuts or lower pension benefits for the less organized younger generations.

Researchers of the St. Louis Fed, indicate the answer is no. They find as a country ages the tolerance for inflation decreases.

Asset managers beware of inflation!

A large issue also with inflation is the current general regulatory and asset managers consensus, that government debt and high grade credits are the safest assets around.

  • Due to this ‘herd’ like consensus the Dutch government bond yields currently at lowest level in almost 500 years
  • Corporate bond yields are at their lowest levels since 1958, and just 1.1 percentage point away from their all-time low in March 1946 (2.5%).
  • And the current spread between European dividend yields and German bund yields, are at an all-time (320 bps).

Picture: Please not these are stock prices (not yields or P/E levels) versus bond yields.

As soon as inflation will appear on the horizon the ‘herding’ effect will work reversely and take its damaging toll on the average portfolio manager and their average investment portfolios of Credits and Treasuries. Taking away yet another portion of the saved up wealth by (future) pensioners.

Equities and inflation

However don’t consider equities to be a safe haven from inflation either. The evidence on the relationship between inflation and company returns are terrible too.

In a famous article in Forbes (1977) Warren Buffett documented that actually nominal returns are fairly stable over decades at 12% (McKinsey now increases this to 13.5%) and higher inflation decreases realized returns to investors and vice versa. This conclusion is in 2010 again confirmed and explained by McKinsey in their 5th edition of Valuation by Koller, Goedhart and Wessels.

As economic growth seems far away, austerity messes with company revenues levels and inflation will hit savings and pension assets, there’s no overall solution helping us out. In hindsight we will discover what have been the best picks. I have a hypothesis, but I will save that for a later post.

My Conclusion (Yours could be different)

Younger generations should start realizing they are on the losing end of the wealth transfer. Current tax bills are high and increasing, leaving little room to save up for costs of education of their children, healthcare and anything currently subsidized by the state (children’s daycare, elderly homes etc.) Unfortunately also their assets (houses and pensions) decline so they will have to start working harder, spend less and invest smarter.

The baby-boomers will have to be smart as well. Selling they’re company and house now is better than tomorrow and they’ll too will have to eventually count on some harsh pension and subsidy cuts.

Asset managers should finally do away with trying to replicate benchmarks, because the benchmarks have a high chance of trending downwards and consequently the capital they manage. In investing, the case for bottom-up value investing becomes stronger and many investment decisions made based on recent data will prove value traps (remember real estate, banks?)

The differences in wealth between the well-prepared and the average population will become larger (again)…and in general, it looks like the ‘rich world’ should prepare to become poorer…

An interesting, but painful solution for the Eurozone’s debt overhang…

As we muddle through the debt crisis in Europe, the believe in a happy ending is fading away fast…many papers and proposals are published and discussed, but many of them lack a practical approach, are short term solutions, increase moral hazard and lack a comprehensive overview…perhaps because the real and exhaustive solutions are too painful?

Two strategy consultancies have published their highly interesting analyses and come to some different conclusions on what should be done.

McKinsey Global Institute proposes an orderly approach by taking successful Nordic deleveraging in the 90’s as a case example.

David Rhodes and Daniel Stelter of BCG, take into account the reality of political forces and come to a different conclusion for the Eurozone.

Studying Sweden and Finland’s example, McKinsey discerns 2 phases of successful deleveraging:

  • following recession, it will take 4-6 yrs to delever private and corporate debt while public debt continues to increase;
  • the subsequent 10 yrs fiscal discipline and public debt reduction are needed;
  • only after the private-debt reduction the economy will return to its pre-recession levels

Some worrying facts about this comparison:

  • The UK and Spain haven’t begun yet to reduce their private debt levels (January 2012) – unfotunately McKinsey merely discusses these two EU countries.
  • Therefore, McKinsey estimates, the UK and Spain are still about 10 years (!) away from reducing their private debt levels. Following the graph per above this implies they will take 20 yrs to reduce their total debt to sustainable pre-bubble levels (!)
  • Sweden and Finland ran budget surpluses before their crises and joined the EU, stimulating foreign investments and export growth
  • Debt reduction alone doesn’t increase competitiveness

6 critical markers of success

McKinsey identified 6 critical markers that policymakers should look for and emphasize in their policies:

      1. Is the banking sector stable? – It’s undercapitalized at best…
      2. Is there a credible plan for long-term fiscal sustainability? – Track records of Spain and UK are deficits not surpluses…
      3. Are structural reforms in place to attract foreign investment? – Are politicians able to loosen labour laws increasing unemployment and social unrest in the short term? I guess Ireland and Portugal are doing a good job, about Greece, Spain, Italy and France I am not so sure…
      4. Are exports rising? – First Spain, Portugal et al. have to resolve the cost of labour per unit of product (10-30% higher than Germany) and the worldwide economic slump is not helping?
      5. Is private investment rising? – Are politicians able to restore business confidence, especially in the periphery? I see many investors running for the exit with valuation multiples this low for European stocks and bonds…
      6. Has the housing market stabilized? Spain still has 1.5 million empty houses…

Can I conclude we are far removed from recovery and a delevered Eurozone economy?The key underlying questions I would like to ask are…do we have the time and patience to pursue McKinsey’s orderly Nordic-style road to recovery and more important...do our politicians have the guts and discipline to lead us through a 10-20-year recovery programme?

David Rhodes and Daniel Stelter of BCG explain, most likely, politicians will eventually be forced into radical action and they outline a painful but much shorter path to debt reduction…

Their analyses starts with sketching why reality will in the end catch up with politicians:

  • current crisis is not only a government crisis, but also a competitiveness crisis
  • uncompetitiveness dominates in periphery and hinders export growth and trade surplus
  • no currency devaluation is possible for Eurozone countries to restore competitiveness
  • real devaluation implies pursuing productivity and lower labor costs at the expense of high unemployment and political risk
  • Eurozone banks are undercapitalized and can hardly take more losses
  • aging of European populations won’t help, increasing health spending, decreasing workers per pensioner etc.

Reducing debt and increasing competitiveness at the same time seems incompatible and will cause serious social unrest

They mention the findings of Cecchetti, Mohanty and Zampolli (Bank of International Settlements) which provide another indication that there cannot be recovery without resolving the debt crisis first:

  • debt becomes a drag on economic growth ones private, government or corporate debt moves in the 80-100% of GDP range;
  • since 1980 debt to GDP quadrupled in real terms to a 300% to GDP today;
  • they urge policymakers to act quick and decisively to prevent a vicious debt cycle spiralling out of control and put a further drag on growth.

Along these lines, Rhodes and Stelter conclude, we’re on the wrong track and that politicians have to eventually implement a real solution: debt restructuring before competitiveness can be restored. Interestingly they also outline how this should be done:

  1. Set the target: Total debt limit at a sustainable 180% of GDP with enforced limits at 60% private, 60% corporate and 60% government debt of GDP
  2. Relieve the debtors: write-off all debt above these thresholds (household, corporate and government)
  3. Secure the financial sector: the EFSF should take the lead to recapitalize banks and guarantee insurers’ payouts to policyholders. Effectively nationalizing the financial sector
  4. Arrange the funding: all Eurozone savings above a €100k threshold would suffer a ~35% wealth tax to pay for the restructuring operation
  5. Install structural reform and controls to prevent repetition: embedding the debt ceiling in constitutions, funding of all governments via eurobonds issued by EFSF, control mechanisms for private debt growth and a clear commitment to resolve pressing aging issues (helathcare spending and retirement age)

Unfortunately restructuring doesn’t solve the competitiveness issues, but it makes at least sure that the Eurozone can start fast with becoming more competitive and safeguard long-run prosperity for its population.

And achieving competitiveness? Well this will hurt too…perhaps leading to an eventual break-up of the eurozone. One problem at the time….

A eurocrisis solution – a German exit

Today, members of Europe’s periphery are faced with the inverse of Pascal’s wager. The potential devastation wreaked by the break-up of the currency union is so great that it makes sense to take precautionary actions however unlikely that outcome may be. Unfortunately, the protective measures that Spaniards and others are taking have dire economic consequences. As a result, they raise the probability of a worst-case outcome.

Read further at FT.com

http://www.ft.com/cms/s/0/9705abbe-c1bd-11e1-8e7c-00144feabdc0.html#ixzz20Lniik35

The writer: Edward Chancellor is a member of the asset allocation team at investment manager GMO