David R. Kotok co-founded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. He holds a B.S. in Economics from The Wharton School of the University of Pennsylvania, an M.S. in Organizational Dynamics from The School of Arts and Sciences at the University of Pennsylvania, and a Masters in Philosophy from the University of Pennsylvania. Mr. Kotok’s articles and financial market commentary have appeared in The New York Times, The Wall Street Journal, Barron’s, and other publications. He is a frequent contributor to CNBC programs. Mr. Kotok is also a member of the National Business Economics Issues Council (NBEIC), the National Association for Business Economics (NABE), the Philadelphia Council for Business Economics (PCBE), and the Philadelphia Financial Economists Group (PFEG).
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Public sector workers in Greece are preparing to strike this week. They oppose the plan to reduce their wages and pensions. These payments are more than half of the Greek budget. Greece’s estimated 2009 deficit was 12.7% of GDP. If the proposed austerity measures are enacted, the proposed 2010 budget deficit will be 8.7% of GDP.
The government of Greece must cut its deficit or the bond market vigilantes will crush the pricing of Greek debt, interest rates will climb much higher, and the country will find its ability to finance its operations significantly impaired. We have some thoughts on how this will play out. But first there is a lesson from Greek history which the unions have ignored.
The famous Greek philosopher and poet, Simonides of Ceos, was engaged by Scopas, a nobleman from Thessaly, to chant a lyric poem in honor of his host. Simonides performed admirably but also included a passage praising the famous twin young Greek gods, Castor and Pollux. After the performance, Scopas offered to pay Simonides only half the agreed sum and told Simonides that he needed to get the other half from the two gods he had praised.
Later during the banquet, Simonides received a message to come outside and meet two young men. When he exited the nobleman’s banquet he found no one waiting for him. Suddenly the roof of the banquet hall collapsed and killed the guests, including Scopas.
The story is famous because Simonides was the only survivor and was subsequently asked to identify the mangled corpses. Since he remembered where folks were seated at the banquet he could state who was whom and coined the phrase “here lies so and so” as he identified the victims’ remains for their relatives. Simonides’ phrase is a probable source of the modern-day epitaph we find on tombstones throughout the English-speaking world.
Thanks for this story goes to my son-in-law, Scott Newstok, whose literary expertise includes the study of epitaphs, as articulated in his new book Quoting Death in Early Modern England. Let me also add thanks to Cicero, who originally recorded the story.
Like Scopas, the Greek public-sector unions are flirting with two relatively young gods of modern finance. They are similar to Castor and Pollux in that they are twins of sorts. They were born out of the post-war European evolution. And the unions are making the modern-day, public-sector equivalent of Scopas’ demands. Those two young organizations are the European Union (EU) and the European Central Bank (ECB).
In our view the future of the euro as a currency and of the EU and the regional economic and currency zone is now at stake. The outcome depends on how they handle the Greek debt issue. In the formation of the original eleven-member euro zone and the original fifteen-member EU, the Maastricht Treaty of 1991 contemplated that sooner or later one of the members of this regional assemblage of states would misbehave. Maastricht is very clear on the importance of the point that the ECB and the other member states of the EU do not bail out a state that violates the agreements on budget discipline.
The credibility of the euro as a hard currency is on the line. President Jean-Claude Trichet and the members of the ECB governing council know it, which is why we believe the central bank will not alter policy to fund Greece directly. Furthermore, it will not bend its rules regarding collateral, if the Greek government fails to implement the proposed budget cures. Greek government budget failure would result in sovereign credit rating downgrades that would render Greek debt unacceptable as collateral under current ECB rules.
The same outcome is true in a different procedural form for the EU’s 27 members. How does the non-euro zone EU member, the UK, or euro zone members France or Ireland explain to their citizens that they will be subjected to risk and maybe taxation so that Greek public workers do not have to rein in their very high compensation and benefits?
Imagine that scenario in the United States. Would Mississippi and Texas be obliged to pay the compensation and benefits that were extracted over the years by government workers in Vermont or New Jersey? If that doesn’t fly here, why do we expect it to fly there?
We expect the public upheaval in the weaker euro zone states to intensify before it runs its course. That is the pattern of the past. We also expect that the EU deliberative political bodies will be very active trying to find words of compromise, while not agreeing to pay. Politicians are the same everywhere.
But in the end, the ECB knows that the most credible and reliable thing that exists in European politics is the trusted currency. ECB also knows that the euro can only survive and maintain its hard-currency and world-reserve status if it is not debased because of pressure from the public-sector employees. The ECB was created by the Maastricht Treaty to avoid this pressure.
So, out goes our neck: we are going to bet on the euro. We believe that the policy of preserving the currency as a reliable and trusted store of value will prevail. Europeans know that loose fiscal polices can be managed if the monetary policy stays consistent and reliable. They also know that if the monetary policy succumbs to political pressures, all the movement toward stability since World War II will be put at risk.
We write this after a hard week of multiple and sequential discussions with colleagues in Europe. We examined this issue in depth with present and former central bankers, economists, and investors from eight countries and representing industrial enterprises and banks.
Lastly, we must acknowledge that there is huge volatility in front of us. My colleague Bill Witherell has described it in his recent missive. Volatility is due to uncertainty. Uncertainty drives risk premia. In sovereign debt, uncertainty shows up in higher interest rates and in the higher pricing of credit default swaps.
Two months ago we wrote that 2010 will be the year of sovereign debt issues. That will be true in Europe and in the United States as governments are forced to address swollen budgets and to restructure their arrangements with public-sector unions. We are seeing that in Greece and Spain and elsewhere in Europe, and we are seeing that in New Jersey and California and New York and elsewhere in the US.
Were Simonides alive today he might be creating the epitaph to be used for the unions that will be striking. He would do it in Greek. We will choose American English, and a limerick.
Here lies the body of the swollen public sector budget.
Markets have repudiated how politicians can fudge it.
Bond vigilantes took out their mop,
Investors cried that “this must stop,”
And now credit default swap pricing will judge it!
February 8, 2010
David R. Kotok, Chairman and Chief Investment Officer
For personal correspondence: david.kotok@cumber.com
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