The European Job
12 July 2011
The following was written by Jawad Mian, Portfolio Manager based in Doha, Qatar
In 1947, Harry Truman delivered a speech before a Joint Session of Congress which became famously known as the Truman Doctrine. Back then, the world feared Greece would fall to Communism in an era of Cold War politics. The stability of the whole Mediterranean depended on Greece not falling it was argued. Truman’s speech was dramatic and exposed a grave national security threat, “If Greece should fail… the effect upon its neighbor would be immediate and serious. Confusion and disorder might well spread throughout the entire Middle East. Should we fail to aid Greece in this fateful hour, the effect will be far reaching to the West as well as to the East. We must take immediate and resolute action.” There was no other option. Greece had to be saved. Looking at FT today, the parallels are clear. The fateful hour has made a return.
Truman justified his aid to Greece by bringing up World War II. The United States had contributed $341 billion toward winning the war, which he referred to as an “investment in world freedom and world peace”. The assistance that he recommended for Greece amounted to little more than 1 tenth of 1 percent of this earlier investment. He believed that it was only common sense that the United States should safeguard that investment and make sure that it was not in vain. “This is a serious course upon which we embark,” he alleged, “I would not recommend it except that the alternative is much more serious.” Not that I really care but I’m quite sure European policymakers feel pretty much the same right now. They have vested much time and effort to harness the European Project. The alternative is unthinkable. It is only common sense that they too should safeguard their “investment”.
But there is more to it than that: The ECB is insolvent. They have roughly €200 billion in Greece related debt. Assuming even a 50 percent haircut on Greece debt would be tragic as the central bank’s own capital and reserve base of €80 billion could be wiped out. I can’t imagine ECB being caught naked like that. That would be embarrassing. The ECB would then have to go cap in hand to national central banks for a recapitalization. Not cool! Trichet is leaving the ECB this fall, I’m certain he does not want to be remembered as the ECB head that presided over a European default. That would kill his legacy. He definitely wants to leave on a happy note, who wouldn’t? That way, he can write a memoir (memoire in French) about how he saved the European Project from complete collapse. I’m sure people would want to believe that, I mean read that. He could call it The European Job.
The point is Europe can’t yet afford a fully fledged sovereign bond default, even in a tiny economy like Greece. Buying time is critical. Spain is too big to bail and it must cheat default. European banks have increased their capital by almost 50 percent but that is still not sufficient to absorb losses. Exposure to Italian sovereign debt and banks equates to about 50 percent of French banks’ book value. Ergo, France gets screwed. It is easy to see the collateral damage would cause plenty of havoc. But complacency is again creeping in at the ECB which is worrying. The pussy-footing must come to an end. In due course, I believe the ECB will give in to pressure from markets and provide additional monetary stimulus (read: outright monetization of sovereign debt) once Italy and France enter the fray. The political will is stronger than the public angst at the moment. That is why Greece will be bailed and the problem contained.
In less than two years, however, the balance of power will shift. Popular discontent for bailouts will mushroom. The public will not be able bear the pain that comes with “austerian” economics. The Greeks will default and not be apologetic about it. Greece has defaulted or rescheduled its debt five times since gaining independence in 1829. In fact, since its independence, Greece has spent 50 percent of those years in default or rescheduling. That’s possibly the worst track record for a country in all of Europe. I don’t know about you but I wouldn’t want to lend to that. Instead, I’d encourage them to default. But my suspicion is that the Greeks don’t need my encouragement. They know what is in their best interest. They have been through this before – many times – and they already know how this will end.
During the time of the Great Depression, roughly 50 percent of the world’s countries either defaulted on or restructured their sovereign debt. The official bailout lending during that time was sponsored by the League of Nations (IMF duplicate). Greece received two loans, one in 1924 and another in 1928. The global crisis hit in 1931, trade collapsed and prices tumbled. Debt service became problematic. Insolvency and default became inevitable. The gold standard had been restored almost everywhere during the mid- to late-1920s and that was making matters worse. Greece left the Gold Standard on April 26, 1932 and declared a moratorium on all interest payments – the only European country to do so at the time. Greece adopted protectionist policies such as import quotas, and coupled with a weak drachma, stifled imports, allowing Greek industry to expand during the Great Depression. By 1939, Greek industrial output was 179% that of 1928. Problem solved.
I remind ourselves of this episode to restore a bit of perspective. For Greece to leave the European Union (and give up on the common currency regime) would not be a new thing. There is clear precedent. The laws can change. For now, I expect the real crisis to be averted. Markets will riot momentarily to force policymakers into action. That is not surprising. I believe in the natural cynicism of the marketplace to the political optimism of governments. Across Europe, social tensions will continue to simmer and economic stress continue to accumulate. The sovereign debt crisis will continue to be a contentious point that will periodically provoke financial market volatility. Looking over at Europe, the economic equation is clear. The political divide is what must be clearly understood. Ultimately, The European Job will not be successful without deeper unification. Looking at the ongoing regionalization and different alliances within Europe, I don’t see how that is even remotely possible.
The political fate of Europe is uncertain. But we are likely to see major political shifts as governments get blamed for eroding living standards, high taxes, and pressure to cut spending. By 2020, the average EU country would need to raise its tax rate to 55 percent of national income to pay promised benefits. Imagine that. One thing is clear, the virtuous cycle of the past many years is ending and a vicious one is about to begin.
Jawad S. Mian
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