Report from Paris, Part 2

Report from Paris, Part 2
December 12, 2011
David R. Kot

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During this trip to Paris, an ongoing e-mail chat has been underway with a number of North American colleagues. Some have asked to remain anonymous, and I will respect their wishes. The conversation centered on the current crisis and political negotiations in Europe, as seen from a North American perspective. Primary drivers of the chat were Americans who function as consultants, professionals, and activists in the financial markets.

One associate forwarded a quote by Terry Smith, chief executive of Tullett Prebon: “[the UK] might be as isolated as somebody who refused to join the Titanic just before it sailed.” This was said in response to the decision of the United Kingdom with regard to the collective bargaining taking place among European Union leaders. Here is the link to an audio clip of Smith’s discussion: http://news.bbc.co.uk/today/hi/today/newsid_9658000/9658489.stm.

Those who follow the news know well that the UK has opted out of an agreement, while the rest of the leadership of the European Union has either concurred (twenty-three countries) or left openings for further discussion (three countries). Twenty-six of twenty-seven countries have at least acknowledged the importance of the European Union and the eurozone.

Smith’s quote implies that the 23 are the countries sailing on the Titanic, destined to sink, and that the UK has made the wiser decision and is still standing on the dock. Through my e-mail exchanges, I raised this issue. My respondents quickly explained to me why it is desirable to be standing on the dock and not on a sinking ship.

However, discussions with other consultants and those here in Europe who are witnessing the ongoing crisis proposed an interesting question. Simply stated, the question is: Who is really standing on the dock and who is sailing away on the Titanic?

The answer is yet to be determined. In fact, as was revealed during our discussion, the position taken by David Cameron, Prime Minister of the United Kingdom, and by the political leadership of the UK, is one that the financial district in London, affectionately known as “the City,” was able to influence. In doing so, it has put Cameron in the position of sponsoring protectionism in its most extreme form. That may be a short-term response to the political pressures his government faces; but in the long run, has he hurt or helped the UK?

More information was revealed at our lunch, which included two expert observers of Europe and European markets who live in Europe and have watched these events unfold. They noted that if you take the income of London’s financial district out of the equation and look at the rest of the UK, you find that it is at a very low level. One expert stated, “It’s almost like Greece.”

What has happened that prompted the UK to isolate itself from 26 other countries in the European Union? Was it a political force incorrectly applied by a leadership that faces political difficulties within its own coalition? Did the UK cast a lot that will eventually weaken the City? Is it possible that it is the UK that has sailed away on the Titanic and the coalition forming in Europe that is left standing on the dock?

European leadership is making every effort to respect history, with which they are very much in tune. The important thing is to look at what created the European Union and the eurozone in the beginning. The concept formed after World War II. It happened because the French and the Germans decided they needed to stop killing each other and that others in Europe needed to do the same. They replaced confrontation with rapprochement, with cooperation, with an attempt to unify points of view. The same leadership that evolved in the ’50s and ’60s also knew the profound distrust that citizens in all countries in Europe had for their currencies. The history of the Weimar Republic and the subsequent rise of Hitler were still fresh in their memories. So, they launched an attempt that led to the euro. They created by treaty a structure in which a central bank would be empowered with seigniorage and the maintenance of the value of the currency, and that it would have the same powers as the sovereign member states of the European Union.

Giving up a degree of sovereignty in return for a set of rules that were supposed to handle the governance of the central bank is the key aspect of the Maastricht Treaty that launched the euro.

There were flaws from inception. A monetary union is not a fiscal union. Fiscal authorities have to deal with taxes and spending, and this power was left in the hands of the sovereign member states. Each of them dealt with it in its own way. In the beginning, there were rules that were adhered to, and the system worked.

Then violations occurred; the leading and most profligate spender, the one that distorted the rules by the largest amounts, was Greece. It restated financial reports after the fact. It continued its behavior in violation of the rules, and did so repeatedly. The crisis started with Greece; but in fact it was the popularity of the concept of bending the rules, and the tacit permission granted by the leadership of the eurozone, that allowed the negative behavior to continue.

The eurozone’s financial crisis is an example of moral hazard at work. Bend the rules once, and they will be bent again. The second time, they will be bent even further, and the eventual penalty may be even more severe. It is the classic case of the child with his hand in the cookie jar. Petulant children have difficulty with moral hazard – especially when the threatened penalty is finally imposed.

That is what has happened with some of the countries in peripheral Europe. The leading example is Greece, which has now become insolvent as a government. The next candidate is Italy, which is the third largest debtor in the world, and is now attempting to close the cookie jar by force.

Now, what lies ahead? We see a coalition of leadership that does not want the eurozone or the European Union to end in failure. Those leaders, including Angela Merkel and Nicolas Sarkosy, have agreed to continue the attempt at rapprochement, cooperation, and have agreed to reject confrontation. They understand that the risk in Europe is exceptionally high and that discussions about dismemberment of Europe and the outcomes from it are intense and reveal ongoing recognition of Europe’s history. Many commentators believe full dismemberment could lead to some modern version of war. They also recognize that Mr. Putin and others of his ilk lurk farther east, watching this dismemberment debate and already fomenting difficulties where they are able to do so.

Lastly, they look at the behavior of the United States. While polite and attentive, since Europeans are very good at such diplomacy, they wonder privately about American arrogance. Think about this in light of the following situation: The Secretary of the Treasury of the United States comes to Europe to lecture Europeans on what to do about policy and financial-market disarray and about dealing with deficits, currencies, and economic issues. He brings nothing but words. He has no political power. His government, the Obama Administration, is stymied by a divided Congress. It cannot add funds to the IMF, even if it wanted to. Geithner traipses around Europe telling people whatever he chooses, making bland commentary about the need to correct imbalances; and then he returns home. He returns to a country that is running deficits as large as the worst deficits in Europe. He returns to a country politically divided and rancorous in its inability to solve a problem. He leaves an impression of American arrogance and failure. For an American in Paris, this is a troubling observation to make.

How will this all play out? I am reminded of the words of Philadelphia Federal Reserve President Charles Plosser on December 2nd. He opened the discussion at a special policy forum of the Philadelphia Fed. The conference title was “Budgets on the Brink: Perspectives on Debt and Monetary Policy.” In his opening remarks, President Plosser raised questions that need to be discussed publically in the United States as well as in Europe. The problems are very similar: when you borrow more than you take in, you fuel the growth of a fiscal juggernaut that will eventually catch up with you and then, if you do not correct yourself, can crush you.

President Plosser offered the following: “Given the magnitude of the fiscal shortfalls in many countries, the way in which fiscal discipline is restored will have profound implications for some time to come. Will there be higher taxes on productive investments by the private sector and higher taxes on wage earners – which would discourage both investment and work effort? Or will there be cutbacks on government purchases of goods and services from certain industries, such as aerospace and defense, or cutbacks on entitlements that would affect health care and social insurance? Or will a viable fiscal plan combine various types of tax increases and spending cuts?” Charles I. Plosser, President and CEO, Federal Reserve Bank of Philadelphia, The Philadelphia Fed Policy Forum: “Budgets on the Brink: Perspectives on Debt and Monetary Policy,” December 2, 2011

This is our second report from Paris. More meetings lie ahead. We will attempt to examine the details and intricacies involving 17 national central banks and the collective mechanics and transactional arrangements that take place in this entity called the European Central Bank. We want to question how the emergency lending assistance structure works with central banks. We have observed that over 40 billion euros in emergency lending has occurred between the Bank of Greece (the central bank of the government of Greece) and Greek commercial banks. The collateral used to secure that lending from the central bank was pledged by the commercial banks but did not qualify as collateral that could be used directly with the European Central Bank. In other words, commercial banks used lesser-quality collateral and borrowed from their own central bank, because they did not qualify with the ECB.

What happens if Greece defaults? What is the position of the central bank of Greece with those claims? How do they fit within the context of the 17 independent national central banks that collectively make up the European Central Bank? Remember, the ECB is just an umbrella of the 17 national central banks; on its own, it has a very minimal balance sheet. It is modeled after the US Federal Reserve System, in which the Federal Reserve has no balance sheet; rather, it is the collective balance sheet of the twelve regional Federal Reserve banks.

We have many questions to ask about TARGET2, the ECB clearing system; about the issuance of currencies; about the policing of collateral; and about reporting. It is going to be a fascinating trip. The rain has stopped in Paris. It’s cold but clear, and one hopes the same visibility that allows the eyes to feast on the festivities in this glorious city can also reveal with some clarity and transparency the monetary and fiscal affairs of Europe.

At a lunch with my friend and fellow GIC board colleague Paul Horne, he recalled the Salomon Smith Barney/Citigroup economists’ report on the UK, done in the late 1990s. At that time, they recognized the importance of the City in the UK economy and noted that without the City the UK would rank, on a per-capita GDP basis, among the poorer of EU countries.

After a quick search, Paul, whose Europe-based research credentials are impeccable, found an interesting report from 2008 on the importance of finance to the UK economy. See: http://postrecession.files.wordpress.com/2009/01/whitepaper6.pdf. The author is Rob Killick, CEO of cScape Strategic Internet Services Ltd. Most of his footnoted sources are reliable, i.e., they are the UK Treasury and BoE. See Section 3 for the importance of the financial sector in the UK. Chart 1.10 is particularly telling in showing the growing importance of finance and business services, relative to GDP.

In addition, check the 2010 rankings of countries by per-capita GDP, using nominal GDP and PPP which, if you take out the 10% of GDP represented by finance, leaves the UK around the level of Italy but well above Greece. See: http://en.wikipedia.org/wiki/Economy_of_the_United_Kingdom.

In my view, Cameron is playing with fire. Britain may be the Titanic, sailing away and leaving continental Europe at the dock. In a world of globalism, he chose isolationism and protectionism. Horne asked, “Given the City’s many advantages, relative to Frankfurt and Paris, would a Tobin tax or increased EU regulation really cause finance to desert London? Is protecting the City worth isolating the UK from EU decision making?”

We are going to find out. Cameron may have put the UK on an irreversible course. Continental Europe must coalesce fiscally to survive and for the euro to endure. Continental Europe has no other choice. It will happen without the Queen’s picture on the currency.

David R. Kotok, Chairman and Chief Investment Officer