Throwing Good Money After Bad

Massive purchases of Club Med country (Italy, Spain, Portugal, Greece) debts, funded by the European Central Bank (ECB), a collective Eurobond, the European Financial Stability Facility (EFSF) or the International Monetary Fund (IMF)—any of these --will be a colossal misallocation of resources and a classic example of throwing good money after bad. In 1999 when the euro was launched, all participants – governments, investors, banks, bank regulators—bought into a fundamental error. That error was that solely by adopting the euro somehow weaker credit countries like Portugal, Greece, Ireland, Spain and Italy were now to be treated like the AAA rated Germany. And, like a college student who has just been granted unlimited access to his parents’ credit card, these weaker credit countries and their private sectors borrowed with wild abandon. The banks of the EU, encouraged by their governments and misguided regulation, feasted on the debts of these countries. And Germany’s export engine significantly benefited from these countries as markets.
 
Unfortunately the world has now “discovered” that the weaker credit countries really are weaker credits and the past twelve years of borrowing was a mistake. For me it’s very simple. If credit has been misallocated, you stop the misallocation process and when necessary write off the past mistake. You don’t throw more good money after bad.

Let’s start with the ECB. One hears deafening demands that the ECB begin printing money and buy the Club Med bonds. The world stock markets would no doubt rally. Just pick up any copy of the widely respected Financial Times and I’m sure you’ll find one of their columnists advocating just that. The German Chancellor Angela Merkel, who has been resisting this, is portrayed as the stubborn bad guy. For me, the ECB printing money to enable Italy to roll over its massive debt is the equivalent of destroying the euro in order to save it. The Germans of all people have a history of no less than six currencies in the twentieth century plus the memory of the early 1920s hyperinflation. I hope the Chancellor can stick to her guns. But I’m not sure she can.

Funding the Club Med countries by a Eurobond would also be a mistake as would funding by the bewilderingly complicated financial contortion called the EFSF.  Cut through the turgid language of any hypothetical future prospectus for a eurobond or the EFSF and this essentially amounts to Europe putting its hand into Germany’s back pocket. Without a German “cosign “on the eurobonds or the EFSF borrowings, they are in the junk category. How can a gaggle of weak credit/ bankrupt countries raise money through Eurobonds or the EFSF to bail out themselves?

Now we come to the IMF. The IMF was set up as part of the Bretton Woods system to offset imbalances that arose in a regime of fixed exchange rates.  Unfortunately the fixed rate Bretton Woods system was ended in 1971.  But for the IMF no problem. To corrupt General of the Army Douglas MacArthur’s famous quote, old international agencies never die and they certainly don’t fade away. Post 1973 the IMF reinvented itself and  went on to bail out one country after the other including Mexico in 1994, Indonesia, Thailand and Korea in 1997,  Russia in 1998 and Argentina in 2001.  The IMF has been widely criticized for its bailouts. In Asia, conditions were imposed that for example with Indonesia upset the domestic political order. Billions of dollars were stolen or wasted along the way. The Russian bailout was a particularly egregious example. Worst of all market participants learned that the IMF was always going to be there if they screwed up. The IMF has played a major role in global bubble creation and the installation of moral hazard in the world’s financial sector.

 If the IMF gets involved with bailing out Europe, essentially this means that the rest of the world is going to do the bailing. Right now, the IMF doesn’t have the cash to take on a full European bailout.  According to Bloomberg, Euro-area governments have to repay more than 1.1 trillion euros ($1.5 trillion) of long- and short-term debt in 2012, with about 519 billion euros of Italian, French and German debt maturing in the first half alone. European banks have about $665 billion of debt coming due in the first six months, with a further $370 billion by the end of the year.  Europe is facing a huge problem: How to fund the upcoming Italian and Spanish debt and keep its insolvent banks from collapsing. 

Christine Lagarde, the head of the IMF, has said she expects the non-European rest of the world to bolster the IMF’s currently “inadequate” resources. (There are those who would argue that the IMF’s resources are too “adequate.”) That isn’t going to go down well with the American public which views its own fiscally-out-of-control government as unable to afford such a task.  The Tea Party will be out in force if there is any hint of American backdoor participation via the IMF.  To get around Congress and help bail out Mexico in 1994, US President Clinton pulled some $20 billion out of a US Treasury “shoebox” called the Exchange Stabilization Fund. He got away with that then but this time it won’t be so easy. And I wonder about China. Spending a great deal of time in Hong Kong as I do, all I hear there is “China is still poor and Europe is rich but lazy. Why should we give money to these lazybones?”

Default Is the Best Option

 I believe Europe needs to find a way to allow its member states to default if necessary. Despite what seems to be the conventional wisdom, I hold the heretical view that increased fiscal union is not necessary for the euro to survive. Angela Merkel is pushing for tight fiscal controls to be imposed on the Club Med states. I would argue that the market can do the disciplining.  Europe isn’t ready for the kind of fiscal union Merkel seems to want.

The problem is the Europeans don’t trust markets. As I have argued repeatedly, nine American states defaulted in the 1840s. The defeated states defaulted after the American civil war in 1865.  The US survived. Moreover, according to a new Peterson Institute paper by Reinhart and Rogoff, the province of Alberta defaulted on its debt in the 1930s. The last time I checked Canada was still there! Of course, the European banking systems will require massive recapitalization, especially since they are stuffed to the gills with Club Med debt. This recapitalization should take place with management changes and losses to bondholders as well as shareholders. Nobody including me has the stomach to let an entire banking system go down.

Having said all that, I seriously doubt the European leaders will do what I am suggesting. Instead, they will push for the ECB to print money, the IMF to join the bailout and the Club Meds to promise to fiscally sin no more. I would give them no better than a fifty percent chance of pulling this off.  It is my belief any fiscal austerity will consist of largely growth destructive tax increases coupled with half-hearted efforts at cutting back government  expenditures. Regardless of what they do, a major recession in Europe seems all but inevitable in 2012.  The euro will survive at least until this “solution” is seen to be a failure.

I will conclude this section with a quote from a recent editorial in the Wall Street Journal, which summarizes my own views and is an example of reason in a cacophony of ill-thought out global advice. Not all the financial media is advocating the easy way out.

“Europe's original sin in this crisis was not letting Greece default, remaining in the euro but shrinking its debt load as it reformed its economy. The example would have sent a useful message of discipline to countries and creditors alike. The fear at the time was that a default would spread the contagion of higher bond rates, but those rates have soared despite the bailouts of Greece and Portugal.”

The Recent Central Bank Moves Were Necessary

The Federal Reserve, the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank and the Swiss National Bankfive other major central banks last week announced that they would take measures to provide cheap dollar financing for the ECB. The stock markets soared upward signaling their approval.

This was not designed to be a bailout of the Club Med countries. Rather it was to keep the European banking system functioning. I think in this case the Fed did the right thing. For those who care to look, the original purpose in the founding of the Fed was to offset seasonal funding shortages in the New York money markets and to be available in the case of a financial panic. The “Progressives” of the day didn’t want America depending on the wisdom and goodwill of evil profit making private bankers. It will be recalled that J.P. Morgan single handedly rescued the United States in the Panic of 1907.  For that the he was vilified by the Progressives who were upset he might have made a profit on the whole thing. No good deed goes unpunished. Of course in 1914 the supporters of the new Fed couldn’t imagine that their creation would be providing liquidity for European banks.

What has been happening is a massive run on European banks. For example the vulnerability of American money market funds to European bank problems was exposed about two months ago in a Wall Street Journal article. Since then the American money funds have been pulling their deposits out of European banks, of course denying all the while that they had any vulnerability.

This action was not some kind of back door bailout of Europe. Rather it is keeping Europe’s fundamentally insolvent banking system functioning until a genuine bailout and recapitalization can be arranged. The European banking system was approaching the point where it could not fund and was about to implode.

A Note on Global Markets

No question that, as we have seen recently, gold can go down as well as up. Given that the advanced nations appear to all be headed for insolvency and that currency destruction is a time honored method of sovereign default, I continue to believe that holding some gold is a prudent investment strategy.

Having said that, investors have to face the facts. The global stock and bond markets are being manipulated by the central banks of the world. Quantitative easing is another word for market manipulation. Warren Buffet pretty much summed up how he was being manipulated. Interest rates are zero, he’s got oodles of cash, IBM is a great company, he had to buy something. So long as there is no serious bad news, the market will “default” to an upward direction. Unfortunately, lately there has been a lot of bad news.

On the side of the bulls the US seems to be avoiding a recession. The coming European downturn is presumably already largely priced into share prices. If the Europeans can cobble together a deal that refinances the Club Med countries over the next year, no matter how bad this deal the markets will likely react positively. If no agreement is reached and the euro falls apart, the world enters a monetary abyss that could be very ugly. And so unnecessary.

 China remains a big question mark for global investors who long to find a place to hide. Right now, everything seems to be following the soft landing scenario in China. The economy is slowing in response to prior tightenings (plus exports to Europe will certainly be weak) and the Peoples Bank of China (PBOC) has started to ease. But as we should have learned by now, Chinese statistics are not reliable and China is a country where information does not flow freely. Is a hard landing lurking below the official numbers? I don’t know the answer to this question and I’m not sure anyone else does either.

 But I remain skeptical about China near term. The state owned Chinese banking system is not a real banking system in the Western sense and in some ways resembles a collection of Fannie Maes and Freddie Macs.  Managements report ultimately to their political masters (in this case the Communist Party) and not shareholders, money is directed to capital wasting state owned firms and profligate local entities,  repayment is always problematic and periodic state sponsored bank recapitalizations – sometimes fake, sometimes real -- have been necessary.  China follows a state – not a market-- directed industrial policy where Solyndras abound and there is an overinvestment in real estate and some types of infrastructure.  Environmental quality is a disaster.

Offsetting all this has been the fact that hundreds of millions of Chinese have moved from the countryside to work in factories thus upping China’s total factor productivity. And it should never be forgotten that Chinese people are on a global basis relatively intelligent, hardworking and well educated. And driven to get rich albeit no matter how. Economists find it hard to model the quality of a population in comparing countries and generally shy away from this since it is politically incorrect to do so. But in my opinion its people are China’s major asset and so far have offset what is a terrible economic system.

 It is no fluke that Chinese dominated Hong Kong and Singapore – with Chinese energy and the inheritance of British law and a sense of honesty and transparency – have become economic miracles. My advice to any investor looking at China as a refuge from the bankrupt West is to stick to firms which have zero state ownership and zero connection to the real estate or state owned banking sectors.  And remember. A Chinese hard landing will pull down all Chinese stocks.