Phase 1 of Germany’s Inevitable Departure from the Euro has Begun

Update:  I wrote in my blog on June 6th (Andre's Intellectual Honesty: Germany’s Inevitable Departure from the European C...: ) that Germany and Southern Europe will enter a grand compromise, where Germany effectively bails out the South and in exchange the South gives up sovereignty.  Yesterday, this is exactly what was announced at the European summit.  To understand what happens from here and the implications for investing, please see my June 6th blog.

In Defense of Austerity

If you had a child that was addicted to heroine, what would you do?  Would you have him go through rehab, meaning going through a painful withdrawal?  Or, would you allow him to keep taking heroine in order to avoid the intense pain of withdrawal that comes with rehab?  I suspect your answer is to have your child go through rehab because the short-term pain is worth the long-term benefit of getting off the addiction to heroine.


Yet, when it comes to economic policy, the press and politicians are universally opposed to the "inhumanity" of austerity.  How can government withdraw social benefits?  How can government reduce spending when the economy is weak?  These are the arguments, but to me its just a question of whether you want to get your child off the heroine.


The US economy is supported by government and individual spending based on debt.  The federal government runs an annual deficit of about $1.3 trillion.  It takes in about $2.4 billion in revenue but wants to spend about $3.7 billion, so it has to borrow the difference.  That same concept is evident among states and local governments, as well as individuals, in America.


But here is the problem.  Unless your child has the biology of Keith Richards, most likely the heroine with eat away at his body and kill him. Likewise, there is a point where the level of debt incurred is so high that it basically becomes mathematically impossible to manage and the economy dies.


By dies I don't mean that economy ceases to exist.  But instead, the US loses its position as the most trustworthy economy in the world.  The consequence being that the US dollar is no longer treated as the worlds reserve currency, leading to much higher interest rates and thus borrowing costs, and less foreign capital investment in the US.  Given the amount of US debt, the higher interest rates will begin to seriously consume tax revenues.  Today, interest only makes up about 7% of US government spending.  At current US government spending levels, in four years interest expense on the debt could approach 40% of spending.  And, this is why I support austerity.  I would rather take the pain in the short-term than die a premature death.


It is critical to understand that there is no magic formula.  There is no hail mary.  The US has to get off the heroine of debt, and it will be a painful process.  Anyone who tells you otherwise is lying.  Unemployment will rise.  Social services will be reduced.  But there is no choice because there is not enough money available to pay for the current level of spending.  There are policies that can be implemented to lessen the pain.  The US could go all-in to exploit its vast oil and gas resources, thus eliminating dependence on foreign oil.  This would add around $250 billion to US GDP (or almost 2%) simply through trade balances, not to mention all the employment to extract, transport and process the oil and gas.  The US could also modify its tax code to encourage companies to operate in the US.  And, the US could modify regulations, principally environmental and labor-related, in order to encourage companies further to operate in the US.  All these policies would lead to economic growth, but they would still be overwhelmed by the negative impact of a balanced budget.  If the US federal, state and local governments ran balanced budgets, GDP would decline 10% or more.  Like I said, getting off the heroine is going to be painful.


Politicians, mostly democrats and some republicans, argue that now is not the time to cut spending since the economy is weak.  But, I have a simple question?  Why is the economy weak?  It has been over three years since the economy bottomed, yet growth is anemic.  Why?  I'll tell you why.  Its because of the debt!  If you know the US has about $10 trillion in debt outstanding, runs $1.3 annual deficits and has unfunded social security, medicare and medicaid obligations in excess of $50 trillion, would you want to invest for the long-term in America?  And, Europe and Japan are in the same situation as the US, meaning over 60% of the global economy is in countries with unsustainable spending levels.  What is happening in Europe is foreshadowing what will happen in the US in the near future if the US does not change its path.


So, when politicians say now is not the time to cut spending, I say, if not now, then when?  Next year the economy will be no stronger because the core problem has not been addressed, but debt will have increased by $1.3 trillion.  The US will have just kicked the can down the road for another year, but the same pain will still be waiting, just a year later.  There is never a good time to take the pain of kicking a drug addiction, but the sooner the better if we want the US to maintain its primacy as the strongest economy in the world.

Germany’s Inevitable Departure from the European Common Currency: A Matter of When, Not If

If you read the financial press, it is dominated by stories on the problems in Europe and potential solutions.


Spain’s banks lent too much money for residential homes, which subsequently collapsed in value and now the banks are sitting on lots of bad loans.  As a result, the banks need huge cash infusions or risk going bankrupt; all of them!!!


Greece’s government runs huge budget deficits, in part because they cannot (or better yet will not) collect taxes, and has to borrow to fund the deficit spending (sound familiar my fellow Americans?).  The debt has gotten so big that the government had to ask for some of the debt to be forgiven, which happened recently.  The humor, of course, is that nothing in Greece has actually changed and it looks like they will default again on the reduced amount of debt.


Italy, Portugal, France, the story is the same.  Spending is greater than tax revenues.  Or, consumption is greater than productivity.


And, the solution from the politicians and bureaucrats?  Basically, it’s a combination of Europe’s various legal entities (ECB, ESM, ESFS…) buying the debt of these countries or their banks, or making loans to these countries or their banks, or all the 17 countries in the European Common Currency guaranteeing the deposits of the banks of these countries, or the 17 countries being able to issue debt that is guaranteed by the other 16 countries, etc. etc. etc.  And, by “Europe” taking these measures, what they really mean is Germany.  Southern Europe is looking to Germany to save them.


The solution to Europe’s debt problem is actually very simple.  Following in the spirit of Herman Cain’s 9-9-9 plan, I call it the 7-2-7 plan:  work a 70 hour work week, only take 2 weeks of vacation a year and increase the retirement age to 70.  Basically, increase your production so that you can pay for your consumption, instead of borrowing to pay for your consumption.  But, I don’t see this happening any time soon.


So, what then will happen in Europe?  The key to Europe’s fate is in Germany’s hands.  There are two options:


1. Germany bails out the southern European countries.  It can take a variety of forms (some of them are described above), but in the end the Germans will transfer their wealth to Greece, Italy, Spain, Portugal and even France in order to maintain stability (in the short term; more to come on this).
2. If Germany will not bail out the south then either the southern European countries have to leave the common currency or the northern European countries have to leave the common currency.  Without Germany’s support, the southern European countries will effectively go bankrupt and will need a cheap currency in order to help them rebuild their economies.


There are competing camps on what Germany will do, but I believe that for now Germany will cave and bail out southern Europe.  From an economic standpoint, Germany relies on southern Europe to buy its exports and therefore wants a solvent south.  From a political standpoint, the politicians are risk averse and will take the easy way out.


But, is this the correct decision?  Ultimately, the answer is no.  All Germany will do is postpone the inevitable, which is Germany’s departure from the European common currency and re-establishment of the Deutsche mark.  Let me explain.


1. Germany transfers it wealth to the south to help the south pay off its debt and/or to stabilize the south
2. Southern Europe (both public and private institutions) then feels less pressure from markets, which means easier access to credit and lower interest rates
3. With the pressure off, Southern Europe then does not push forward reforms to their economies
4. Over time (one to two years, I would guess), Southern Europe continues to run deficits and incur debt to fund consumption, leading back to the exact same place we are now.


German officials will argue that my points in #3 and #4 are wrong because the German’s will receive authority to oversee the finances of the south to ensure that #3 and #4 do not happen.  That the south will give up some of their sovereignty.  But, I have one simple question:  how will this be enforced?  Greece tells Germany that in exchange for a bailout it will improve its tax collections.  But, Greece turns out to be ineffectual at collecting taxes and continues to run deficits and thus can’t pay its loan obligations.  What will Germany do?  Aside from invading Greece and taking over the government by force, Germany will be powerless to enforce #3 and #4.


For a German bailout of the south to work, it requires southern Europe to fundamentally change their mindset toward work, leisure and consumption.  And, that is a very big bet for the German’s to make.  The only way that southern Europe will adopt a 7-2-7 mindset is if they are thrown into crisis, not by being bailed out.


What does this mean for the markets (over a 3 to 6 month period)?


1. Germany will bail out the south and the Euro will rally back to US$1.35 to the Euro.
2. German sovereign bonds will fall in value (yields will rise on the 10 year to about 2%) as the “flight to quality” trade unwinds and as Germany’s credit quality is diminished by its wealth transfer to the south
3. US stocks and all risk assets will rally as the fear of Europe’s financial collapse is off the table.
4. US government debt will fall in value (yields will rise on the 10 year to about 2%)


But over the next 12 to 24 months, what will happen?


1. Germany will realize that the bailout was a failure because the south did not change their ways and all Germany did was reduce its wealth with no benefit.  Germany will finally realize that they simply have to take their medicine.  That, it’s not a matter of it, but of when.
2. Germany will leave the European common currency.  This is less problematic from the standpoint of existing contracts being written in Euro terms.  This way existing contracts do not need to be re-written
3. The Euro will collapse to US$0.70 to the Euro.
4. German sovereign bonds will massively appreciate in value, with yields on 10 year notes going below 1%
5. US stocks and all risk assets will fall significantly as Europe goes into a depression, impacting Chinese exports and the global economy in general.  Dow Jones average will fall to 7,000-8,000 and S&P 500 will fall to 700-800 (35% to 45% from current levels).
6. US government debt will increase in value (yields on the 10 year note will fall below 1%), as the US undergoes its own hard recession and asset prices fall across the board (i.e., deflation).  The crisis in Europe and fear of the US suffering the same fate will finally get the US president and congress to reform spending and get the US’ fiscal house in order.  This will be hugely bullish for US government debt.


I know this sounds grim, but this is what happens when the developed world grows its economy for 30 years with borrowed money, instead of growth based on hard work.  Which leads to my next blog, “Austerity – That Dirty Little Word”.  Stay tuned…