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Europe on the Brink

Two experts question the eurozone’s response to the debt crisis and wonder whether it’s possible to repair the damage.

Ben Johnson, 02/01/2012

The characterization of the unfolding saga in the eurozone in the financial press has gradually evolved from a liquidity crisis to a solvency crisis to what is now increasingly being viewed as a political crisis. Just over a decade after its formation, the European Monetary Union is facing questions about whether its very existence makes economic, fiscal, and political sense.

At this time, the ultimate fate of the euro is unclear. If anything is clear, it is that Europe faces months and years of difficult challenges as the 17 countries of the eurozone decide whether they have the wherewithal (and desire) to keep the euro intact. Furthermore, the eurozone does not exist in a vacuum, and the progression of events in Europe will inevitably affect markets worldwide.

To learn more about the roots of the crisis, what the situation is today, and the remedies, we invited two prominent experts who have been studying the euro union since its inception in 1999 to participate in this issue’s Morningstar Conversation. George Magnus is a senior economic advisor at UBS. Magnus was one of a handful of economists who warned of a pending global financial crisis as early as 2007. Edward Chancellor is a member of the Asset Allocation Team at GMO. Chancellor has written extensively on the topic of the current crisis, specifically examining the ways in which the eurozone’s predicament differs from historical sovereign defaults.

They both called in from London. Our conversation took place on Dec. 19, 2011 and has been edited for clarity and length.

Ben Johnson: Let’s first discuss the causes of the crisis. George, can we start with you?

George Magnus: Sure. This euro-system crisis is really, in essence, a good old-fashioned balance-of-payments crisis. It seems to be about budgetary discipline and fiscal issues, which obviously have plagued Europe since Greece first appeared on the scene a couple of years ago. But this is just a manifestation of the problem of an incomplete monetary union and coming to terms with the fact that imbalances between member states don’t disappear. And, of course, these imbalances have grown to rather large proportions; France and Italy actually have been chalking up external deficits, which are the largest they’ve been since the monetary union began.

So, I think that’s really what the underlying cause of the crisis is. The misdiagnosis of the crisis is leading Europeans into adopting a flawed agenda with inappropriate policy tools. I don’t really see that they are even close to coming to terms with this as yet.

Johnson: Edward, you’ve done a terrific amount of work examining historical sovereign defaults and trying to provide context for the issues facing Europe today. How is the current crisis similar to past crises and how is it different?

Edward Chancellor: First, I’d like to say that I agree with George’s analysis that this is a balance-of-payments crisis. There are a number of ways of referring to the periphery of Europe, as sometimes they’re called, in a derogatory way, PIIGS. One other way of referring to them was as CADs, which stands for current account deficits. It was a term coined by Bernard Connolly, who is a longtime euro skeptic. Connolly elaborated that idea of the problem within the eurozone long before this crisis, even long before the global financial crisis.

Now, one of the problems with a balance-of-payments crisis-and this is why it’s quite similar to previous sovereign debt crises-is that during the boom times, the periphery- which normally when we’re referring to the periphery, it’s probably a Latin American country like Brazil, Argentina, or Mexico- typically runs a current account deficit that’s offset with capital inflows or a capital account surplus. And then, during the bust, money flows from the periphery back to the core, and no one is funding the current account deficits. Countries that have fixed currencies typically then find themselves with a large amount of external debt, possibly in an uncompetitive position, and with capital outflows, and that is followed very typically by a default.

One sees that pattern recurring from the first Latin American debt crisis of the 1820s, periodically through the 1870s, again in the 1930s, and again in the 1980s. So, these are sort of 50-year-plus cycles.

What’s different today, as George pointed out, is that the periphery is actually part of the currency union with the core. In the past, if creditors in the City of London suddenly decided they didn’t want to lend to Argentina, it might bring down Barings Bank, but it wasn’t going to bring down the British economy.

The trouble with the currency union is that if the core of Europe decides that it does not wish to fund the periphery, it creates an existential problem for the European currency union. That, in turn, creates a very severe problem for the French and German financial systems. So, in that sense, it has many of the hallmarks of a typical sovereign debt crisis- feckless low savings, overborrowing, peripheral countries. But the difference is that the seriousness of this crisis is, in my view, a lot greater.

Johnson: So, we have a monetary union without any sort of fiscal policy coordination. Yet some of the remedies being put forth are trying to coordinate fiscal policy across the member states. Is this something that is even feasible, given the various interests involved and that the pain of creating any sort of common fiscal policy may not be shared?

Magnus: It’s theoretically feasible. There are instances where we know that it’s practically feasible. In the case of monetary unions, there are examples such as the United States, the United Kingdom, greater Germany post-unification, and so on. So, these things can be done. But it requires a degree of political integration, which happened in these cases and in others, sometimes violently and sometimes over long historical periods.

The problem that the Europeans have is that it’s a bit of a Catch-22. They’d almost have to have a political union in order to agree to a feasible fiscal union. And, of course, they can’t get a political union because there probably isn’t any basis for it.

So, I wouldn’t say trying to establish some degree of fiscal coordination and integration is a wild goose chase. But I don’t think that what Europe is trying to do at the moment is going to be particularly effective, partly because the fiscal union and fiscal discipline implications-which the Germans, in particular, are stressing— may be something that you have to have by way of institutional arrangements to deal with future financial crises. But I don’t think it resolves or even addresses the current, as Edward said, existential crisis in the eurozone.

In fact, it’s going to make it worse, because what they’re trying to do is to institutionalize what I call the “pro-cyclical austerity zone.” In other words, Europe is in a situation where European countries have similar problems to the U.S. and the U.K.-the credit system has malfunctioned, they’ve lost their growth drivers, and so on and so forth. But on top of those problems, the Europeans are now trying to institutionalize fiscal austerity and the kind of rigid observation of deficit and debt targets that will slip ever further into the future the more austerity the European countries are forced to, or voluntarily choose to, implement.

So, in effect, what economic policy inadvertently is doing is turning Europe into kind of an economic zone, which is likely to be characterized by rising unemployment, weak or no growth, and occasional economic slumps, one of which looms during the coming 12 months.

Chancellor: Think of Spain, a country that has around 23% unemployment and is still running a current account deficit, which suggests pretty strongly that it’s uncompetitive. It has a very enormous amount of private sector debt relative to GDP. Its nominal GDP has not contracted, unlike Ireland’s, which has gone through this deflationary bust over the last couple of years. Now, if Spain loses any sort of capacity to run a countercyclical fiscal policy, it is then set for a deflationary adjustment, while having a private sector debt/GDP ratio of around 400%.

When I wake up in a very depressed mood about the eurozone, the way the crisis is working out reminds me of the Gold Standard in the 1930s, when you had the Credit-Anstalt Crisis of May 1931, and that was followed by bank runs and runs on various currencies across Europe. The Gold Standard forced countries into reducing their deficits at a time when their banks were experiencing runs, and there was a severe deflation. If you look at the history books, that was not a good thing to do to the European economies.

But today’s crisis is even worse, because the great thing about the Gold Standard is that any country could decide, as Britain did in 1931, that it had had enough and leave with very little ill effect—in fact, with immediate recovery. But you can’t leave the eurozone, as [European Central Bank chief Mario] Draghi is now pointing out, without there being immense ill consequences for your own economy.

The Competitiveness Problem

Johnson: One of the main motives for leaving the common currency would be to inflate away the value of one’s debt. But as we’ve seen, that is just a near-term and not a long-term solution. A long-term solution is to regain competitiveness. Isn’t it one of the more elemental issues that the eurozone is facing? Certain peripheral members have just fundamentally lost their competitiveness.

Chancellor: I think that some of the data is a bit confusing because people often choose 2000 as a starting point to compare unit labor costs with Germany. They then point out how Italy’s unit labor costs have risen relative to Germany’s. But in fact, the starting point was probably a period in which the German unit labor costs were relatively high, compared with the periphery’s. We’ve been doing a lot of work on Italy, and Italian exports actually have been very strong over the last year. In fact, they’re only just about 1 percentage point behind Germany’s. So, it doesn’t look to me, in terms of export growth, that Italy has a particular problem. Ireland has deflated its unit labor costs by a great chunk over the last few years and is now back to around a current account surplus. Spain, I think, is the most worrying on the competitive front. But perhaps George has a different view.

Magnus: Not necessarily. There are obviously quite a few horses for courses already that we’ve seen since the crisis began, Ireland being the case in point, and other smaller economies like Latvia and Estonia. I agree that Italy’s competitiveness problem is not quite as blatant as Spain’s and Portugal’s, from the pure point of view of labor costs—although I think most countries in Europe did suffer to some degree, compared with Germany, over the last several years.

But the competitiveness problem can also be couched in terms of the inability of countries like Italy and Portugal to really grow. A little anecdote concerning Italy: Since 1999, when the monetary union started, Italy’s fixed-asset investment grew by half as much again as Germany’s, but it only got about half as much GDP as was recorded in Germany. In other words, Germany’s return on investment is substantially higher, maybe twice as high, than Italy’s. And one of the reasons that people have suggested for this can be found in the World Governance Indicators, which is published annually by the World Bank. Over the last 10, 11 years, Italy has slid down the rankings very rapidly in terms of things like operation of the rule of law, effectiveness of government, and spread of corruption. These kinds of things are not easily fixable.

So, the problem is-from the point of view of sovereign solvency, which is the immediate issue, even though we could present all sorts of math that shows that Italy could fund itself reasonably for a little while longer even at current interest rates-that without growth, the debt trap that Greece has fallen into is likely to become more widespread and could easily happen to Italy. Italy will have a recession, quite a deep recession, in 2012, which means that all of the best-laid plans of [prime minister Mario] Monti’s government to meet demanding deficit targets will continue to retreat into the future.

So, competitiveness is part of the whole imbalances problem. It can be seen both from an export and a unit labor cost point of view, but also from a wider perspective, which is the ability of the country to grow. We’re not trying to excuse debtor countries from having to do public sector reform and fiscal restraint over the medium term. But we’d like them to be able to find ways of regaining growth that would enhance competitiveness without having to rely solely on an internal devaluation, which is the extraordinary reduction in wages, costs, and prices that countries have to endure.

Chancellor: At GMO, we’ve created an index, comprising a number of competitiveness and corruption indices-the Corruption Perceptions Index, the Index of Economic Freedom, the Ease of Doing Business Index, the Global Competitiveness Report, the Economic Freedom of the World Report. We then looked at the eurozone countries and found, to no one’s surprise, that Greece scored the worst. Italy, I’m afraid, came in second place with Spain and Portugal also registering negative scores. By the way, Ireland, which is often considered a so-called PIIGS country, actually gets a perfectly respectable score, more or less on par with the U.K. And, funnily, its score is even higher than Germany’s.

But when people start worrying that Italy cannot grow and that, therefore, the debt can never be paid back, it poses a problem, because Italy is—or at least was, until its bonds started falling-the third-largest government-bond market in the world. The thought of the third-largest government-bond market in the world not functioning properly is a very, very serious problem.

George will know that Britain in the 19th century had a debt burden—much larger than even Japan today. But because it was a relatively peaceful time, because the government didn’t have many welfare obligations, and because the laissez-faire economics, for better or for worse, allowed the economy to keep on growing, Britain was able to reduce its government debt/GDP ratio from 1820 to 1914 from around 250% of GDP down to about 40% of GDP. They did it solely by growing the denominator. They didn’t actually pay back any debt; they rolled it over—the debt was perpetual. They did it by the economy growing.

So, it is very important that Italy grows. One hopes that Mr. Monti will make Italy an easier place to do business, and Italy’s economic potential will be released. Whether Monti has time to actually implement those reforms—whose fruits would take several years to grow-is another matter.

Johnson: What are some of the precursors to sustainable growth in the periphery? What has to happen for these countries to instill confidence in their markets so they can make structural reforms and grow their economies?

Magnus: It’s going to be really difficult for the debtor countries of sovereign Europe to set themselves onto a growth path. I don’t think they’re going to be successful in the absence of some kind of symmetry in the behavior of creditor countries as well. There is a basic inconsistency in the German position. Not that the Germans have actually said this, but in effect, what they’re saying is, “We need everybody to become more disciplined like us.” They haven’t said, “Everybody needs to be a surplus country,” which of course is nonsense, but effectively, that’s kind of the thinking behind the current policy stance.

If countries-Italy, Spain, Greece, Ireland, Portugal, even France—have to set a course to save more-i.e., in the process of deleveraging public and private sector debt-then obviously within the monetary union the integrity of that arrangement will only endure if their increased savings can be offset by somebody else’s reduced savings. Even though there is a strong case for more labor-market flexibility, public-sector reform, restructuring of public expenditure, and so on, I just don’t think these things can actually help them return to economic growth in the absence of adjustments by creditor countries, of which Germany is the largest, and a more proactive position by the European Central Bank, which can provide the kind of bridge financing via quantitative easing that’s necessary for structural economic changes and adjustments to work. But at the moment, very little of this is on the agenda.

So, when you ask for precursors, a de minimis precursor is that debtor countries should be trying to do their adjustments over a reasonable period of time and not trying to rush it through in the next two years, whilst making employment the litmus test of pretty much everything they do in terms of structural reform from a macroeconomic perspective.

And as I said, that on its own is unlikely to lead them to success. It requires the creditors, mainly Germany, to imagine that they have some self-interest in structural reforms, too, even though it may not have seemed like that to the German government and to German voters. It will make them less of an export, surplus-centric country, less mercantilist. I realize that I’m whistling in the dark by saying that, but that’s the underlying reality of it.

Chancellor: One of the ways I started to think of what is the central problem of the single currency is in terms of a so-called trilemma, when you have three different objectives and it’s impossible to achieve all of them simultaneously. The famous trilemma in economics was identified by Robert Mundell and Marcus Fleming, who observed that a country couldn’t have a fixed exchange rate and an open capital account while keeping inflation under control.

The Germans have a slightly different trilemma. They have three different desires. First, they want the single currency to survive, because if it doesn’t survive, the German financial system is in a very perilous state. Secondly, they want to limit the amount of money they are paying to the periphery in terms of bailouts or future support. And thirdly, they want the European Central Bank to keep to its mandate to keep inflation low. I don’t think you can have all three of those together. I don’t think the single currency will survive if you put the periphery through a deflationary bust with Germany refusing to put its hands in its pockets to provide large, continual transfers to the periphery. But that seems to be the course we’re on at the moment. The Germans haven’t budged from that position.

Now, one potential solution is that they relax on the inflation side of things. I’m not in general an inflationist, but if Germany accepted a higher level of inflation, then the uncompetitiveness of the periphery would diminish. They wouldn’t have to go through a deflationary bust because German unit labor costs would rise relative to the periphery.

I’m not saying that it’s in the cards, but if you had a weak euro and very strong relative credit growth and money supply growth in Germany, and that fed through into a boom in Germany— and this would answer George’s desire that Germany begin to run a current account deficit—then the eurozone might hold together.

But the Germans are quite stubborn. They’re not very good at economics. I hate to say it, but they’re not very good at finance, either. And they’re quite puritanical. So, they are setting Europe on this disastrous course.

Magnus: The great inflation of the 1920s is in German DNA as much as the Great Depression is in ours. The reunification of Germany itself gave Germans additional cause to reflect on the implications of what was for them an explosion in their fiscal deficit and in their bond yields and in inflation.

Chancellor: It’s true that the Germans remember the inflation of the early 1920s, but they appear to forget the deflation of the late 1920s and early 1930s. It was the deflation-with Germany going back onto the Gold Standard, wringing inflation out of the system-that set the political preconditions for the rise of the Nazis. Inflation preceded it, but it was the deflation that was so politically destabilizing. And exactly the same, I’m afraid, can be said for Japan in the 1930s. So, the Germans may fear inflation, but we know that inflation is, when you have too much debt, the path of least resistance. Default is a much more painful route. If the Germans really want to go down that route, they may one day rue it.

The Tough Road Ahead

Johnson: What’s the endgame here?

Magnus: I think it is really difficult to look much beyond the next few months at this point. But forced to choose, I think that there may still be enough political bonds between European countries, particularly between Germany and France. Politics was the driver of the project in the first place after World War II. Those political binds may be sufficiently strong to maintain some sort of eurozone in the future.

But I can’t possibly imagine a eurozone in which all 17 incumbent members will find it comfortable to stay. Bit by bit, I think the Europeans will probably change their governance structures and mechanisms with a view that makes it easier to leave the eurozone—well, as I say, “easier,” note that there is no provision for anybody to leave the eurozone. But I think that may change.

It’s also possible, of course, that countries could make a decision to leave and try to win the moral support of the rest of the eurozone countries to ensure that the departure is as orderly as possible, if it is possible.

Obviously, the extreme version is that there’s a complete implosion of the eurozone, which could occur as a consequence of some kind of dire economic backdrop—involving a really steep recession, together with the inability of countries to effectively stay the fiscal austerity course, and this might give rise to a banking crisis that we were so close to seeing back in November and early December.

Johnson: Edward, your vision of the endgame?

Chancellor: It depends on which side of the bed I get out of in the morning.

There is a nightmare scenario, which can come about in various different ways—a European banking crisis, as capital flows from the periphery to the core are not sufficiently replaced by the European Central Bank funding. The other is a more long, drawn-out deflationary bust—that is just too painful for countries like Ireland, Greece, Spain, and possibly at some stage, even Italy.

There’s a more optimistic outcome in which a credible solution is found and the yields in the periphery come down. The Germans agree to tide over with the necessary payments and transfers to the periphery. As I mentioned earlier, that probably requires a higher level of inflation in Germany and a pretty weak euro.

I think George’s idea that the eurozone would probably hold together but some members will leave is very troubling for investors, because the moment you start factoring that in, you start looking at the Italian yields and say, “Well, yeah, they’re pretty good if Italy doesn’t default, and who wants to let Italy default? But they’re not so good if Italy actually leaves the eurozone.” Once people start worrying about that, those high yields stay in place, and the problem becomes self-fulfilling.

So, it’s very important to find a credible solution. The longer there is no credible solution, then one tilts, I’m afraid, towards some of these more-dire outcomes.

Johnson: How should investors be positioning themselves in this environment?

Chancellor: I’m afraid it’s a really difficult problem because one is caught between greed and fear. Greed says that European equities, by and large, are cheap. In one of our recent seven-year forecasts, eurozone equities had an expected real return of about 8% annualized, which would be a pretty good return. In Italy, inflation-index bonds are trading north of 6% in real terms. If Italy doesn’t default, holding an inflation-index bond for 10 or 15 years yielding more than 6% is a pretty good investment.

In addition, you may have heard of European dividend swaps. European investment banks offer various investment products that leave them long European dividends, and they need to get them off their books, so there’s a market for European dividend swaps. Now, if the eurozone holds together, these will turn out to be very good investments. If the eurozone doesn’t hold together, and given that your counterparty for a European dividend swap is typically a French bank, that is more worrying.

There are some times in investment when you’re offered an opportunity that is a no-brainer, and you take it in as big a size as you can get. In Europe, you’re getting some reasonable investment opportunities. But given that we’ve sketched some very nasty scenarios that are quite plausible, you don’t really want to be taking overly large positions.

So, what seems to me to be a reasonably good portfolio for the current times is a core of U.S. quality—with a bit of eurozone or EAFE, if you want. I actually think that Japanese equities are probably a better buy today than Europe. Their valuations are in line with Europe’s, and Japan isn’t facing quite such dire problems.

Johnson: Sum up the next six to 12 months. What do you think will happen?

Magnus: When markets regroup early in 2012, there are a number of things that will attract attention. One of them may be fairly imminent, which is the downgrade of the French sovereign. One of the major rating agencies just put France on for a negative outlook. The review of sovereign ratings in Europe will happen during the first quarter, and I imagine that both the major rating agencies will probably confirm a downgrade of the sovereign. That is bad political timing, from the point of view of President Sarkozy, who is facing election on the 6th of May. And obviously, it’s not good anyway from the point of view of trying to strength of the European financial stability facility, which they’re still trying to do, because when France gets downgraded, that takes about EUR 150 billion of their guarantee value away from the agency. So, effectively, the proposals there will be pretty much confirmed as unrealizable.

Then, of course, we’ve got the resumption of heavy sovereign issuance early in the new year, including a EUR 15 billion redemption that the Greek government has to make in March, which, at the moment, looks like it may be the occasion for the long-awaited default, though the ECB’s recent announcement of these three-year lending facilities may defer that for a little while. We’ll have to wait and see. In any event, those are the major issues that I think will drive markets at the beginning of the year. As we go through the year, the idea that you can throw ECB and/or IMF money at this problem and resolve it will be seen to be a bit of a sham. The underlying fundamentals and the contraction in the European economy will continue to chip away at the credibility of the whole sovereign strategy.

So, “recurring crises” would be my bottom line. And we will never know which one of these crises might prove to be a game changer, or even terminal.

Chancellor: What can I add? If both George and I say “recurring crises,” we know whenever financial commentators are unanimous in their views they are almost invariably wrong. So, if I want to make the world a better place, I better agree with George and sacrifice my reputation.

Magnus: Maybe it will be all right, Edward. Maybe it will be all right.

Chancellor: I don’t want to be more depressing, but there is another area where we’ve done a lot of work, which is China. And China has been the source of global growth since the financial crisis of 2008. China looks to me in a very, very perilous state. It looks like Ireland 2008, but 300 times larger. China has just come off a huge property bubble, a huge credit boom, and a huge fixed-asset investment infrastructure boom. And that is very problematic.

I don’t know what the source of the global growth engine is. And frankly, I don’t know what the outcome is-other than a huge amount of volatility, I’m afraid, which means that by this time next year, I’ll probably be about as tired as I am today, because, it’s been an incredibly tiring year, I must say.

Ben Johnson is Morningstar’s Director of European ETF Research.

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