If I were a German

Charles Gave, GaveKal Research

If I were a German, this is how I would analyze the euroland crisis:

The monetary union was supposed to transform the Greeks, Italians, French and Spaniards into solid citizens, who played less and worked more. As a German, I did not believe a word of it, but I was willing to give them a chance. Meanwhile I myself had to keep reforming because the world out there was becoming quite competitive (China, etc). So this is what I did in the post-EMU years; but my fellow members did not, of course. And guess what? They have problems—and apparently, it is my fault?

So what am I to do in such a situation? I have not been that successful historically (nor has anybody else) at telling the other countries in Europe how they should manage themselves. Even if our orders are filtered through a pan-European body, it will look about as independent from Germany as Philippe Petain or Vidkun Quisling.

Plus it will cost a lot to even try. They call it "federalism," I call it theft. The implementation of these reform policies would easily have me transferring €100bn or more of my income to these guys every year during a transition phase...which will probably last forever. This is what the East Germans cost annually during the unification, but at least these guys were Germans and I had let them down big time in the past. Anyway, lending more money to a guy managing himself in a bankruptcy is just not a good idea.

Of course, if the euro project ended today, this too would be expensive. For the last ten years, I have sold €1 trillion more to my neighbors than I have bought from them. During which time, my banks lent the same amount to EMU sovereigns. If the euro breaks now, I could easily lose half of my roughly €1 trillion in claims on the rest of the EMU. These IOUs would be worth at most €500bn—and the capital of my financial system is around €350bn.

So my choice, broadly speaking, is take a big loss up front or pay without hope some 4% to 5% of my annual income forever. I choose the first one. However, I should be careful not to be too tough for quite a while. I am perceived everywhere in Europe as the fellow who destroyed Europe twice in the last century. I do not want a third catastrophe on my head—even if the euro was not our idea, but a stupid French invention which they fed to Helmut Kohl on the idea that otherwise they would refuse the German reunification (as if they could).

It is better, therefore, to bide my time. This allows my companies to diversify their exports while my financial firms write off as much as they can. The price to pay is to go to all these stupid meetings in Brussels and accept some silly plans concocted by a bunch of guys who have never understood what a proper currency is. After accepting in principle, I then hold up the implementation on technicalities—then do it all over again at the next summit.

The objective is to wait for the French to follow the Greeks and Spaniards into bankruptcy. I was a little bit worried by the previous French president who did one or two things which were quite sensible. Fortunately, the French electorate took care to replace him with a fellow who is raising taxes and scaring away business—a socialist agenda which almost guarantees to sink the economy (see The Coming French Depression). (This incidentally is very good news for my companies, as a lot of their most dangerous competitors are being destroyed by their own government.)

The French, not known for taking a beating quietly, will be in the streets as soon as the economic demise unfolds. Their long rates will shoot up, sending the primary deficit exploding upwards. By the middle of next year France will be mired in a recession, have an out-of-control budget deficit and also need to raise a huge amount of money. Promises to rein in the budget deficit will be revealed as an absurd fantasy, and the new government will be left with no good options. In the end it will be the French who destroy the euro. Which will lead to a France very much weakened, and a very efficient and productive Germany which will survive the revaluation.

I cannot believe our luck. After all, Kohl was a genius.

The One-Handed Economist

GaveKal Research daily

"Give me a one-handed economist!" President Truman used to ask. Right now, he would likely have a hard time finding one as the past 24 hours have presented investors with some conflicting macro data points. On the one hand, the July US factory orders and the August Milwaukee PMI came in stronger than expected, and stronger than the prior months, raising hopes that the shockingly weak Philly Fed survey was an outlier. The Chicago PMI was also decent enough and the latest German retail sales were surprisingly steady after a strong spring. On the other hand, Korea (one of the countries more "plugged in" to global trade and typically a decent cycle benchmark) just published a much weaker than expected industrial production number, as did Poland, while Italian retail sales undershot already weak expectations. So what is an economist to do?

As far as the Brazilian central bank is concerned, sitting on the fence was apparently not an option. Last night, the central bank took the market by surprise and cut interest rates by -50 basis points, to 12%, becoming the second central bank, following Turkey, to officially cut policy rates in the face of what seems to be unfolding weaker global growth. Brazil's move is occurring at a time when inflation is running ahead of the central bank's targets. Clearly, the message sent out is that "we are more worried about growth than inflation." Ironically, this last Friday, China sent out exactly the opposite message by raising reserve requirements on off-balance sheet deposits. So which central bank is right?

As far as China is concerned, we are not surprised by the single-minded focus on inflation. After all, China's policymakers may not look very communist any more but the religion in which most were raised remains Marxism. And to a Marxist, revolutions and other paradigm shifts in history do not happen because of individuals, or ideas, but because of economic forces. And there is no economic force stronger or more destabilizing than inflation. After all, Marx did explain that Louis XVI lost his head because of the poor harvests and high food price inflation in the late 18th century. Just as Chinese policymakers explain today that the Tiananmen events of 1989 had little to do with Chinese students wanting more "democracy" or "freedom," but instead had everything to do with the high inflation afflicting China in the late 1980s. Needless to say, this hardcore belief that inflation is the number-one threat to social stability (and Communist Party rule) will have only been amplified by this year's events in the Middle East.

Of course, Brazil's political situation is very different and Alexandre Tombini and Dilma Rousseff do not need to worry as much about angry riots over rising food prices. Instead, they are probably more concerned about the country's growth outlook and the ability to roll out the large infrastructure that Brazil still needs to make it into the "first world" club. But will today's rate cut help Brazil in that task? Unfortunately, here, we are back to our "one-handed economist"! On the positive side, the lower cost of capital should help capital spending. On the negative side, most investors into Brazil have an institutional memory of how devastating inflation can be. Nervousness at the sight of a central bank willing to cut in the face of high inflation may thus increase? Moreover, investors are bound to ask themselves "what does the bank know that I do not?" And if they review the recent experience of Turkey, they may well conclude that the rates cut there seemed to have backfired-they only helped the Turkish Lira become the emerging markets' worst performing currency (-10% ytd) and hardly helped boost the Turkish stock market (-19% ytd in local currency terms).

Are We Entering Into Revolutionary Times?

GaveKal Research

In "A Study of History", Toynbee explains that the role of a society's elite is to rise to the challenges of the times, and find solutions fitting to those times, even if this involves a radical break with the past. Meanwhile, the modus operandi for most leaders is to try and maintain the status quo, and restore the "old order" that prevailed before the disruption. But if the problems are large enough, this does not work, and the same challenges reappear until either a solution is found (e.g., the European Union project as the solution to Franco-German rivalry), the elite is replaced by a new elite (i.e., revolution), or the country, system or civilization disappears (e.g., end of the Soviet Union). Now if one buys into Toynbee's grid of reference (and a number of us do), then it is possible that welfare states everywhere around the world are entering revolutionary times.

Indeed, eighteen months ago when we drew our first decision tree to review the possible scenarios for a denouement in the Greek crisis, we indicated that the worst possible outcome would be the "fudge." But of course, this is what we got and a year and a half later, we are none the wiser as to who will carry the losses on the Greek loans that everyone knows have been wasted. Worse yet, Spain and Italy are now coming into play.

Over that period, a number of our papers have been centered on the idea that negative real rates, increases in government spending, devaluations and transfers of debt from banks to taxpayers would not work. Worse yet, the very low nominal rates of the past decade have led to a huge expansion of what can be best described as "social clientelism," i. e., governments wasting money as never before in peace time through social transfers to "buy" votes. We now seem to be reaching the logical end to this process, though there are few signs emanating from the elite of a will to tackle this issue (witness how the French socialists and centre right are patting themselves on the back for agreeing to reduce the French budget deficit to -3% of GDP by 2013 if GDP growth continues to remain above trend -- as if the market will give French technocrats that kind of time and leeway!).

Now if today's elites cannot fathom confronting the imbedded benefits of civil servants and pensioners anymore than Louis XVI could take on the privileges of French aristocrats, then following Toynbee's grid, we have to fear that elites will be changed forcefully.

Of course, this is exactly what the US Tea Party is all about which is why we find the movement encouraging; at the very least, it offers a democratic alternative. Meanwhile, in Europe, where the economic and budgetary situations are arguably worse in a number of countries, nothing has emerged on the political scene. When a challenge as pressing as the one Europe is currently facing is obvious for all to see and yet nothing is done as politicians try to stay the course until the next election (for what?), this leaves an open field to the demagogues.Of course, demagogues are a great European tradition when the going gets tough. Historically, foxes are replaced by lions in the US and the UK, by demagogues elsewhere. We fully expect that coming elections across the Western world will produce some hair-raising outcomes.