WHITHER EUROPE?

 

 

I’M A ‘PIG’ TOO

As a descendant from PIGS parents and born in Dublin, I am keenly following events, and associated credit-events in the European Union. Only two years ago, I was travelling with my brother (who lives in Derry) through Southern Ireland towards Achill Island in County Mayo. Throughout the journey, I noticed the intense, postered scepticism regarding the Lisbon Treaty and the perceived threat to democratic continuity in the Irish Free State. I returned downunder to all the horror of unfolding spreads in Irish, Greek and now Portugese debt. One of my favourite investors, Warren Buffet will tell you, don’t get emotional about business (or lack thereof). Clearly, however, there are the seeds in Europe of a global systemic problem. In this blog, I will be drawing on the work of Farrell, Quiggin, Eichengreen and Krugman. And so I ask, whither now the EU and the Euro??

PREACHING IN A CRISIS: ‘HOW TO SAVE THE EURO – AND THE EU’

Given my PIGS heritage, Henry Farrell and John Quiggin’s article, ‘How Keynes can Save Europe’ in the May/June edition 2011 of Foreign Affairs got me closely thinking about the future of Europe. In some respects, Farrell and Quiggin have the bully pulpit. In light of recent Australian, Asian and US market events, it’s safe to say the ‘peripheral’ countries are very much in our global peripheral vision. Indeed, Farrell (an Irishman) and Quiggin mention Michael Noonan, the incumbent Irish Minister for Finance in regard to his opposition to the Union and specifically German intransigence in the face of Ireland’s budgetary malaise. (Many Irish are not all too keen, I previously discovered, about transfer payments to Brussels for the EU Parliament and Commission).

According to Farrell and Quiggin themselves, moreover, the EU was never that great for the ‘core’ economy, Germany nor was the EU unified in the face of budget difficulties and constraints on growth.

‘TO BE OR NOT TO BE’: UNITY OR DELUSION?

Originally a cognac salesman, Jean Monnet travelled through Europe and the United States. Later, he served as Deputy to the League of Nations but is remembered as founding father of the European Steel Community, forerunner to the European Economic Community and ultimately the Union. In Monnet’s words,

‘There will be no peace in Europe, if the states are reconstituted on the basis of national sovereignty... The countries of Europe are too small to guarantee their peoples the necessary prosperity and social development. The European states must constitute themselves into a federation...’

Together with Robert Schuman and his announcement of the Schuman Declaration, Monnet and Schuman urged Germany to commit to a reunited and mutually beneficial, strengthened Europe. The key to ESC and later the EEC and now EU’s future prosperity was, and, to many commentators, is Germany. As Schuman claimed before the United Nations,

‘Our hope is that Germany will commit itself on a road that will allow it to find again its place in the community of free nations, commencing with that European Community of which the Council of Europe is a herald’.

MONNETARISM

Accepting the Karlspreis in Aachen in commemoration of that great ‘European’ conqueror, Charlemagne, European Central Bank President Jean-Claude Trichet wore his central banker’s heart on his sleeve in support of deepening fiscal and financial union. The speech was entitled ‘Building Europe, Building Institutions’. In common with Monnet and Schuman, Trichet focussed not on widening bond yields and interbank spreads, but rather on the mental divagations and metaphysical fancies of Erasmus, Victor Hugo and Immanuel Kant toward a cosmopolitan, ‘supra-nationalist’ continent.

Amidst this grandiosity, however, Trichet remains a hard-headed monetarist. Principle-bound to the M in EMU, Trichet insisted that monetary union and fiscal responsibility were the primary determinants of a lasting political union for Europe. In order to build Monnet’s inter-generational cultural synthesis, Trichet enjoined fellow ‘true Europeans’ to disregard any talk of crisis surrounding the Euro and to commit to strict anti-inflationary targets below 2%.

Channelling political theorist Max Weber (interestingly, an expert on puritan ethics), Trichet stated that conviction and responsibility dictate that the ECB ought to be granted additional ‘non-standard’ restructuring powers to expel non-performing actors if they did not permit increased vigilance and monitoring by the ECB over fiscal policy and public debt levels. In Trichet’s view, what are otherwise peripheral sovereign debt concerns will have to translate into a ‘quantum leap’ in EU economic governance. Yet strangely for one so sanguine, Trichet concluded his speech with an enigmatic quote from Monnet:

‘And Jean Monnet in his memoirs 35 years ago wrote: “Nobody can say today what will be the institutional framework of Europe tomorrow because the future changes, which will be fostered by today’s changes, are unpredictable.”

So I ask, yet again, whither Europe?

FARRELL AND QUIGGIN’S DEMANDS FOR ‘DEMAND’ SPENDING: IS THE EURO WORTH ITS WEIGHT IN GOLD?

According to Farrell and Quiggin, austerity economics has not worked and the solution is hence entirely ‘clear’. In the authors words: ‘Hard Keynesianism would not solve all of the EU’s economic and political problems. But it would steer the union away from the disaster toward which it is now sleepwalking’.

In this vein, Farrell and Quiggin point to the fact that the 750 billion euro European Financial Stability Facility is under pressure - under a scenario involving risk of Spanish default, the authors project the necessity of a bailout to the tune of a cool 600 billion euros taken directly out of the EFSF. (The BIS estimates current PIGS exposure at more than 1 trillion euros). 

Anticipating a reverse Golden Age for Europe, Farrell and Quiggin liken the current ECB and domestic austerity measures to the bad old days of fixed-exchange rates backed by the Gold Standard and that age’s recurrent slumps in economic output. Following this attack on the ‘bad old’ gold standard, they advert to probably the leading authority on the subject, Professor Barry Eichengreen and his celebrated tome, ‘Golden Fetters’. Indeed, it is worth quoting a recent Eichengreen paper, 'Fetters of Gold and Paper' to obtain the flavour of Farrell and Quiggin’s scathing critique of current ECB and European sovereign debt policy:

‘As in the Great Depression, this second round of problems stems from the prevalence of fixed exchange rates. Fixed exchange rates facilitate business and communication in good times but intensify problems when times are bad.

We argue that the gold standard and the euro share the attributes of the young lady described by Henry Wadsworth Longfellow (American, 1807-82):

There was a little girl, who had a little curl Right in the middle of her forehead, And when she was good, she was very, very good, But when she was bad she was horrid’.

Thus, Eichengreen shares the assumption that the Euro, akin to the previous Gold Standard, is an ‘extreme’ form of exchange rate backed by an extreme regard for supra-national solidarity. Eichengreen attributes both outbreaks of economic extremism to a nineteenth century mentalite, redolent of Trichet, Schuman and Monnet’s most perfumed writings. Mindful of my recent encounter with Irish sentiment toward Brussels, I note that Eichengreen explicitly reproaches the lack of flexibility in the Lisbon Treaty. There is no scope for reintroduction and depreciation of a Euro member’s national currency in a time of recession.

And it is doubtful, Farrell and Quiggin remind us, that the EMU is actually an ‘optimal currency area’ (Cf Mundell). Via contagion, peripheral damage is becoming collateral damage for the Eurozone herself. On this subject, Farrell and Quiggin vituperate Angela Merkel’s plan to institute ‘Debt Brakes’ which would place additional pressure on public spending and reduce aggregate demand. With deficits set to rise as growth slows and the output gap widens, Quiggin, in a posted rejoinder to Paul Krugman on his Blog, ‘Crooked Timber’, states: 

‘Krugman has long criticised the eurozone on the grounds that it is not an optimal currency area and that the European Central Bank must therefore pursue an unsatisfactory “one size fits all” policy, too contractionary for economies that are doing badly and too expansionary for those that are doing well. Back in February, I argued that in fact ECB policy was “One size fits nobody” and that even Germany was vulnerable to its contractionary effects’.

Proposing a Keynesian surplus – not a minimal deficit – in good times, Farrell and Quiggin advocate a combination of deficit spending, quantitative easing, ECB intervention/purchase of impaired assets, inflationary policy and resort to capital markets. Specifically, Farrell and Quiggin advise Euro members to abolish Growth and Stability Pact bye-laws mandating budget deficits below 3% and Debt-to-GDP ratios lower than 60%.

By far their most interesting suggestion, I think, is for issuance of a new Eurobond..   

A LITTLE RESTRUCTURING NEVER HURT ANYONE: THE CONCEPT OF A ‘EUROBOND’

I must confess the Eurobond was an idea I liked before I heard it officially introduced in the press and in Farrell and Quiggin’s article. For some time, I have believed that a Brady-bond style restructuring will be essential to calm investors while committing the core to sustainable backing of the Eurozone. After all, the ECB is already intervening to stabilise the Italian and Spanish bond markets pushing their yields, at least temporarily, below 6%.

According to Reuters, former ECB chief economist, Otmar Rissing acknowledged that the Central Bank has ‘crossed the rubicon’ away from ‘price stability’ by purchasing Irish, Greek and Portugese debt. Ironically, this has put Trichet at loggerheads with the Bundesbank. Nonetheless, the introduction of a Eurobond may be a less ad-hoc solution, delivering investor certainty. Further, it would reduce the risk of ECB intervention into overnight markets (Cf Brunetti, Fillipi and Harris).     

WHITHER THE WORLD?

In the Return of Depression Era Economics, to return to the issue, Paul Krugman admits candidly that our globalised world has entered the ‘Mother of all Crises’. We have experienced the convergence of mortgage, currency, capital market and public debt blowouts due to the increase in unregulated (or poorly regulated) international capital flows, which have magnified the damage. Even with a growing credit supply, there is little demand and banks are not on-lending. Instead of ‘singing the praises of financial innovation’, Krugman admonishes bank executives, central bankers and governments to embrace good old-fashioned Keynesian stimulus.

As Krugman observes, the Brady Plan allowed the Mexican government to impose a ‘haircut’ on investors in their high-yield Mexican debt by writing down the face-value of Mexican bonds. In turn, this periodised the crisis and restored confidence to bond markets. By marking a psychological turning point, Brady restructuring contained crisis spread and reduced the risk of capital flight. As a result, the primary deficit itself came down. By 1993, Krugman recalls, Mexico had raised $30 billion in foreign investment. This was helped by Mexico’s improved access to short-term debt. Krugman’s advice:  initiate an orderly restructure thereby reassuring investors, and see the process through.  

The ECB, Farrell and Quiggin assert, has been ‘possessive about its powers’. One-time cost inflation to Germany backed by a newly issued Eurobond would ‘shore up the euro long enough for further-reaching reforms down the road’. It may, also, save the Union.

A PRICE TO PAY: PRICING CULTURE INTO EUROPE’S RESURGENCE

I admire Trichet’s technocratic savoir-faire. But maybe he has the wrong mentalite.. So as to guarantee the future of the European socio-economic project, it is necessary for the core, able to bear the risk, to forgive the vices of the periphery. In so doing, Germany and the stronger countries of the 17 member union (including France, before she too is in trouble) to remove the plank in their own eye. A French and German push for debt brakes could instead be diverted to backing the Eurozone with concerted funding assistance and a new Eurobond.

As Trichet indicated, ‘Each generation needs to affirm its commitment to Europe’ faced by its own concerns. Whereas debates concerning global financialisation and fiscal responsibility can be left for another day, it is imperative to shore up a more legitimate, more stable Union, an EU that is economically and culturally sound. Sound Keynesian policy aiming toward surplus should be backed by the Eurobond.

REFERENCES

Henry Farrell and John Quiggin, ‘How to Save the Euro -- and the EU: Reading Keynes in Brussels’ in Foreign Affairs

Paul Krugman, The Return of Depression Economics and the Crisis of 2008,

Barry Eichengreen and Harold James, ‘Golden Fetters: The Gold Standard and the Great Depression’, 1919-1939, NBER Series on Long-Term Factors in Economic Development             

                                                

Barry Eichengreen and Peter Temin, ‘Fetters of Gold and Paper’, UC Berkeley, MIT and NBER

Brad De Long, blog ‘Are We Handcuffed by Golden Fetters?’, March 27, 2009 at http://delong.typepad.com/sdj/2009/03/are-we-handcuffed-by-golden-fetters.html

Jean-Claude Trichet, President of the ECB, ‘Building Europe, building institutions’, speech upon receiving the Karlspreis in Aachen, 2 June 2011 at ECB website  http://www.ecb.int/press/key/date/2011/html/sp110602.en.html

Rudiger Dornbusch et al, ‘Mexico: Stabilization, Reform, and No Growth’,

Brookings Papers on Economic Activity, Vol. 1994, No. 1. (1994)

Narayana Kocherlakota, ‘Modern Macroeconomic Models as Tools for Economic Policy’, Banking and Policy Issues Magazine, Federal Reserve Bank of Minneapolis, May 2010 at http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=4428.

N Gregory Mankiw, ‘The Macroeconomist as Scientist and Engineer’, Harvard University, May 2006 at http://www.economics.harvard.edu/files/faculty/40_Macroeconomist_as_Scientist.pdf

BACK TO VALUE

APPRECIATING GOOD VALUE

Well, I must say my original post was very intoxicating, though perhaps I drank too deeply of Nietzsche’s heady insights.. I have just made my way, therefore, through a revised edition of Benjamin Graham’s ‘Intelligent Investor: A Book of Practical Counsel’ with an updated commentary by Jason Zweig and Preface and Appendix by the Sage of Omaha, Warren Buffet. To be frank, I was most interested in Buffet’s analysis of Graham’s investment ‘philosophy’of value investment, though I’m sure Graham and Buffet would see the matter more prosaically. The whole text, nevertheless, is still a great read and Zweig’s commentary is contemporary.

As such, I’m on a new search for value. (At least, I am critically revisiting the Value Investment perspective).

TWO PARTNERS

Opening onto the value investment scene, Warren Buffet and Ben Graham know ‘very well two partners’ – Graham himself and partner Jerome Newman - who made a killing off investment in the insurer, GEICO. With $11,413 shares invested in the General Employees Insurance Company through Graham-Newman growing to $1.66M by 1972 (p 533), Buffet himself later made one of his most significant investments in the concern.

The point being, Buffet asserts in his appendix speech at UCLA, Value Investment has worked, and continues to work.. Charlie Munger, Walter Schloss and Bill Ruane, though Wall Street tyros, as long-time value investors did pretty well too. The returns are all available in another appendix and taken from Buffet’s presentation.

MOVING TO GRAHAM-AND-DODDSVILLE

Named after its most celebrated (and among its wealthiest) inhabitants, Buffet then traces the value investment approach to Graham’s lectures at Columbia Business School. Buffet thus names the value school, Graham-and-Doddsville after Ben and David Dodd, co-authors of ‘Security Analysis’.

Life in these parts is founded on the ‘margin-of-safety’ principle. In this way, Graham outlines his definition: an ‘investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return’ (p 35). In Chapter Five of ‘II’, Graham and Dodd advise an heuristic, general rule-of-thumb encompassing a 50-50 split between stocks and bonds, adjusted for a 25% bias toward common stock in a bear market and vice-versa. Graham and Dodd insist on high-quality corporate/municipal bonds and high quality, mid cap stock.

REAPPRAISING VALUE

Throughout the original text and associated commentary, the Investor as opposed to the Speculator is admonished to avoid being burned. Discarding the high-volume trading and dot-com frenzy surrounding the Qualcomms and Worldcoms of the investor’s world, Graham et al instruct the real investor not to pay a dollar more than is justified and personally justifiable. (Aim for the IBMs).

Buffet has no truck for high-frequency/volume or day-trading or ‘growth’ speculative bets, and casts doubt on the very foundations of the CapM Markowitz modern portfolio with its Beta. Cultivate a no-nonsense mental attitude free of enthusiasm and emotion. Manage your downside. Avoid start-ups, IPO’s and even AAA credit companies, and instead invest in the business of business-like, intelligent stock investment. Revel in bargains, but track each companies earnings and debt service capacity to build in that buffer..

A VALUABLE OUTLOOK

In the final analysis, Nietzsche’s ‘transvaluation of all value’ may well be replaced in the Value Investor’s Universe by the Search for Value.. In the end, however, both ‘philosopher’s avoid the ‘Herd’.

If you can make your way through this revised Graham-and-Doddsville classic, then you will surely acknowledge Buffet’s observation that, ‘In an area where much looks foolish within weeks or months of publication, Ben’s principles have remained sound – their value often enhanced and better understood in the wake of financial storms that demolished flimsier intellectual structures’.

You will see, in line with ‘II’s opening quote,

‘Through chances various, through all vicissitudes, we make our way’….

                                                                                                            Aeneid

RECOMMENDATIONS

I would highly recommend the following two articles, though they take some time to wade through..

1. Carmen M Reinhart, M Belen Sbrancia, 'The Liquidation of Government Debt', Working Paper 16893

© 2011 by Carmen M. Reinhart and M. Belen Sbrancia. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit,including © notice, is given to the source.

And

2. Laura Alfaro, 'Global Capital and National Institutions: Crisis and Choice in the International Financial Architecture', Harvard Business School, publication date not supplied at http://www.people.hbs.edu/lalfaro/IntroGlobalCapitalandNationalInstitutions.pdf

The two articles provide wonderful insights, I think, into the nature of sovereign debt and history of sovereign debt default, international capital flow and capital markets and the volatility experienced in emerging markets with attendant consequences for international monetary policy and debt restructuring.

CLASH OF THE TITANS

Although perhaps not exactly new in business/finance or life generally, I have noticed some interesting divides in the economics world. What is fascinating is the way recent heated debates have become polarised around two opposing and erudite camps.

A few examples should get the ball rolling: in one corner, we have Professor Niall Ferguson, in the other Paul Krugman. Recently, I read Professor Kenneth Rogoff's ringing defence of the IMF against his former supervisor and mentor, Joseph Stiglitz who, of course, worked for the world bank. And finally, there was the more grandiose faceoff between Keynes' camp and the monetarists behind Milton Fridman.

Curiously, the same phenomemon can be found in music history: there were the implacable enmities and imprecations passed between fans of Johannes Brahms versus the Wagner clan.

Leaving, or in philosophical language, 'bracketing' the content of these disputes, I would be interested to hear your views on the 'phenomenon' described above..

SEEING THINGS DIFFERENTLY: Van Gogh, in his own words, 'trying to render intense colour and not a grey harmony' for 'life and progress in art'.

FEEL THE RHYTHM: MUSIC AND THE MARKET

Zarathustra stood there like one drunken: his glance dulled, his tongue faltered and his feet staggered. And who could divine what thoughts then passed through Zarathustra's soul? Apparently, however, his spirit retreated and fled in advance and was in remote distances, and as it were "wandering on high mountain-ridges," as it standeth written, "'twixt two seas,--Wandering 'twixt the past and the future as a heavy cloud… It carrieth me away, my soul danceth. Day's-work! Day's-work! Who is to be master of the world?

 (Freidrich Nietzche, LXXIX. The Drunken Song, ‘Thus Spake Zarathustra’)

As long as the music’s playing, you’ve got to get up and dance (Chuck Prince, Citigroup)

Models currently in use are based on the misconception that markets can only foreshadow events, they cannot shape them. My approach recognizes that financial markets can also precipitate or abort future events (George Soros, ‘The Alchemy of Finance’)

"The symphony must be like the world. It must embrace everything" (Gustav Mahler)

• The market - property, commodities, foreign exchange - follows the rhythm of music. 

• This applies especially to the stock market.

• The stock market is a million different instruments and tones comprised of market participants and speculators together in a national orchestra. (With the merger of the Singapore exchange and ASX, we have a much larger symphony).

• The conductors of Australia’s well-managed companies, the cream of business, drive the market but, as with any great conductor, they must anticipate it also.

• For as Gustav Mahler wrote, “a Symphony is the World”.

• Mahler further observed that “Tradizion ist schlamperei”: tradition is sludge. This requires any great conductor to observe the orchestra members and the group and inner dynamic and react accordingly. Conventional dictates, though parasitic to traditional risk management, can retard performance.

• Indeed, the late great Australian conductor Charles Mackerras emphasised ‘Australlung’, or emanation. Conductors and market leaders need to seek ‘360’-degree hindsight and foresight to beat the S&P 200.

• They aim to adjust their institutional or individual investment performance/portfolio to rising and falling indices as well as wider political and socio-economic events.

• Hence, master investors such as Warren Buffet and George Soros are able to anticipate, if not exactly predict, trending toward leading market events: the OPEC Crisis, Volcker-led unravelling of inflation and the eminence of Reagan’s Imperial Circle, the rise of a Super-Bubble fuelled by credit expansion and growing commodity prices, the Brady Bond/Latin American Debt Crisis and the Swedish Banking Crisis. (Cf. ROGOFF and KRUGMAN). Perhaps they did not expect the Asian and Russian debt crises, but they were waiting for the GFC.

• Anticipation and rhythmic attuning to the savage despondencies and euphoric joys of the Market – in all its forms – as well as to the atomic mechanics of daily market performance improves, or at the very least, cultivates hindsight and foresight: the ‘360 approach’.

• In the final analysis, one must watch how the numbers dance.