Who Will Rescue the Rescuers?

The Amphora Report

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German President Christian Wulff posed this provocative question in a speech in late August, the first official German statement to the world that Germany can no longer be relied upon to save euro-area member countries from the consequences of fiscal profligacy. Serving as an apolitical head of state—not head of government, a role that belongs to the Chancellor—Mr Wulff’s statement should be interpreted as a clear signal that a large and growing majority of Germans do not support recent government initiatives to further extend existing bail-out arrangements. But it also has far broader applicability. Just as there is no free lunch in economics generally, there is no free rescue. Someone always has to pay. Politicians may obfuscate this fundamental economic law from time to time, but no act can repeal it. Investors should take note.

Do Policymakers Possess a Magic Wand?

Any sensible adult knows, deep-down, that the world does not owe us a living; that with liberty comes responsibility; that there’s no such thing as a free lunch. Still, what is glaringly obvious at the personal level is less so when esconced within the highly complex system of the modern global economy, in which, at times, it can appear as if we can get something for nothing.

Take, for example a loan guarantee for a young adult with little or no credit history. Let’s say that said young adult has recently secured an attractive job requiring personal transport and would like to lease a simple car, confident that they can easily service the lease with their future employment income. They go online, search for an appropriate approved used vehicle in their target price range and, once located, head into town to the dealer to haggle the price down a little, agree the terms of the lease and hopefully take delivery of the vehicle within a few days, prior to starting work at the new job.

Later that day, all is going well, with the dealer willing to move lower on the price due to currently weak demand. A sale price and terms of lease are soon agreed. Some paperwork is produced and various signatures are required. So is a standard background credit check.

Unfortunately, both the dealer and customer are disappointed to learn that, due to an essentially non-existent credit history, the customer does not qualify for standard lease terms without a co-signer, who must possess a particularly good credit history.

But all is not lost. The customer is aware that her parents have quite solid credit histories and she knows that they are pleased with her new job, so she assumes that a quick phone call will convince one of her parents to co-sign.

Sure enough, the parent is reached and quickly agrees to co-sign, the necessary paperwork is faxed around for signature, the lease is approved and, prior to starting work the following week, the car is given a quick dealer check and made available for delivery.

Now at first glance it might appear that the young adult in question has just got something for nothing. After all, a simple parental signature was required on a form and, voila, the credit issue was solved. But look more closely and what we see is that, in fact, rather than a free lunch having been served up, a contingent liability has been created. What if, for example, the young adult should lose her job, through no fault of her own? Well, guess what, her parents will have to make good on the lease payments or the car will be repossessed. In this instance, her parents are more than pleased to assist, and she is more than pleased to receive help, but neither party should be under the illusion that there are not potential costs associated with the benefits of the arrangement.

Contigent liabilities, more commonly known as guarantees, take myriad forms in the modern financial world, some obvious, some obscure. Yet occasionally events transform the obscure into the obvious. Such is the case with the contingent liabilities associated with the euro-area.

We discussed the topic of contingent euro-area liabilities in some detail in a previous report, THERE MAY BE NO FREE LUNCH, BUT IS THERE A MAGIC WAND? in September 2010, back when euro-area policymakers were scrambling, as today, to calm down financial markets concerned about the large and growing debt burdens in Greece, Portugal, Ireland and potentially also Spain and Italy. As we put things at the time:

Just as there is no free lunch in economics generally, there is no magic wand in economic policy. Policymakers who claim otherwise are like magicians distracting their audience. As is the case in the physical world, in which there is conservation of energy–the first law of thermodynamics–there is also conservation of economic risk. It cannot be eliminated by waving a magic wand. It can, however, be transformed from one type of risk to another.

With respect to EMU, if the FX risk does not simply disappear, where does it go? Consider what creates FX risk in the first place: Currencies fluctuate for a variety of reasons which ultimately boil down to relative rates of sustainable economic growth and expectations thereof. As the EU economies have fluctuating relative growth rates, this creates fundamental FX risk. Only by eliminating these fluctuations could the real, underlying relative economic risk also be eliminated. But if these fluctuations are not eliminated, the risk remains. Once again we ask: Where does it go?

There answer, as it turns out, is credit risk. When a country’s relative sustainable growth rate (or expectations thereof) declines and the currency devalues it improves the terms of trade and, as such, raises the expected future growth rate. This in turn increases inflation and tax revenue expectations which make it easier, in principle, to service debt denominated in the domestic currency. As such, other factors equal, as a currency devalues, domestic credit risk declines in tandem.

But consider now what happens in EMU. A country that underperforms cannot devalue. There is no improvement in the terms of trade and hence no increase in either inflation or tax revenue expectations. Indeed, these are more likely to decline. Debt service thus becomes more rather than less onerous. Credit markets thus demand a higher risk premium to hold the debt Unless steps are taken to improve relative economic competitiveness, this higher risk premium may remain in place indefinitely, draining resources from the economy and reducing the future growth rate. Ultimately, the only ways to break out of a vicious circle of economic underperformance and higher relative borrowing costs is either to secede from EMU and devalue or to restructure the debt. In either case the fundamental risks are ultimately realised.

This is what is happening in Greece and Ireland today. It might soon take place in other EMU member countries. Those investors who have understood that EMU did not eliminate but rather transformed economic risk and who observed the chronic relative economic underperformance of Greece and certain other euro members were well-positioned to profit from onset of the euro sovereign debt crisis.[1]

So here we are, one year later. Borrowing costs not only for Greece but also for Spain and Italy, are significantly higher. Notwithstanding some apparent efforts, deficits in these countries are not coming down, leading to exponentially growing debt burdens.

As for the core euro-area countries, most notably Germany, which have provided explicit debt guarantees for Greece and potentially other weak euro-area sovereigns, the implied contigent liability grows and grows. Might it eventually grow to the point that, even if Germany remains willing to bail-out these countries—something that we consider highly unlikely—that it is simply unable to do so? Bailng out Greece or Portugal is one thing. But Italy? The market capitalisation of Italy’s debt is comparable to that of Germany!

It could be argued that Italy’s large accumulated debt is precisely the reason why, once markets got concerned about Italy’s finances, weaker euro sovereign yield spreads to Germany moved sharply wider. Italy is, it would appear, just too big to bail out. Or is it really?

Enter China. In recent months, China has publicly stated that they have been selectively buying euro-area sovereign debt, including that of some relatively weak issuers. Just last week, they increased their involvement with an offer to purchase more Italian debt. Does China thus see good value here? Are they seeking to diversify out of their colossal US Treasury holdings? Are they kindly offering help to trading partners in need?

While those explanations are possible, there is another that is more subtle and much more interesting. The Chinese offer to assist the euro-area comes with some rather visible strings, in particular, a Chinese request (read: demand) that Europe assist China with an accelerated granting of ‘market economy’ status under the World Trade Organisation (WTO), which would improve China’s terms of trade not only with the EU but with all WTO members, including the United States. As it stands now, the WTO will first grant China this status in 2016.

As reported in the Financial Times, Chinese Premier Wen Jibao has offered that, “If EU nations can demonstrate their sincerity [to support China’s ‘market economy’ status] several years earlier, it would reflect our friendship.” In other words, China is prepared to purchase additional euro-area sovereign bonds, in particular from some of the weaker issuers, in return for significant trade concessions.[2]

(As it happens, Brazil has also indicated that it might be interested in participating in some sort of collective BRIC (Brazil, Russia, India, China) action to assist the euro-area, although it is unclear on what terms. BRIC officials are meeting in Washington this week for one of their occasional summits and the issue of whether to assist with euro-area bail-outs is apparently on the agenda, as reported in the Financial Times.)[3]

Trade concessions are of huge importance for China, which is slowly losing competitiveness due to high inflation, including in wages for manufacturing. As such, the Chinese request for this particular quid-pro-quo for increased euro-area bond purchases is understandable and entirely sensible. Why, after all, would China offer Europe something for nothing? Indeed, the Chinese naturally find it difficult to be charitable to their far wealthier western counterparts. To quote from the same Financial Times article, “To most [Chinese] citizens, it is ludicrous to suggest spending the foreign reserves, which are viewed by many as the ‘blood and sweat money’ of the masses, to bail out decadent Europeans who only a few generations ago were trying to colonise the country.”

So do we think there is going to be a deal here? We don’t know. It appears there is a good basis for one, as both sides have identified clearly something they would like the other to provide in exchange. Yet such deals are subject to all manner of political caprice on both sides. Regardless of whether it happens or not, we think it would be a mistake for financial markets to react as if this would somehow solve the euro-area sovereign debt crisis.

Why? After all, China’s foreign reserves are huge, at over $3tn. (Total BRIC reserves, of course, are even larger.) They could buy up a substantial portion of weak euro sovereign debt. Together with ongoing ECB bond purchases and a modest intra-euro bail-out package from Germany and others, this would seem to comprise a formidable arsenal of buying power for distressed euro sovereign debt.

Yet there are two reasons why we do not believe that even action on this scale would solve the underying problem and thus resolve the crisis. First, China and the other BRICs remain primarily buyers of safer German debt. Even in the event that a deal is struck, it could well be the case that, rather than buy weak euro-sovereign debt directly, China and the BRICs buy German debt instead, issued to fund German contributions to the European Financial Stability Facility (EFSF). In this way, China would indeed be assisting with the bail-outs but in a way which minimises their credit risk which would, instead, be borne by the German taxpayer.

As President Wulff has clearly indicated, however, it is not in the interest of the German taxpayer to participate in further bail-outs. As such, regardless of whether there is Chinese support available, Germans are increasingly likely to refuse to participate in additional bail-out measures in future and might even renege on those agreed to date. Consider: In recent months, such prominent figures as IFO Institute Head and Member of the German Council of Economic Advisors, Gernot Nerb, and current Bundesbank President, Jens Wiedmann, have also expressed the view that the bail-out arrangements agreed to date are not in Germany’s interest. Former Bundesbank President Axel Weber and the ECB’s Chief Economist, Juergen Stark, have recently resigned in protest. The Chairman of the Bavarian CSU party, an important partner of Chancellor Merkel’s CDU, has also expressed this opinion.

Unlike in the US, where Fed officials are not particularly highly regarded by the public at large, this is not true of the Bundesbank, which historically has been held is significantly higher esteem than the government. Indeed, Germans give the Bundesbank credit not only for their post WWII ‘Wirtschaftswunder’ (economic miracle) recovery but also for the general stability of the German economy through the tumultuous 1970s and right up to the beginning of EMU in 1999.

Second, omitted from this discussion is whether the Chinese and other BRIC economies are going to remain healthy enough to provide a credible backstop for weak euro sovereign debt for a sustained period of time. If China and/or the other BRICs have a hard economic landing, they will have their own bad debt problems to worry about. As sovereign nations, they could, of course, at any time, choose to limit or withdraw entirely their support for any euro-area bail-out arrangement.

In our view, a BRIC hard landing is a material risk. Consider that, back in 2009, various policy stimulus measures in the US, Europe, Japan and elsewhere began to provide significant if temporary support for exports from the BRIC economies. As recent data in the developed economies demonstrates rather clearly, the effect of this stimulus is now wearing off and a renewed downturn is in the works. Should we be confident that the BRICs will be able to decouple?

Absolutely not. Indeed, they might turn down relatively more sharply. Why? Well, for one, BRIC rates of investment have remained elevated, implying much excess capacity in the event that export demand slows. Second, all BRIC economies have been raising interest rates over the past year in response to surging inflation. The lagged impact of higher rates might now be taking effect on growth. Finally, as is always the case with rapidly growing emerging markets, their economic cycles simply tend to be more volatile on both the upside and downside.

This is why certain indications of slowing BRIC economies should be of concern for those who believe that the BRICs will “rescue the rescuers.” There are now several to note.

First, monetary authorities in both Brazil and Russia have taken action recently to ease policy, by lowering interest rates and talking their currencies lower. Clearly they believe that the cycle has now turned. Second, a handful of highly growth-sensitive Asian currencies—the South Korean won, the Taiwan dollar and the Malaysian ringitt—have weakened sharply of late, something that also happened, incidentally, in the early stages of the general global downturn of 2008. Finally, and this is perhaps most obvious, the BRIC stock markets have not been performing well this year, in particular that of China. The Shanghai Composite Index failed to bounce along with global stock markets last week and is closing in on key support at 2,400. If that is taken out, it theoretically opens up downside all the way to the lows the index reached at the nadir of the 2008 financial crisis.

Could it be then, that just as the BRICs step up to “rescue the rescuers”, they, too, find themselves in need of some form of rescue? But with the entire global economy slowing down, where on earth is that going to come from? The moon? Mars?

The sad fact of the matter is, with terrestrial demand across the globe already having been stimulated time and again, hence the insurmountable sovereign debt mountain; with rescuers having already come to the rescue, now in need of their own; with global financial markets demanding loud and clear that there is just too much debt and credit risk in the world and it must be reduced, by bankruptcy and default if necessary, the end of the neo-Keynesian road has been reached. Stimulating lunar or martian demand is simply not an option. But as we explore in the following section, policymakers have hardly finished in their efforts to force financial markets to behave as they would prefer.

The All-Too-Real Consequences of Policymakers 'Magic'

In a sense, policymakers are like court magicians: They always seem to have yet another trick up their sleeve. One of the classics is when they surrepticiously add a few coins or banknotes to the wallet of someone momentarily distracted by something else. When they discover their windfall, at first they are both surprised as delighted. However, what they also didn’t notice, was that the magician had already worked the room. Most wallets have already been so fattened with conjured money. Nominal wealth may have increased, but not real.

Economists refer to this as inflation. By increasing the money supply, policymakers obscure weak or negative real economic growth with artificially stronger rates of nominal growth. Of course this growth is unsustainable and simply fictional. While it is underway, most don’t notice. But as the inflationary stimulus wears off, the true nature of the deception is revealed.

Well, guess what. In some places, the deception and subsequent failure of post-2008 stimulus measures is becoming glaringly obvious. As reported widely in the financial press, the US misery index, which combines the rates of unemployment and consumer price inflation (CPI) for a general measure of economic malaise, has recently risen to 12.9%, the highest level since the early 1980s. But what the mainstream financial press has missed, and missed rather badly, we would add, is that the way in which both unemployment and CPI are calculated has changed significantly through the years. Were we to apply the 1980s method for both, the Misery Index would now be at a whopping 34%, a record high! Remove the statistical smoke and mirrors and the real economic horror show of the US economy becomes plain for all to see.[4]

Ah, but if you thought the smoke and mirrors of inflation (and statistical manipulation) was bad, wait until you get a flavour of what some eurocrats might be planning, in the event that we are proven right and that the BRIC “rescue of the rescuers” is aborted at some point in future. In a recent opinion piece in the Financial Times, two prominent European public sector economists claim that there is, in fact, no chance whatsoever that euro-area sovereigns will default. The article, appropriately titled “Compulsory borrowing is the WMD (Weapon of Mass Destruction) in Europe’s fiscal arsenal,” makes the case thus:

…Europe’s fate is not sealed. The spectre of sovereign defaults and rising spreads in Italy, Spain, Belgium and other countries can be chased away in one fell swoop and the panic of contractionary fiscal policies can be stopped. National governments must simply take out of their fiscal armoury the weapon that has served them so well in war and peace alike: forced borrowing.

It consists of coercing taxpayers to lend to their government… Compulsory lending is an unconventional weapon but it is high time it be used, even on a small scale, to remind investors that sovereigns are not private borrowers: they need never default because they can always force-feed debt issues to their own residents.[5]

Let that sink in for a minute. This is just breathtaking in its bureaucratic, undemocratic audacity. Let us see if we can get this straight: Paraphrasing the above excerpt can help (as can affecting an appropriate European accent while reading the following aloud):

…Europe’s fate is not sealed. The spectre of sovereign defaults and rising spreads [caused by government and Eurocrat mismanagement] in Italy, Spain, Belgium and other countries can be chased away in one fell swoop and the panic of contractionary fiscal policies can be stopped, [thereby allowing government and Eurocrat mismanagement to continue indefinitely until the European economy is a complete ruin]. National governments must simply take out of their fiscal armoury the weapon that has served them so well in war and peace alike: forced borrowing. [Served them so well? Forced borrowing financed WWI and WWII, not to mention numerous smaller, regional European wars.]

It consists of coercing taxpayers [who, as taxpayers, are already being coerced] to lend to their government… [S]overeigns…can always force-feed debt issues to their own residents. [In other words: “You WILL buy our crappy debt, against your will and better judgement, and you WILL LIKE IT!]

Euro-area governments like to call themselves democracies. Yet here we see some eurocrats threatening to use WMDs on their own citizens! The tyrannical European emperor has no clothes.

The Investment Implications of Financial Repression

Coercing residents to buy up spiralling public debts is but one additional, arbitrary way in which so-called ‘democracies’ can go about extending unsustainable government policies.

Deficits, inflation, artificially low interest rates, coerced borrowing, capital controls—all of these represent, separately or frequently together, forms of ‘financial repression’, that is, ways in which governments, via the financial system, absconds entirely legally with some portion of the accumulated savings of the masses.[6]

From time to time, ‘financial repression’ becomes so acute and obvious that the masses refuse to co-operate and some sort of revolt or even revolution ensues. Recent examples include the protests in Greece and elsewhere in the euro-area and the so-called ‘Arab spring’ revolts/revolutions in North Africa and the Middle East. But two decades ago there were a series of debt crises and associated electoral shifts in the Nordic countries which resulted in a partial dismantling of their welfare states and, just over a decade prior to that, the Thacher/Reagan episode in the Anglo-Saxon world.

How should investors prepare for and respond to financial repression? To a certain extent, it depends on what form it takes. However, there are certain universally applicable methods for protecting wealth when governments seek to appropriate it for their own use.

First, let’s tell it like it is: With the possible exception of war financing, governments do NOT engage in financial repression for the benefit of their citizens, although they might like to think so. They do it, rather, to cover up their past policy mistakes, which are what placed government finances in such a precarious position in the first place. Blaming financial markets for a government funding crisis is nothing more than shooting a messenger. It might be politically expedient to do so but it has nothing to do with addressing the real causes of the crisis. The last thing an investor should do, once financial repression sets in, is to trust the government to act in his/her interest.

Second, as the more common forms of financial repression involve various inflationary policies, it is important for investors to think in real rather than nominal terms. The most straightforward way to do this is to stop measuring wealth in a fiat currency, the supply of which is under the direct control of the repressing regime.

Third, investors should focus on investments that have, in real terms, tended to best retain their purchasing power through historical periods of financial repression, regardless of which methods were employed.

Fourth, as the precise form of financial repression can change suddenly and unexpectedly by government caprice, investors must diversify, in particular internationally, as international financial repression is difficult or impossible to coordinate in theory and in historical practice.

Finally, investors simply need to be realistic. There are historical periods when it is relatively easy to grow wealth and others when it can be challenging merely to preserve it. We need to play the hand we are dealt, however poor. There is no point lamenting the fact. One simple action that all should do is to step back from day to day life and ask some deep, serious questions about what a given future lifestyle is going to cost and whether or not it is going to be realistically affordable in an age of financial repression. The simple virtues of saving and thrift thus take on renewed importance.

Taking all of the above points together, our specific suggestions for dealing with financial repression would be the following:

  • Underweight financial assets, in particular those that are dependent on real, rather than merely nominal growth to justify current valuations.
  • Overweight real assets, as historically these have held their value better under repressive policy regimes.
  • Diversify. And beware that what appeared diversified under normal circumstances may not remain so under a repression regime.
  • Think internationally. Repression in some countries will almost certainly be greater than in others.
  • Take the long view. Sadly, historical periods of financial repression can be prolonged, lasting over a decade in some cases. But when it is over, there are going to be great opportunities to grow wealth again.

As we have written before, no generation wants to accept that some of the more painful lessons of history must be learned in its own time. But so it is with us. Now is not the time for denial or delusion. Rather, it is an opportunity for us to grow up, to face the unfortunate circumstances as they are, and to make certain that our children, and theirs, don’t do as we have done and repeat some of the more common historical mistakes. Oh well, here we go again.

Resources

[1] THERE MAY BE NO FREE LUNCH, BUT IS THERE A MAGIC WAND? THE AMPHORA REPORT, SEPTEMBER 2010.

[2] “China sets terms for largesse in Europe,” Financial Times, 15 September 2011.

[3] “Brazil backing,” Financial Times, 15 September 2011.

[4] For further information on how the CPI and unemployment rate calculation methodologies have changed through the years, please see www.shadowstats.com

[5] “Compulsory borrowing is the WMD in Europe’s fiscal arsenal,” Financial Times, 15 September 2011.

[6] The concept of financial repression was popularised earlier this year in an influential paper by Carmen M. Reinhart and M. Belen Sbrancia, “The Liquidation of Government Debt,” Working Paper Series, Peterson Institute for International Economics, April 2011.

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