Dr. Pippa Malmgren
Principalis

Senior Advisor:

Harvest Asset Management

Advisory Board Member:

Indiana University, SOAS, Ditchley Foundation, Board of Governors, MIT Legatum Center for Development and Entrepreneurship

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September 2011 Policy & Markets

News to expect in the coming days and weeks:

  • Greece defaults
  • Germany protects German banks but other countries cannot do the same thus quickly provoking multiple sovereign defaults and or bank failures, all of which may easily lead to a payments crisis in the global banking system. Derivatives are particularly at risk in terms of operation and execution.
  • The Euro falls in value especially against the US dollar
  • The Germans announce they are re-introducing the Deutschmark. They have already ordered the new currency and asked that the printers hurry up.
  • The Euro falls even more on any news that Germany is withdrawing from the Euro.
  •  Legal wrangling begins as to the legality of Germany’s decision. Resolution takes years.
  • Germany insists that the Euro continues to exist even they do not use it any longer. They emphasize that European unification will continue and suggest new legal instruments to strengthen European Unification including new EU Treaties.

The markets are focused on the imminent default by Greece. But, this is not the most important issue now. The historic development the markets have not priced in as that Germany is preparing to exit the Euro. The markets are very likely to have to contend with the re-introduction of Deutsche Marks in the near future. This is bound to mean a collapse in the value of the Euro for those countries that will remain in it (devaluation for the rest of Europe). This step may seem unthinkable but, I believe that the German government is telling us in multiple ways that there is no other solution from their point of view. It is also why you will hear various policymakers at the G7 meeting his weekend echo Christine Lagard’s comment that the world economy is entering a "dangerous new phase."[i] This was certainly the atmosphere at Jackson Hole where policymakers openly talked about entering a period of history where we would face challenges beyond the scope of anything we have seen in our careers. 

The Vice Chancellor of Germany, Philip Roesler[ii], gave a speech on September 11th in which he said there will be no more bailouts and any German politician who approves a single Euro for the debt problem of another European nation will not survive in office.  This is consistent with a German poll over the weekend that shows more than 70% of Germans oppose any more transfer of German wealth to nations with debt problems.

Please note his specific language: "Roesler told the Monday edition of Germany's Welt daily there should be "no limits to thinking" of possible scenarios of how to end the euro crisis."[iii]

The Germans have already concluded that if they are going to write any further checks then they are going to write them to their domestic institutions and protect their domestic investors.  Necessarily, this means that many Eurozone countries will default on their debt. It now seems this will happen within a matter of days. Germany has, therefore, already announced its intention to ring-fence and support their own banks and only their own. This may ultimately involve the nationalization of some or even all the German banks. This is necessary because a falling Euro will further weaken the ability of the other Eurozone members to meet their commitments and thus increases the risk of multiple sovereign defaults. Eurozone countries that are going to default will do so virtually simultaneously rather than sequentially.

Eurozone countries may or may not have the resources to nationalize their banks. Therefore, we have to expect that bank failures are a real possibility. Apparently, the Europeans are warning the US to come up with a plan to nationalize Bank of America given that it is already in a precarious position, despite the injection of capital from Warren Buffet. The multiple lawsuits against Bofa and other banks alone will render the US banking system vulnerable to any dramatic announcement out of Europe. But, no doubt US banks have immense exposures to European institutions and some may even have sovereign credit risk directly on their balance sheets.

It is hard to overestimate the shock that this will bring to the financial markets.  Risk aversion will set in quickly as people start to consider the multiple possible consequences, some unintended, of such a decision. Huge fortunes will be made and lost in this moment in history.

It is worth providing a review of the evidence that led me to this conclusion.

Christine Lagarde’s speech at Jackson Hole revealed the recognition that there was a risk that Germany might not “write a check” to bailout the Eurozone members. She said, to paraphrase, “somebody needs to write a check or we are going to have historic multiple bank failures.” Everyone in the audience understood that no check is coming. The ESFS is not yet funded and a number of the contributors will not hand over cash if there is no collateral. Of course, the only collateral available is the insufficient gold reserve, or handing over ownership of the nations industrial assets[iv], which amounts to having a nationalization of industry, which is then put under the control of a foreign government. So, there really is no meaningful collateral. Also, there is no international party, including China, that can write a check large enough to fill the cumulative debt hole that exists across the various Eurozone countries.

Apparently, Lagarde and Trichet spent a day after Jackson Hole, in a heated argument with Lagarde pushing for a more realistic assessment of the Eurozone debt and of the true condition of Eurozone bank exposures to the debt. Trichet, in contrast, believes that it is possible to buy time and lead the market to believe a resolution is possible. Lagarde’s view is that many European banks are fundamentally insolvent and that’s why they are taking liquidity directly from the ECB. This is before the defaults even occur. Trichet’s view is that the banks might be able to earn their way back to health if they had more time.  The cynical view is that Trichet does not want the Euro to end or a bank crisis on his watch. It is said that this was the principal issue that led to Jurgen Stark’s resignation: Stark and Lagarde favor facing the facts as soon as possible whereas Trichet does not want his legacy marred and or he believes that it is always worth buying a little more time.

Meanwhile, the German Finance Minister recently gave a historic interview with Der Speigel[v] where he said this: Still, we would be a strange government if we didn't prepare ourselves for all eventualities, however unlikely they may be.”  What eventualities might he mean? Well, he spells it out later in the interview:

SPIEGEL: In historical terms, there have been only two solutions to these kinds of problems: either inflation, which devalues a country's debts more or less by stealth, although it does the same to citizens' assets …

Schäuble: … or, in the past, a war, which is nowadays, thank God, impossible -- precisely because of the process of European unification …

SPIEGEL: … or at least a monetary reform.

His reference to “monetary reform” is telling. He did not say “fiscal reform”. Fiscal reform would potentially cure the problem. Instead he says “monetary reform” meaning Germany pulls out of the Euro and prints DMarks again. He totally rules out either Eurobonds and or bailouts when he says, “There is no collectivization of debt, and there is no unlimited support.” This is consistent with the views expressed by Otmar Issing to Bloomberg back on August 15th[vi] when he said in reference to Eurobonds, "That is a catastrophe," adding “that he does not understand why politicians in Germany would agree to such a thing given that they would threaten Germans with higher taxes or cuts in government spending.” It is clear to Shauble that this debt crisis threatens the institutions and agreements that hold the Euro and the European Union in place. If you want an EU to survive this impending blow then you need to start thinking about new agreements that can replace the ones that will be damaged or destroyed by these events. This is why he is talking about a new EU Treaty[vii].

The fact that the Troika (ECB, IMF and EU examiners) had to suspend their assessment of Greece was another important sign. The IMF wanted to be much more realistic about the magnitude of the Greek problem than the ECB wanted to be. Suspension of the mission merely confirms for Germans that the problems in the periphery are bigger than is understood and cannot be dealt with through austerity.

The Federal Constitutional Court Press Release[viii] has also been misinterpreted by those who want to believe that bailouts will occur. The FT reported that the court ruled in favor of Chancellor Merkel. But, the reality is that the court took the authority to decide away from the Chancellor and gave it to the Budget Committee in the Bundestag. This committee has 48 members and each is certainly driven by the polls and cares about re-election. The Budget Committee is deeply likely to oppose any bailouts that will cost German taxpayers, just as Dr. Issing says.

The next thing you know Dr. Joseph Ackerman gives a speech on September 5th[ix] that has been described as “terrifying”. Business Insider[x] provides a reasonably comprehensive account in English. He said, "It is an open secret that numerous European banks would not survive having to revalue sovereign debt held on the banking book at market levels." He continued: "Most institutions have a rating of "below the book value or at best". He then spelled out the choice Germany’s politicians must make: bailout Europe or bailout us, the German Banks. But he tried to make the case based on a cost analysis (typical financial market guy). He said, "The costs of supporting weak member states, particularly from the German perspective, are less than the costs of disintegration.... It is a dangerous illusion to believe that a country could do better should it reclaim the sovereignty it has delegated to the EU." The issue for the German politicians is not the cost. The issue is the principal of sovereignty and protecting the German population from any return to their horrific experience with inflation. Eurobonds and bailouts to peripheral countries are all ways of increasing the money in circulation as a means of filling the hole. But, no politician in Germany can accept that path given their history, as Wolfgang Schäuble says so clearly in his interview. Ackerman knows that failure to go down the inflation path will probably result in a partial of full nationalization of the German banks, his own bank included. At the very least, the leadership of banks in the new world will have to be less focused on profits and more focused on safety. This is why he says, “"We must in my opinion, check all our work in all areas thoroughly again to ascertain whether we prioritize our genuine tasks as servants of the real economic needs." But, I fear it is too late for him or any other German bank leader to claim that they can be a “trusted good guy” going forward.If any doubts remain about the German inclination to return to the DMark then consider these announcements. Switzerland announces a peg to the Euro. It was crystal clear at Jackson that the Swiss leadership expected an historic event to occur which would culminate in a rush into Swiss Francs. They tested the water by announcing a “fee” which would be applied to all non-Swiss purchasers of their currency. Within a few days they announce the peg. In short, Switzerland knows what is coming and has just barred the door to anyone who might try to escape the demise of the Euro by leaping into Swiss Francs.

The statement by the central bank in Canada is similar. I happened to be in Canada when the statement was made. Canadians were deeply confused. After all, to paraphrase, the central bank said, “all the bad things we thought might happen, are now happening, so we are going to maintain a highly defensive position”. In other words, Canada is also gently warning the markets that it will do what it has to do to prevent the currency from suddenly accelerating in the event of a European currency implosion. The Japanese are hinting at this as well. According to Reuters the Finance Minister, “Azumi also said he was ready to step into the currency market to counter speculative moves, although Japan would likely struggle to gain G7 support for intervention.”[xi]

It therefore seems likely the US Dollar and US Treasuries will be a major net beneficiary of any failure to bailout Europe. As an aside, this means the market would undertake QE3 as it were. The Fed won’t have to do “operation twist” or consider QE3. They will be able to focus their attention on the inflation “target” and finding ways to justify letting it rise.

It is fascinating that Jurgen Stark’s resignation[xii] has caused people to think the chances of a bailout are increased when in fact his resignation signals that the risk is increased that no bailout will occur AND Germany will withdraw from the Euro. Stark has been a board member at the ECB until his resignation.

The day before Jean Claude Trichet became rattled at a press conference when a journalist asked him if Germany might return to the DMark[xiii]. He used it as an opportunity to point out that Germany had experienced better price stability under the ECB than it had under the Bundesbank. I view this defence (which took six minutes) as a telling signal. Trichet could have said, “no, don’t be ridiculous”. Instead, he says Germany gets better price stability with me at the ECB than it got for fifty years with the Deustche Bundesbank. This is a plea for Germany to please stick with the ECB and not return to national monetary policy.

But, that was not enough to stop Stark’s resignation. When we look back in history we will see that all the important German policymakers resigned from the ECB before Germany formally returned to Deutschemarks, just as one would expect. It also seems too much of a coincidence to my mind that former Head of the Deutcshe Bundesbank and ECB board member Axel Weber leaves the ECB just before all the proverbial starts hitting the fan, goes to UBS as Chairman, and the next thing you know that describes the ways in which countries could leave the Euro including the potential costs if Germany left.

The Greek debt problem cannot be contained with the CDS spreads blowing out at the current speed. Many European countries have huge debt issuance plans for October and November. Germany is not only thinking about the risk of a Greek default, but also the risk that many other countries will need a lifeline very shortly. The only solution that meets the needs of German taxpayers and citizens is to protect their own interests first.

 

Banking and Payments System Crisis

The nationalization of the German banks, or the creation of a purely German Bailout mechanism, will immediately cause the markets to blow out the spreads on all debt instruments around the world with the possible exception of certain G7 countries like the US and the UK. Note that even the UK has massive bank exposures to the continent especially in Ireland. Ireland may get a bailout from the UK (again) but it is hard to imagine the UK writing a check to anybody else. This would force other Eurozone members to consider how to deal with their own bank debt problems: France, Italy, Belgium all leap to mind but the market will be bound to pressure others from Cypress and Eastern European countries to Bank of America. In fact, the entire banking and payments systems will be subject to entirely unknown shocks and logistical problems should this announcement be made.

Greece defaults and Germany will shore up the German banks. Other countries will either have to do the same or the market’s will discern which countries cannot bailout their banks due to lack of funds. The UK will be asked whether it is going to support the Irish banks. I suspect the UK will say yes but they may not be ready to answer the question when it comes. Any delay will force the UK government to reveal that the UK banks are cash rich. This will raise questions about their lack of lending. Bank failures will probably occur. Small institutions may bring significant consequences. We will see if the French have the resources to manage their banks. Christian Noyer insists that they do, but he would.

 

The Federal Reserve will have no choice but to make unlimited liquidity available to the market. They won’t need to announce QE3. The market will do it for them. But, the Chairman really wants to announce QE3 and may use these events as a reason to do so.

Gold, diamonds, agricultural assets, energy prices and mined asset prices will rise. Default reduces the debt burden and allows growth and inflation to return. If central banks (other than the ECB) throw huge liquidity out into the market because of this event then the liquidity is going to lean away from paper financial assets other than the most trusted and liquid (US Treasuries), and lean toward hard assets.

I would expect a major unscheduled speech from the President of Germany once it is decided to leave the Euro. After all, this step will mark the first independent move by Germany since the European Union project began with the European Iron and Steel Community after World War Two. A Germany that is not tied into monetary union requires an explanation. I imagine the Germans will emphasize their total commitment to European Unification and explain why the loss of monetary union is either temporary or can be overcome. To reiterate, the Germans will find it inconsistent to remain inside the Euro if the value of the currency plummets because the markets have no confidence about the financial position of most of the members. The idea that Germany would tie its manufacturing base and economy to a devaluing currency that has no fiscal discipline is unthinkable in Germany.

A European Bank “holiday” might be required to deal with the payments problems and with sudden and dramatic changes to valuations and therefore to the true balance sheet position of many banks and other financial institutions.

I disagree with Jim Rogers’ view. He says, "the euro will go down a fair amount. But I would buy all the Euro I could at that point because then that would mean that Europe is going to have a very strong, sound currency”. "People can not lie about their finances anyone, people have to run a tight ship."[xv] This might make sense if Greece is the only defaulting country, but it won’t be. It would make sense if Germany stayed in the Euro. But, I believe the risk is that Germany will not stay in.

Europe is about to become a very cheap place to go on holiday or to buy a beach house or a ski chalet or a vineyard.

Countries that already have inflation can expect much more once these events unfold. This is going to make the policy problem for Australia and Canada substantially more difficult. The cost of living will rise but no central bank can raise rates against the backdrop of a crisis environment.

The world is about to experience deeper stagflation. The cost of living will now rise even more but growth remains stunted. Policymakers will start to veer back and forth between dealing with unemployment and dealing with inflation. The years ahead will be referred to as “stop go” years because policy will at times try to stop price hikes and at other times policy will try to push growth.  Luckily, the world has seen this movie before in the 1970’s. Hopefully, we have learned something from the past and it ends rather more quickly this time around.

 Dr. Pippa Malmgren

 

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