Barron's Cover
SATURDAY, JULY 14, 2012
The Euro's Fate
By RANDALL W. FORSYTH
To resolve its debt crisis, Europe has to continue to cut social spending and reform its labor laws, but it must also engage in a massive stimulus program. Will the euro fall to parity with the buck?
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Against the intense media glare trained on crucial recent events of Europe, notably Greece's election and the latest summit of European Union leaders, one important development was all but obscured. Airbus, the European consortium that is the main rival to Boeing, recently announced that it will establish its first production facility in the U.S.
There, in sharp relief, is the tangible evidence of the crisis that besets Europe's economy; the only way Airbus can compete with the rest of the world is to move away from the Old Country. Just as BMW and Mercedes-Benz before it, Airbus is moving to America's Deep South in search of what it can't find in Southern Europe -- a highly productive, low-cost workforce that can compete globally, with the help of a competitive currency.
That's precisely what Europe, with unemployment levels not seen since the 1930s, needs -- and what it sorely lacks. The cure for deficits is growth. And the quickest way to spur growth is via monetary reflation.
A still-cheaper euro -- at parity with the U.S. dollar -- can restore Europe's competitiveness, end its debt crisis, and save its currency. It worked before, in the last decade, and we're now more than halfway to parity, from a peak of $1.60 in 2008 to around $1.22. After two years of haircuts and half-measures, the only way left to save the euro may be to debase the euro.
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There is a growing realization that, as expensive a proposition as that might prove to be, it will be less costly than a breakup of the single currency, which Germany's Der Spiegel said would precipitate a horrific result: "All of Europe would plunge into a deep recession. Governments, which would be forced to borrow additional billions to meet their needs, would face the choice between two unattractive options: either to drastically increase taxes or impose significant financial burdens on their citizens in the form of higher inflation."
That is what forced European Union leaders to reach some consensus at last month's summit. And the crisis has produced an alphabet soup of new entities to deal with it -- the EFSF, the European Financial Stability Facility, to be succeeded by the ESM, European Stability Mechanism, which is to be given the ability to directly recapitalize the ailing Spanish banks.
But only the European Central Bank, led by Mario Draghi, has the capacity to print euros to buy assets like Spanish and Italian government debt without limit. And it will likely take yet another market meltdown to push that resolve. When it does -- and we expect it will -- it will mark a once-in-a-decade opportunity to buy already very cheap European stocks. But not before.
THE IDEA OF PRINTING MONEY is dangerous heresy to European authorities, not least the ECB itself, whose sole legal policy aim is for price stability, in contrast to the Federal Reserve's dual mandate to promote both low unemployment and low inflation.
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Foerster/Bloomberg News
ECB chief Mario Draghi
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Instead, European Union officials have pushed spending cuts and tax hikes as conditions for bailouts of Greece, Portugal, and Ireland, along with reforms of regulations that restrict job growth even in the best of times. But Richard Koo, the chief economist at Nomura Research Institute, sees the crisis from the vantage point of Japan's bust and stagnation of the past two decades. Europe suffers from a combination of pneumonia and diabetes. Adopting a regimen of healthy diet and exercise to contain the diabetes will be futile if the patient succumbs to pneumonia.
The Germans point out that they underwent productive, but painful, reforms starting in 2003 and emerged an economic powerhouse as a result. What they don't mention is that Germany then had the advantage of a hyper-competitive euro.
Koo contends that, more than the labor and health-care reforms launched by then-Chancellor Gerhard Schroeder in 2003, Germany benefited from stimulative ECB policies to offset the effects of the bursting of the technology bubble in 2000.
That's what's needed now for Europe: an even more stimulative policy by the ECB to bring down long-term interest rates for highly indebted nations, especially Spain and Italy, to sustainable levels and, most particularly, lower the common currency to something closer to parity with the dollar. The "pneumonia cure" would give time for the reforms to get a debt-ridden "diabetic" Europe on its feet.
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Europe's political leadership, led by German Chancellor Angela Merkel, contends that structural and fiscal changes are what are needed first, and that excess money and credit were the causes of the current problems. Simply revving up the printing press would only let Greece, Spain, and Italy off the hook. European leaders want to use the current crisis to force reforms that wouldn't be possible in normal times.
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Moreover, the Bank for International Settlements -- the central bank for central bankers -- warned last month in its annual report that the ECB, along with the world's other major central banks, including the Fed, the Bank of Japan, and the Bank of England, had reached the limits of their ability to boost economies. With interest rates at or near zero and the expansion of their balance sheets, the report continued, central banks risk harmful side effects of potential inflation and stoking asset bubbles, especially in emerging economies.
But there is reason to doubt the present policy prescription of budget austerity and reform will yield success. While there are signs of progress, the Bank Credit Analyst observed, "At this pace, it will only take another 30 years of debt deflation and mass unemployment before competitiveness in Greece catches up with Germany." To close the gap more quickly, inflation in Germany has to rise faster than in the periphery. "Germany may not want to accept higher inflation," BCA concludes, "but the alternative -- a collapse of the euro zone -- would be far worse."
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THIS CONUNDRUM IS THE COST of the single currency. Flexible exchange rates allow the adjustment for economies where inflation and productivity trends get out of whack. Devaluation offsets the loss of competitiveness for high-inflation, low-productivity economies.
Fixed exchange rates, meanwhile, force an "internal devaluation," in which belts are tightened literally and figuratively -- prices are lowered, wages and payrolls are reduced, and government budgets are cut -- in order to maintain the currency's value. These are painful steps that don't go down well in a democracy.
The fixed exchange rate across the euro zone is supposed to enforce discipline, and the conditions for the bailouts in Greece, Portugal, and Ireland have been austerity and a steep resulting recession. And last week, Spanish Prime Minister Mariano Rajoy unveiled new budget cuts of €65 billion ($79.3 billion). While this was applauded by the European Commission, the move angered protesters in Madrid, who threw rocks and firecrackers at police over cuts in subsidies. The police reportedly responded by firing rubber bullets at the protesters. This is how austerity plays in the streets.
An easier ECB policy would likely induce higher inflation in Germany, but in the periphery "excess capacity is abundant," so stronger demand would translate into greater economic activity, rather than upward pressure on wages and prices. "A more dovish monetary stance would also lower the value of the euro, giving the periphery's exporters a much-needed boost," the BCA report concludes.
While easy money is dismissed as a palliative, it "can facilitate structural adjustment," Sebastian Mallaby, the Paul A. Volcker senior fellow for international economics at the Council of Foreign Relations, similarly writes in Foreign Affairs.
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Mallaby concludes: "If the ECB prints enough money to hit its target of 2% inflation across the Continent, this is likely to mean zero inflation in the crisis countries, where unemployment is high, and 3%-4% inflation in Europe's strong economies, where workers are confident enough to demand wage increases. By delivering on its inflation target, in other words, the ECB can help Italy and Spain compete against Germany and the Netherlands, gradually eroding the gap in labor costs that lies at the heart of Europe's troubles. That would boost the competitiveness of the crisis economies against the rest of the world, further increasing the odds of an export-led recovery."
The problem, adds Mark Haefele, the head of investment at UBS in Zurich, is that in 2000-2009 labor costs rose 50% in Spain and 35% in Italy, versus 18% in Germany. It would take 10 years of adjustment to close the gap. But that risks unsustainable deflation in the periphery, which would worsen the crisis by raising the ratio of debt to gross domestic product.
CAPPING THE BORROWING COSTS of large debtor nations, such as Spain and Italy, also would play a role. Surging borrowing costs on sovereign debt that exceeds the sizes of their economies could result in the debt compounding at a faster rate than the growth of nominal gross domestic product. That is why a 7% yield on Spain's benchmark 10-year bond sets off alarm bells.
The ECB did this, to a limited extent, by buying those countries' bonds last year in its so-called Securities Markets Program, or SMP. But since then, the bank eschewed these purchases, instead providing €1 trillion in financing to banks through the LTRO, or long-term refinancing operation.
Purchases of government bonds could also be made through the ESM, the soon-to-be launched bailout fund, which will have €500 billion in capital. Of that, €100 billion will be injected into Spain's banks. How the rest of the money will be divided has yet to be determined.
Only the European Central Bank has the unlimited firepower to stop a destructive rise in bond yields. Bond traders know the EFSF (and its successor, the ESM) has limited resources, and they will sell when they see the bailout funds will be tapped out. But if the ESM is made into a bank -- with the ability to borrow from the ECB and to issue debt that the ECB can buy -- it will have unlimited resources.
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How much it will cost to fix Europe is anybody's guess. For example, the Federal Reserve thought $1 trillion would be enough to right the U.S. economy, then came back with another $600 billion for QE2 and even instituted Operation Twist. Ultimately, it will depend on the market's response.
THE ONGOING DISASTER IN SPAIN offers "the best hope" for debt monetization by the ECB through the back door of the ESM, writes Christopher Wood, strategist of CLSA, in his widely read Greed & Fear newsletter. Only "sharply lower share prices" would induce the Germans to go along with debt monetization and "the ECB is not going to act independent of the politicians, most particularly those in Berlin," he adds.
The notion of actively devaluing the euro goes against consensus opinion. Haefele notes that it could raise the specter of so-called currency wars, as Brazil's finance minister accused the U.S. of starting in 2010 with the Fed's QE2 of money printing. In that regard, central banks around the globe all have been easing monetary policy to boost flagging growth -- including Brazil, which last week slashed interest rates to record lows.
Others doubt the efficacy of devaluation. Mark Grant, managing director of corporate syndicate and structured products at Southwest Securities, who was way out in front in his January 2010 prediction of Greece's default, thinks the euro will fall to $1.18 and ultimately reach parity with the dollar. But if the ECB prints money, which violates its current statutes, it could "send European credits into a tailspin."
BUT BCA SEES A "happy ending" after a "market riot" that forces "risk mutualization" through issuance of joint eurobonds and bank-system backup -- making Europe more like the U.S. Then the ESM could be made into a bank and issue its own triple-A bonds, which the ECB could buy without limit, printing euros and effectively ending the crisis. That would provide investors with an opportunity to buy deeply oversold European equities and peripheral bonds.
Even though European equities are at their lowest valuations, relative to their U.S. counterparts, in 40 years, BCA says the time to buy is when the markets plunge and force the European authorities to act. When that happens, investors can avail themselves of exchange-traded funds that provide broad exposure to European equities.
The $6 billion Vanguard MSCI Europe
The SPDR Euro Stoxx 50
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Total, also a top-10 holding of the Vanguard ETF, trades at just 6.6 times this year's earnings, and offers a 6.7% dividend yield, numbers akin to what was seen in the 1970s when interest rates were in double- digits, rather than at record lows. That's far below ExxonMobil's
Daimler
A lower euro won't benefit Daimler's Tuscaloosa County, Ala., operations, but it will deter other companies from following Airbus' flight from Europe. Moreover, a euro at parity with the dollar would boost the whole European economy by easing the debt crisis that weighs on the entire world economy and markets.
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