John P. Hussman, Ph.D.
The repeated waves of fresh crisis and temporary hope in Europe are starting to look a lot like the Hokey Pokey. Last week, Italy briefly put its right foot in. Then, thanks to purchases of Italian debt by the European Central Bank, it put its right foot out. Meanwhile, everyone is calling on Germany to turn itself around, and Greece is still just shaking all about.
Until last week, much of the concern about European debt focused on relatively small countries with high debt/GDP ratios. In particular, Greece, Ireland and Portugal have debt/GDP ratios of 166%, 109%, and 106%, respectively. But Italy actually comes in at 121% debt/GDP, the highest of any European nation next to Greece. Far worse, Italy has a GDP that is 7 times the size of Greece, and is 3 times the size of Greece, Ireland and Portugal combined. So Italy’s debt is not just huge relative to its own economy – it is just plain huge, at about $2.5 trillion in dollar terms. This is a terrible problem for France, whose banks are the largest single creditor to Italy, holding Italian debt worth about one-fifth of Italian GDP.
With Italian yields pushing past 6% and briefly passing 7% last week, Italy is actually very much in the situation that Greece was in about 18 months ago, when it was hoped that new « austerity » measures would shrink the deficit by forcing painful cuts in government spending. They didn’t. The effect of austerity policies in weak economies is generally to damage the economy even more, causing a significant shortfall in tax revenues, so deficits don’t materially improve despite the reduced spending.
As I noted more than a year ago in Violating the No-Ponzi Condition :
« The basic problem is that Greece has insufficient economic growth, enormous deficits (nearly 14% of GDP), a heavy existing debt burden as a proportion of GDP (over 120%), accruing at high interest rates (about 8%), payable in a currency that it is unable to devalue. This creates a violation of what economists call the « transversality » or « no-Ponzi » condition. In order to credibly pay debt off, the debt has to have a well-defined present value (technically, the present value of the future debt should vanish if you look far enough into the future). Unless Greece implements enormous fiscal austerity, its debt will grow faster than the rate that investors use to discount it back to present value. I suspect that budget discipline to the extent required will not be easily implemented, and may be so hostile to GDP and tax revenues as to make default inevitable in any event. »
While present plans to « leverage » the European Financial Stability Facility (EFSF) has allowed attention to deviate from Greece, the fact is that the EFSF has already had problems issuing bonds – having to pay unexpectedly high spreads just to secure a few billion euros of debt, much less tens or hundreds of billions of euros. Meanwhile, the planned 50% haircut on Greek debt does not include « official » debt to the IMF and ECB, which as I noted last week, contributes to the question of whether the 50% figure will actually hold up (particularly given that Greek debt at every maturity is already trading at a 38 handle or less, and the 1-year yield is now up to a record 220%).
If the problem broadens to Italy (and mathematically, we suspect it will because Italy’s debt now also violates the no-Ponzi condition), the implications are very unpleasant. Given leverage ratios of more than 40-to-1 for most European banks, there is no way to meaningfully restructure Italian debt without wiping out the capital base of Europe’s banks, and forcing the nationalization of the entire European banking system.
This is not just a technical issue, and not one that some appropriately « technocratic » government can solve (despite heroic expectations for the Super Mario Brothers heading Italy and the ECB). It is an algebraic issue that cannot be solved without making 2 and 2 something other than 4. Austerity plans will not help, particularly in the context of a likely global recession, which is already clearly evident in peripheral Europe and is showing up now in the coincident indicators of even the presumably « stronger » European economies (Germany had already reported unexpected weakness in factory orders; last week, it reported « surprising » job losses for October). Europe’s problems are simply beyond the point where greater « austerity » will be sufficient.
The main problem within the Euro zone is that its fiscally unstable members cannot print their own currency. Ultimately, the potential for sequential credit crises can be avoided only by removing that constraint, individually or collectively. Printing money is really just a softer method of default, because it effectively converts the meaning of default from « getting less than 100% of the currency you were owed » to « getting all the currency you were owed, but ending up with less than 100% of the purchasing power you expected. »
To remove the constraint individually would require fiscally unstable members of the Euro to adopt what would effectively be a « dual currency » system, rolling over their debt into instruments that allow the debt to be converted into their own national currencies. Of course, investors would demand an interest premium on newly issued debt to compensate for the expected probability of conversion (and the associated inflation and depreciation), but they already do that to compensate for default risk, which would be much smaller for convertible debt. Needless to say, nobody in Italy wants to consider the possibility of eventually going back to the lira instead of the euro, but my impression is that this could change as a likely global recession unfolds.
Alternatively, Europe could decide to collectively remove its constraint on printing money, which would involve changing the authority of the ECB to allow it to purchase vast quantities of debt from fiscally unstable countries.
Undoubtedly, the largest concern about printing money is that it can create a significant risk of inflation in the long-run (though not necessarily in the short-run). Printing money – at least if it is unexpected – also represents a transfer of wealth from lenders to borrowers, since lenders get less purchasing power than they bargained for, and borrowers are able to pay their debts back in cheaper currency. Printing money can also be devastating for people on fixed incomes, who find their cost of living rising beyond their income.
Yet even if one ignores these typical risks faced by a single country when it prints money, there is a much larger problem in using the European Central Bank to print money for Europe as a whole. The problem is that money-printing is effectively a fiscal policy operation. When a central bank buys the debt of a country, and pays for it by creating paper money, it has effectively paid for the government spending of that country with new paper. If the ECB was to go on a bond-buying spree, it would actually be distributing fiscal revenue - the beneficiaries of the money-printing exercise would be the countries that are most fiscally unsound, while the costs would be mostly borne by the fiscally responsible nations.
Think about that. Anytime a government prints money in order to purchase government debt, it obtains a sort of revenue that economists call « seigniorage. » In effect, the government has gone out and bought real goods and services on behalf of its citizens, paying for them with nothing but paper. The real « revenue » from that operation is measured simply by the quantity of money issued, divided by the general price level. Seigniorage is sometimes called an « inflation tax », but that term can be misleading – the inflationary effects can be a long-run process, so people often believe that printing money is costless if they don’t see inflation result immediately. Yet regardless of whether inflation results immediately or not, it is always true that buying government bonds with newly printed money represents a fiscal revenue-generating operation.
From this perspective, it is clear that Germany is reluctant to use the ECB as a money-printing machine not just because the Germans are stubborn, but instead because the whole operation would divert real fiscal resources toward fiscally irresponsible governments, rather than to Germany’s own citizens. It is easy for other European governments to complain about Germany being stubborn, but Germany’s concerns are well placed. The desire to use the ECB to print money is nothing more than a veiled desire to steal fiscal resources disproportionately from the German people.
Germany is not likely to have any part in this. As a result, we can expect to observe one of the following three outcomes:
1) A European Federal System emerges whereby each country surrenders its own fiscal sovereignty, losing the ability to set fiscal policy without broad approval from a central European authority. This is the only condition on which Germany would be likely to agree to a change in the ECB’s mandate to allow it to broadly purchase weaker European debt. It is difficult to see how a sufficiently binding enforcement mechanism could be created to prevent individual countries from acting in what they see as their own best interests. In my view, any hope for this solution has a shelf-life of about three months, because as a broadening recession becomes clearer, the willingness of individual European countries to give up their own fiscal reins may vaporize.
2) Heavily indebted European nations begin to adopt versions of a dual-currency system, issuing various forms of IOU’s or convertible debt, thereby creating the longer-term option of converting their debts into currencies that they can print and devalue individually. This is probably the best option for Europe, but is not one that distressed countries will choose on their own so long as bailouts can be extracted.
3) Germany adopts a version of a dual-currency system by itself. This is something of a « nuclear option » after failing all other approaches. The benefit of this is that it would effectively allow Germany to issue new debt at negative real interest rates in euro terms, as Germany’s own inflation and exchange rate credibility is greater than that of the euro itself. Indeed, Germany could likely convert its entire stock of euro-denominated debt to deutschemark-denominated debt within about a week, and could legislate DM as legal tender just as quickly. This would also free the ECB to print euros to its heart’s content, without extracting seigniorage from the German people. It would, however, accelerate the depreciation of the euro since a reinstated German mark would be viewed as a safe-haven, much like the Swiss franc. It would also create some difficulty for German companies with long-term contracts having revenues payable in euros, and would sharply narrow Germany’s trade surplus with the rest of Europe. The benefit is that technically, the peripheral European countries would be saved from default. Moreover, Germany could conceivably re-join the common currency on more favorable exchange terms, post-depreciation, so it would not necessarily be the end of the euro.
In short, if you can’t save the euro by restructuring the debt of the weak members, or by having the weak members leave, or by having the fiscal costs fall squarely on the German people, the remaining option is for Germany to leave, inflate the heck out of the euro to deal with the debt problem, and reinstate Germany on post-devaluation terms.
Needless to say, any of this would require revisions or abandonment of various treaties and understandings, which makes financial turbulence and repeated cycles of hope, frustration and revulsion likely. The immediate effort may very well be toward some « Federal » solution among European nations, but again, the risk is that this will quickly dissolve if – as we expect – economic conditions become more challenging.
Ultimately, all of the possible outcomes are undesirable solutions, but we are now in a world where good solutions are no longer on the menu. The bottom line is that you can’t have a common monetary union without common fiscal restraint, and Europe is much too far along to achieve a necessary fiscal convergence without some sort of debt restructuring or devaluation among its weaker members.
Sound monetary policy requires sound fiscal policy, coupled with a habit of the private sector to allocate resources productively so that the government isn’t forced to compensate for bad decisions. That’s where the global economy has failed. What is needed most is to disengage the expectation that bad decisions, public or private, will be bailed out; to minimize the use of new resources to make past mistakes whole; to appropriately restructure and write down bad debt so that past errors don’t persist as massive anchors to future growth; to reduce the transmission of risks between financial institutions (through higher capital requirements, lower leverage, and transparency) and countries (through a partial or complete return to independent monetary systems) so that mistakes are not amplified or socialized; and to pursue policies that encourage and even subsidize the allocation of scarce resources to new investment, R&D, and other productive purposes.
And that’s what it’s all about.
As of last week, the Market Climate for stocks remained hostile, with rich valuations (we estimate 10-year S&P 500 total returns around 4.5% annually) coupled with a set of technical conditions that have historically best been characterized as a « whipsaw trap. » While the market has crossed some widely followed technical levels such as the 200-day moving average, broader internal divergences and price-volume action characteristic of short-squeezes combine to create an environment that is prone to sharp downward reversals, on average. That said, as I’ve noted for several weeks, that 200-day moving average crossing, if coupled with a few more technical developments, could help contribute to a speculative trend-following mood if we get a respite from bad news for any sustained period of time. In that case, we would not be inclined to « fight » the speculation by raising our strike prices or further tightening our hedges, and in some possible configurations of data (particularly the absence of overbullish sentiment) might even accept a moderate positive exposure to market fluctuations despite our recession concerns. We don’t see that evidence here, but we’ll respond if we do.
All of that is to say that we are very open to changes in our investment position in response to the specific evidence we observe, but that any constructive exposure is likely to be fairly restrained – or at least have a line of put option defense close at hand – until we clear out some of the more daunting negatives such as still-present recession risk and rich valuations.
Strategic Growth and Strategic International remain tightly hedged at present. Strategic International is fully hedged in terms of equity fluctuations and partially hedged with respect to foreign currency fluctuations (primarily using a long position in the dollar index). Presently, we don’t view the broad basket of foreign currencies underlying our holdings as particularly overvalued or undervalued, but in general, the real yields are comparable. When you hedge foreign currency exposure, you also give up any real interest rate differential over the long-term, and given the general profile of real interest rates internationally versus the U.S., fully hedging currency exposure hasn’t been a good long-term policy. As always, our hedging reflects the overall return/risk profile that we observe at any particular time. Presently, we do expect some potential for additional « flight to safety » movements toward the U.S. dollar, but not enough to hedge off all of our currency risk.
As for precious metals, gold prices tend to be inversely correlated with the dollar provided that gold prices are relatively stable in foreign currency terms. At present, we observe continued upward pressure on gold prices in foreign currency terms, so even the prospect of a stronger dollar doesn’t necessarily imply weakness in the dollar price of gold. Moreover, gold equities are near record lows relative to the metal, and combined with other factors, we continue to gauge the Market Climate in precious metals shares as very positive. Strategic Total Return continues to carry a duration of about 3 years in Treasury securities, with a few percent of assets in utility shares, and about 20% of assets in precious metals shares, which account for most of the day-to-day fluctuations in the Fund at present.