Acropolis Now, Again

It goes without saying that you pick up any newspaper or journal of late and one is bombarded with how Grexit and contagion risk will undermine the European project. Founded in 1957 with the Treaty of Rome we have witnessed decades of bitter political disputes across Europe on the merits of membership to its Union, no more so than in Britain.

In the next two years the British will have their say on whether they would like to remain or not in the Union. But perhaps the bigger question is the viability of the Euro and with it the EU, as it currently stands. Many economic commentators have argued the Euro should not exist as it’s currently structured. We find it hard to disagree.

In 2010, we wrote in a letter at Hinde Capital entitled ‘The Euro Brady Bunch’ that the Euro crisis was a making of its own flawed foundations and that of the fiat currency system. We have included an excerpt here to remind us of the euro’s fragilities.

  • The euro was introduced on 1st January 1999 for accounting purposes, achieving full circulation on 1st January 2002, and to date has the highest combined value of banknotes and coins in circulation in the world, surpassing the US dollar.
  • Inspiration for the € symbol itself came from the Greek letter epsilon (Є), which is the first letter of the word Europe – a reference to the cradle of European civilisation – crossed by two parallel lines to certify the stability of the euro. The euro concept was derived from the economist Robert Mundell. His ‘Optimum Currency Area’ theory postulated that a geographical region’s economic efficiency would be maximised by that region sharing a single currency (a group of countries comprised a region). This theory better suited the Federal model of the USA, than the newly federated European bloc.
  • A decade on from the arrival of the euro, one can see how the ‘mastic’ for EU was lacking real adhesive structure. The flaws that we have outlined explain why it is highly likely that if one of the periphery countries defaults, it is likely to be the result of an exit from the single currency and the European Union. This, in our opinion, would lead to the demise of the single currency, as the rest of periphery is likely to exit as capital flows stop.
  • The implications for an encumbered Western Europe banking system would be disastrously deleterious, to put it mildly. We just do not think the euro can ultimately survive that. Hopefully, it will result in a reassessment and reaffirmation of the original core values of the Treaty of Rome, as laid out by the Union’s forefathers.
  • We have long stated that this is a solvency issue, not a liquidity issue. Although large infusions of EU and IMF ‘money’ will stave off the inevitable for a time. Desmond Lachman, a fellow at American Enterprise Institute (AEI) rightly suggests in his piece, ‘Can the euro survive?’, that a major part of the European periphery’s fiscal deficits constitutes primary balances (i.e. excluding interest payments). This means that even draconian debt restructuring will only be a partial remedy of budgetary issues, as further retrenchment in budgets would later be necessary. In essence, you can reduce the stock of debt, but the budget deficit excluding interest payments still remains, i.e. the flow of debt continues to accumulate.
  • We mentioned earlier that Mundell’s body of work on Optimal Currency Regions is the footprint for the Eurozone. Far from being optimal, we believe the Eurozone has always been a sub-optimal currency regime. Let’s apply Lachman’s analogy of the Eurozone to another currency union – the USA – to illustrate our point:
  • Europe does not enjoy nearly the degree of wage flexibility that characterises the US economy. Its rigid labour markets and legislative protections mean that wages in Europe are very slow to adjust to rising unemployment and the declining production. This lack of wage flexibility, in the context of a currency union, makes it difficult for individual European economies to regain lost international competitiveness, as is needed through downward movements in wages. This lack of wage flexibility also makes the European countries vulnerable to sharper declines in output and employment than is the case with the individual states in the United States.
  • Considerable language and cultural barriers, combined with poor housing infrastructure, makes labour very much less mobile in Europe than in the United States. Unlike the United States, where labour readily moves from states in recession to states enjoying a boom, European labour does not readily move towards job opportunities in other parts of the Eurozone.
  • Unlike the United States, Europe is yet to develop an effective system of fiscal federal transfers. Lacking the same sense of shared national purpose as in the United States, there is a strong reluctance of the more prosperous European countries to have their tax revenues transferred to countries that are experiencing fiscal shortfalls.
  • The European economies are characterised by a great degree of diversity, which makes them particularly susceptible to adverse asymmetric shocks. This vulnerability can prove to be important in a currency union where the central bank can only set one interest rate to satisfy the needs of all of the union’s member states. The greater susceptibility to asymmetric shocks in Europe also highlights its greater need for labour market flexibility and labour mobility in a currency union.

As UK citizens, we thank every day that Margaret Thatcher was a disciple of Austrian economic values. (She reputedly carried a copy of Hayek’s “Road to Serfdom” in her handbag at all times,) She fought hard to keep us Brits from entering into the EMU, and the implicit loss of national sovereignty that would have entailed within a centrally controlled bloc.

Thatcher’s objection to EMU, though, was not xenophobic. Rather it was economic:

“I want to see us work more closely on the things we can do better together than alone… Europe is stronger when we do so, whether it be in trade, in defence or in our relations with the rest of the world. ”

She understood the deflationary implications of such a “fixed” currency bloc. She understood Germany’s phobia of inflation and the need of the periphery countries to devalue in the absence of any productive mechanism of growth; an impossibility within a single currency union such as this.

Today, we are on the verge of a Brexit being triggered by an ‘out’ vote in our EU Referendum. We feel like the clock is being rewound. All the objections that Thatcher had to “ever closer union”, and her simple vision for participation, in Europe were the correct ones.

Before we can even contemplate the possibilities of our own exit, which seems so convoluted and riddled with complexity, we must surely witness the demise of Greece in the Union. Simply put Greece will default at some point.  There may yet be pretend and extend, but unless whole-scale debt forgiveness and deep fiscal reform takes place then they will follow a pattern similar to that of the stop start road to default that Argentina undertook in the 80s and 90s.

There is very slim chance in our opinion of true public policy reform in Greece as her political regime is socialist right across the spectrum. XOI could well become a ναί, yes, for Grexit, despite talk of a 3 yr  €53 + bn deal. The deal looks more constructive, although how the Greek electorate will take to essentially Tsipras agreeing to the very deal they snubbed in the referendum vote seems clear – not very well. Deal or no deal though so much harm has been done to the Greek economy this past 6 months. This damage and the imposition of capital controls and deposit withdrawal controls have likely done nothing to prevent the likelihood that Greek banks need restructuring.

Everyone believes that the contagion risks of Grexit are small across Europe, financially this may well be the case, but we would still note that the doom-loop between banks and governments has not gone away. As Citigroup rightly pointed out this week – a looming Greek bank default and likely restructuring prompts one to recall that deferred tax assets or tax credits, which are an important part of bank capital throughout the periphery, are only as good as the credit of the sovereign that stands behind them.

Greece is the strategic gateway between Europe, the Balkans and the Levant. The US run the show in Greece, well at least the CIA does. They monitor the vast migration of people, capital and energy supplies with a steely eye, as Greece literally bifurcates the war on terrorism and the axis of evil. Greece is so much more than 2% of EU GDP.

In light of all this many understandably ponder, why hasn’t gold done much?  As Fund Managers who run both Income (HALF.L) and Real Asset Funds (Hinde Gold Fund), the exact question we hear most often of late is – why isn’t gold moving up in reaction to all the turmoil in the world?  – we have Grexit risks for Europe, ISIS and other such geopolitical tremors such as a re-run of Cold War 1 and 2, as well as the mania and panic of Chinese stock markets. Fair question indeed. There is a simple answer to this. In real terms Gold has done really well for those at the epicentre of the turmoil.

Certainly there is a “desensitation” of gold and failure of it to react with sustainable rallies, but equally we are not witnessing any sustained traction lower. If you are a Greek citizen, gold has done what you need it to do. Other assets have collapsed whilst gold in euro terms has largely not moved. The purchasing power of a gold Greek holder has been maintained.

Let’s be even more discerning. It isn’t just gold which has lost some of its reaction function to risks, other signals of stress such as credit spread widening have been relatively benign (so far). TED spreads and high yield to government debt yield spreads have edged out wider but nothing like the extremes of 2007 or 2011. Simply the markets have become more inured to the risks of another financial crisis. This is partly a reflexive phenomenon. Market participants recognise that government agents have smoothed over actions in the financial market. They will be the back-stop. Central banks buy bonds and stymie stock collapses. 

Periphery bonds haven’t risen much in yield or widened much to German bond yields as Mario’s QEuro has taken the sting out of the sales. Liquidity may be as dried up as the Gobi desert but when an “economic” agent has infinite digital fire power, in a disinflationary environment those cracks on the desert floor aren’t able to widen as much as they ordinarily would.

Gold and credit stress indicators have acted hand-in hand. The gold market is showing interesting dichotomous behaviour though. The physical market has become tighter as gold inventory mainly coins and bars have been run down by safe haven buying, whilst the Comex futures market are experiencing very high speculative short positions. These have grown to levels commensurate with the record shorts back in 2000, the start of the bull-run for the precious metals market. There are some substantial short-side bets out there which seem counter-intuitive to the prevailing risks at hand and the tightening physical markets.

Remember doom-loop bank risk is very real and central banks would like nothing more than the canary in the proverbial gold mine to ‘snuff’ it. God forbid the canary sings and gold reacts violently higher, then the State monopoly on debt and money really would be up. Wouldn’t it?…