Is The German Eagle a Grey Swan? (Part One of Two)
While the several sovereign debt crises in the euro-area have taken markets largely by surprise–thus leading them to be labeled as unforecastable, “Black Swan” events–we see a potentially much greater risk ahead, that Germany, at some point, will reconsider its commitment to the bail-out framework agreed with other EU states in May.
In financial jargon, the term “Grey Swan” has come to mean a risk event which is considered highly unlikely and hence disregarded by most but, for those who have the necessary expertise and who take the trouble to look and do the proper analysis, it is regarded as, in fact, likely enough to have a material impact on asset valuations and, if it should occur, will lead to abrupt swings in asset prices due to the surprise factor involved. If so, the crises to-date are likely to escalate and spread into additional euro-area countries, causing a general, global credit crisis perhaps as large as that catalysed by the Lehman Brothers bankruptcy in Q4 2008.
Earlier this month, in a previous report, we discussed how European monetary union (EMU) did not eliminate intra-EMU currency risk but rather transformed it into credit risk. In recent weeks, this credit risk has surged again, with spreads for Greek, Portuguese and Irish bonds soaring relative to benchmark German government bonds, known as Bunds. Why now? Has the economic situation or state of government finances in these countries suddenly deteriorated again? Well, no. Things were bad before and they remain bad now. There are, however, two good reasons why spreads are widening, one related to credit markets generally and the other more specific to EMU.
Let’s consider first what has been happening in credit markets generally. Following an improvement in credit conditions and tightening of spreads during the summer, when it appeared that the global economy was continuing to recover, there was a sharp deterioration in a broad range of leading indicators which began in July and then intensified in August. As such, it was perfectly reasonable to expect that credit markets and risky asset markets generally would suffer a setback, with spreads widening back out.
However, whereas the widening in credit spreads generally has been rather modest, spreads for the weaker EMU sovereigns are back to their crisis highs of the spring. At first glance, this seems rather odd, because back then it was still far from clear whether the European Central Bank (ECB) would step in to provide support or whether the EU would agree some sort of bailout package. But step in the ECB did, together with the EU, which at an emergency summit over the weekend of May 8-9 agreed a bailout framework for Greece and other countries potentially in need. So why are Greek, Portuguese and Irish bond spreads to Bunds back to their crisis wides, implying a significant risk of default?
To help answer this question, we need to turn the focus away from the weaker EMU sovereigns and place it on the strongest anchor of EMU, namely Germany. German economic performance has been impressive this year to say the least. Growth is the strongest it has been for many years. Unemployment has declined substantially. Exports have been particularly strong, notwithstanding a relatively strong currency and weak demand in most European countries. This has been possible because Germany is a leading producer of capital goods, in strong demand in the rapidly growing manufacturing economies of China, India and Brazil, and also numerous smaller ones. Indeed, German exports have been one of the biggest beneficiaries of all the stimulus that the US has thrown at the global economy in the form of low dollar interest rates. While the intent of US policymakers was no doubt to stimulate domestic demand, much of this stimulus has leaked out of the US economy because credit impairment and weakening confidence has led to a substantial increase in the private-sector savings rate.
One of the many accounting identities of economics is that savings = investment. But this does not need to hold at the local level. Global capital flows can be substantial, in particular when there are major shocks, such as the collapse of the US housing market and impairment of the banking system. For years, global capital flowed to US firms and households. Yet now the US private sector is de-leveraging and, facing unusually high tax and regulatory uncertainty as well as an impaired banking system, US businesses are understandably reluctant to take this savings and invest. But for savings to equal investment, there must be investment somewhere, and it has been showing up, among other places, in German exports to rapidly growing developing countries.
Yet while German economic performance has been impressive, this highlights the extent to which a number of other euro-area members have lost economic competitiveness. Ever since EMU began in 1999, the gulf between Germany and the so-called “PIIGS” (Portugal, Ireland, Italy, Greece and Spain) has never been greater. This implies that, for EMU to be sustainable, Germany is going to have to provide far larger subsidies to these countries than the architects of EMU ever imagined.
Let’s look back briefly at the history of EMU. EMU blueprint arrangements comprised a large part of the Maastricht Treaty of 1992, which established the European Union (EU) out of what had previously been known as the European Coal and Steel Community (ECSC), the European Economic Community (EEC) and the European Community (EC). Yet long before the Maastricht Treaty was signed, France, Germany and the Benelux countries had envisioned a single currency as a means both to cement existing and promote future economic integration. Let’s now turn specifically to Germany for a moment.
Of all the post-WWII European economic success stories, Germany stands head and shoulders above the rest. It is difficult today for us to imagine what it must have been like in Germany in the late 1940s. First of all, Germany was divided and militarily occupied as the European front line in the Cold War between the US and the Soviet Union. Second, German industry had been completely and utterly devastated in the war. Third, a generation of potentially economically productive, young German men had been killed, placing an enormous burden on young and old survivors alike. Yet within 20 years, Germany would emerge as the most prosperous major country in Europe. What made this possible?
First, there was massive external assistance. The US needed West Germany as an ally in the Cold War and thus helped to rebuild the German military and the economy needed to provide for it. Second, Germany had a hugely successful industrial past which provided much of the blueprint for what could be rebuilt. Third, notwithstanding a socialist political streak in certain parts of the country, Germany had a culturally strong work ethic. Finally, and perhaps most pertinent to our discussion here, the West German Constitution (known as the Grundgesetz or Basic Law) provided not only for a completely independent central bank but also one with a single, overriding mandate of maintaining price stability.
During the 1950s and more so during the 1960s and 1970s, the contrast between Germany and southern Europe and even with France became increasingly stark. Whereas the Mediterranean countries responded to economic weakness with the occasional currency devaluation, Germany grew its economy faster notwithstanding a strong currency, as a result of high rates of business investment and worker productivity growth. Indeed, this combination became a virtuous circle: A strong currency meant that German firms could grow their global market share and profits only to the extent that they increased productivity. So they invested in their infrastructure, capital goods, education, research and technological development. When the going got tough, the central bank would not devalue the mark to ease the pressure. No, if industry faced a squeeze, they would need to find another way out. They would need to reorganise and innovate. Frequently this was done with the blessing and involvement of the government but, regardless, profit-seeking German firms, not politicians or central bankers, were in the driver’s seat.
When EMU was being planned, it was generally assumed that, once wearing the single-currency “straightjacket”, the Mediterranean countries, unable to devalue their way out of periods of weak growth, would focus on increasing their competitiveness instead. A German-style, independent monetary policy and associated hard currency would widen the German virtuous circle to include all participating countries. It was nice to think so, but something else happened on the way. As has been the case repeatedly in many parts of the global economy in recent years, asset bubbles began to form, in particular in real estate and euro sovereign debt.
Once EMU was a done deal, euro sovereign borrowing costs converged rapidly down toward the German level. Previously funding their debt at several percentage points above Germany, countries ranging from Ireland in the extreme European northwest to Greece in the southeast discovered that their borrowing costs were less than one percent greater than Germany’s. Faced with sharply lower borrowing costs, the governments of these “windfall” economies had the option of paying down debt and reducing deficits. In a few cases, such as in Ireland, Italy and Spain, for awhile they did just that. With governments requiring less savings to fund deficits, there was more available for private sector investment. But this led, in time, to large real estate bubbles in several of these “windfall” economies. Underneath the surface, something sinister was afoot. While public sector finances were looking rather better for a time and property prices were booming, workers’ wages were rising fast, faster than in Germany. This implied that these “windfall” economies were losing competitiveness. By the mid-2000s, there had been up to a 20% appreciation of the real effective exchange rate in the “windfall” economies, implying a 20% loss of competitiveness and yet, with borrowing costs low and asset prices rising, no one seemed to care.
At the time, I was working as a bond strategist for a major US investment bank in London and it was my job, among other things, to have a view on the relative attractiveness of the various euro-area government bond markets. Ever since EMU had begun, spreads for euro-area sovereign bonds relative to German Bunds had generally continued to converge even for the least competitive countries. In 2005 and 2006, borrowing costs narrowed to as little as 0.25%. This was completely inconsistent with the 20% loss of competitiveness in these countries, which implied far lower relative growth rates and difficulty with debt service in future. As such, we began to recommend that investors aggressively underweight these bonds. It may have taken a general global credit crisis to catalyse a reaction but now it is plain for all to see just how unsustainable the original EMU arrangements were from the start.
[Editor’s Note: The above essay is excerpted from The Amphora Report, which is dedicated to providing the defensive investor with practical ideas for protecting wealth and maintaining liquidity in a world in which currencies are no longer reliable stores of value.]