The European Debt Crisis: A Symptom of a Chronic Illness and the Nature of the Beast
GUEST POST by Chris Richey, Neosho Capital, LLC
From our vantage point at Neosho Capital, the European sovereign debt crisis is actually a symptom of two larger, more intractable, issues: the inherent difficulties of governing a federal entity and the perennial national and cultural tensions that have defined Europe for at least the past 2,000 years. It is our belief that while the short run problems caused by excessive sovereign indebtedness will eventually pass (at some point, either the debt is repaid, or it is in default), we believe Europe faces two longer-term issues that will likely persist over the coming decades, perhaps centuries.
The Symptom: The immediate question is whether Greece, and possibly Italy, Spain, Portugal, or Belgium or some combination thereof, will default on their sovereign debts. Despite the application of many bandages over the past two years, Greece continues to bleed and the possibility of a default this quarter looms ever larger. With some €14.5 billion bonds maturing on March 20 and a further €22 billion maturing before year-end combined with German and French leaders facing elections in which voters have little desire to pony up further funds to save the Greeks, something has to give, and soon.
Of Greece’s €350 billion national debt, €206 billion is held by private entities while the EU, the IMF, and the European Central Bank hold the remaining €144 billion. Of the €206 billion, about 60%, or €124 billion, is held by “big banks” who, as members of the Institute of International Finance (“IIF”), a few months ago agreed to a 50% reduction in the face amount they were owed in return for concessions from the Greeks on asset sales and fiscal austerity. We note that the debt held by the EU, IMF, and ECB is not part of this 50% “haircut.” We do not know the rationale for the EU, IMF, and ECB refusing to agree to a reduction in the principle of their own Greek debt holdings. Perhaps they will not insist on being paid back at all, or, more likely, they consider it perfectly acceptable for private entities to take a hit, while they have the power to insist of full repayment. Regardless, the goal of the 50% haircut on the remaining €206 billion is to reduce the remaining indebtedness to 120% of Greece’s GDP in 2020, supposedly a level that Greece can sustain.
Complicating the proposed 50% haircut solution is that it is estimated that 40%, or €82 billion, is held by hedge funds and other distressed debt speculators, most of whom have insured themselves against a Greek default with the purchase of credit default swaps (“CDS”). These CDS holders will only receive their insurance payments if Greece actually defaults, i.e. Greece fails to repay the contractual amounts owed on time and in full. If the creditors holding these CDS voluntarily agree to receive less than the contracted amount, the CDS will not pay out.1 This explains why the non-IIF Greek debt holders did not participate in the 50% haircut agreement of last autumn. As long as they have confidence that their CDS counterparties will pay out, they would be foolish to accept anything less than full repayment from the Greeks. Essentially, they are betting that the prospect of the Greeks defaulting is an unacceptable outcome to the Greeks, the EU, the ECB, and the IMF, and that those latter three or some combination thereof will pay the bill for the Greeks.
Another possibility is that the Greek government will “end around” the intransigence of the rump of uncooperative debt holders by unilaterally inserting what is called a “collective action” clause in its outstanding debt. Such a clause states that if some significant majority (60% or more) of the debt holders agree to a change in repayment and other terms and conditions, such terms are binding on all other debt holders. The problem with this involuntary solution is two-fold: first, the possibility that those debt holders not agreeing to these terms have ground to take their cause before the European Courts for Human Rights on the grounds that property rights are human rights under the European Charter; and, second, that a small minority of Greek bonds were not issued under Greek law, but under Swiss and English law, both of which contain parri passu provisions (meaning that all bondholders must be treated equally), which is a problem if the bonds held ECB, IMF, and EU are not subject to the 50% haircut imposed or agreed to by other Greek bondholders.
A last, and rather major, complicating factor is the growing sense in Greece that an outright default would be preferable to living under the levels of austerity required to remain in good standing with the EU, the ECB, and the IMF. Unemployment has gone from 13% just last year to 19% this year, with estimates that it will rise even further to 21% in 2012. Rates of homelessness, suicide, crime, and HIV are all up by large amounts. Further adding to the difficulties of Greece keeping its bailout commitments to the EU, ECB, and IMF is the fact that Greece’s largest labor union, GSEE, which represents about 2 million workers, has said it will not renegotiate its wage contracts and that the 2 extra months of salary, i.e. GSEE members get paid for 14 months of work per annum, are not on the negotiating table. Further, Greece has promised to sell off a massive €50 billion worth of state assets — including €25 billion in real estate — but has so far only raised a total €1.56 billion under that program. Defaulting would relieve them of the need to meet this commitment and spare them selling off public stakes in gas, refinery and mining companies, land on the islands of Rhodes and Corfu, a northern highway, 39 regional airports and 12 harbors.
Why does a Greek default matter? They have renounced their debts on several occasions over the past 170 years, so yet another self-declared “jubilee” should come as no surprise.2 The obvious problem a Greek default creates is that it would, one, wreck some of Europe’s largest banks and create a financial panic spurred on by ETF, HFTs, and a sensational press, two, it would undermine the credibility of the EU, IMF, and ECB, and render all their efforts, expenditures, and promises up to this point null and void, and, three, it raises the possibility that Portugal, Italy, Spain, and Ireland (and that order is deliberate) would default on their sovereign debts. Their increased risk of default raises their borrowing costs, which further increases the odds that they default on their debts. In short, it begins a vicious, downward spiral, the end to which is hard to predict, as we saw from the collapse of Lehman Brothers in 2008.
We view a Greek default, whether outright or via the “collective action” clause, as probable at this point and that the best the EU, ECB, and IMF can manage is to make the default and its aftermath as orderly as possible.3 After all, the damage to Greek creditworthiness whether their failure to pay in full is formally called a “default” or not, has been done. The sovereign debt window effectively is closed to them for the near future: either they must pay unbearable levels of interest in issuing new sovereign debt, or no one will buy it, if it can be issued at all.
The Chronic Illness of Federalism: Moving beyond the arrogance of the present and the immediate problem of a probable Greek default, we now turn our attention to the wider problem in Europe: the federal nature of the European Union and its constituent parts. We on this side of the Atlantic should be very aware of the problems of federating multiple sovereign states into a cohesive, effective, and unitary state. Ever since the Continental Congress of 1774, on through to the Articles of Confederation, and now the current Constitution of the United States of America, the United States has grappled with the core question confronting any regime where two or more entities share power: “Who is in charge here?”4
Even defining “Europe” is a problem: is it the 38 nations occupying the westernmost portion of the Eurasian continent starting at the west coast of Ireland and stretching eastwards to the borders of Russia, the 27 member states of the European Union5, or the 17 nations whose national banks comprise the European Central Bank and the Euro? In the instance of the current European sovereign debt crisis, we are talking about a combination of two of these subsets: the European Union and the European Central Bank. The graphic below maps out the disparate nature of European economic and political integration at this time.
By contrast, the U.S. federation suffers only from two levels of substantial political power (State and Federal) combined with a unitary central bank, the Federal Reserve. Thus, the permutations of mischief and dispute are more limited than the situation confronted by Europeans. The ongoing problems presented by the European patchwork federation are two-fold: first, there is practical political problem of the absence a central authority with the ability to impose a solution on its member states, and second, there is the economic problem of sharing a common currency and debt ratings across states with such disparate fiscal policies, social security systems, levels of economic development, demographics, and attitudes about capitalism.
The confusing and ambiguous nature of European federalism has certainly contributed to both the underlying crisis (the over-leveraging of individual nations and the lack of oversight) as well as the piecemeal and ineffective nature of the solutions offered and implemented over the past two years. Some (Merkel of Germany and Sarkozy of France) argue that the way to solve these problem is through the grant of more power to the E.U. and tighter integration, while others (David Cameron of the U.K.) argue that it was the over-centralized nature of the EU which has brought Europe to this crisis point.
The Nature of the Beast: We believe this centralization versus decentralization argument will continue to rage on, regardless of the outcome of the Greek debt crisis, because of the lack of cultural coherence across Europe and because of the history of conflict across Europe. Underlying both the symptom of sovereign debt defaults and the problem of the current form of European federalism are the historic and ingrained cultural, religious, and linguistic differences between, and often within, European nations. Europe’s record of intra-national warfare over the past 2,000 years is unmatched in terms of its consistency and longevity starting with the rise of the Roman Empire and its conquest of Brittania, Gaul, Germania, Hispania, and Illyrium. We note that the trend, up until recently, was for bloodier and bloodier conflicts involving not just armies, but civilian populations and ever wider geographic areas. We need only look back a few decades to find that two of the deadliest, if not the deadliest, wars in human history took place on European soil.6
While we are now 67 years removed from the last major conflict on European soil (with the exception of the relatively contained Balkan conflict of the 1990’s), significant intra-European differences and historic enmities remain as the primary impediment to the creation of a united Europe. To grasp how divided Europe is in practical terms, we need only view the chances that a currently unemployed Spanish construction worker would move to Germany to seek work: 0.1%.7 This compares to U.S. job mobility between States of 3% per annum, or 30 times greater than the European rate of annual mobility. While European travel quite freely and frequently between countries, actual emigration to take up permanent residence in another EU country remains an extremely rare thing.8 Intra-European geographic mobility is essential for the success and prosperity of the EU for two reasons: first, the creation of a true “European citizen” would be a symbol of European integration and the demise of the old hostilities, and, second, job mobility is important in labor market efficiency and ongoineconomic prosperity.9 Clearly, this has yet to happen, regardless of the creation of a common European passport.
Closer and more effective European integration will not be a reality until more cross-border and permanent migration occurs between European nations. The speed with which the primary movers in the E.U. (the Germans, the French, and the Italians) wished to both integrate economically and culturally outstripped the ability of their respective populaces to make that dream a reality by moving from one language and cultural region to another.
Is the dream of a truly unified and peaceful Europe over? We think not, as it has been a dream as far back as the Roman Empire (Pax Romana), on through to Victor Hugo and Winston Churchill. However, it is mostly likely several decades, if not a century or more, away from reality. Nonetheless, the “peaceful” portion of the unified Europe dream has been a reality over the past six decades and this alone is an enormous accomplishment.10 Given our collective ability to destroy whole cities in an instant, thanks to nuclear weapons, perhaps Europeans and all of us should view the price this debt crisis as a bargain compared to the inestimable and horrific costs of yet another war in Europe.11
Bottom Line: In sum, here is what guides our current thinking in managing our portfolios in light of the current European debt crisis.
First, the Greeks simply are not able to repay their debts and many of their creditors have a genuine interest in seeing them default. In fact, while some consider the Greeks already in default, we believe that a default (whether outright or by Greece unilaterally declaring new terms) is likely to occur in a matter of weeks. Indeed, we wonder if a Greek-declared default is not the desired result of the leaders of the EU, ECB, and IMF since it then places the blame squarely on the Greeks, versus the ineffectual actions of those three bodies.
Second, a declared default will undoubtedly cause a massive sell-off in stock and bond markets around the world, and gold and commodities will experience significant increases in their prices as investors make their flight to safety. Central to the scale and persistence of this crisis will be the credit default swaps: the ability of their underwriters to meet their obligations. If the capital backing these credit default swaps is adequate, we believe this panic will be temporary in its impact. If, as in the Lehman Brothers crisis, the underwriters of these credit default swaps have underestimated the likelihood of a default and failed to hold the capital needed to back their obligations, the situation could cascade into another late 2008 panic.
Third, the problems in Europe run much deeper than sovereign over-indebtedness and that the current structure of the European Union and the Euro currency are flawed by virtue of their prematurity. While a free trade zone makes tremendous sense, as existed under the European Community in the pre-Euro days, a currency union stretching across the continent north to south and east to west is untenable given the economic differences between the Euro’s constituent nations.
Finally, while we believe that there will be a reduction in the number of nations participating in the Euro, rather than a scrapping of the entire currency, we believe that even in the event of the complete demise of the Euro that “core” Europe would continue to remain a prosperous region. After a period of adjustment, the return of the Deutschmark, Franc, Peseta, Lira, Schilling, and Guilder would not herald an economic apocalypse and that the creation of value would continue within and between European states, no matter how that value was denominated.
Chris Richey
Neosho Capital LLC
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1 Fitch Ratings has stated publically that even the voluntary 50% haircut deal is a “default” by their definition, so Greece is already in “default” on the IIF-portion of the €206 billion of debt, whether or not the hedge fund and other non-IIF Greek debt holders agree or not to the 50% haircut deal. Greece Monkeys Around, Will Default in March, Investment News, January 17, 2012.
2 According to the Old Testament (Leviticus 25:10-13), every 50 years, slaves were freed, foreclosed property was returned to its original owners, and all debts absolved.
3 The only alternative at this point appears to be the ECB and IMF taking the hit on their portion of the Greek debt, a move they are reluctant to make since it raises the possibility that the Italians, Spanish, Irish, and Portuguese would follow suit and a terrible precedent would have been set.
4 The battle within U.S. federalism continues to this day: the U.S. Supreme Court will hear arguments in March, 2012 over the constitutionality of the Patient Protection and Affordable Health Care Act of 2010 aka “Obamacare” with 26 U.S. States as the plaintiffs claiming that the U.S. Government overstepped its Constitutional boundaries in key provisions of this law. Such State governments versus Federal government Supreme Court battles are perennial events.
5 Even within the European Union, there are subsets of control which play important roles in the resolution of the current crisis: the European Commission, which proposes and implements EU policies, the Council of the European Union, which represents the national governments in certain capacities, the European Council, consisting of the heads of state of the 27 member countries, and the European Parliament, which consists of 626 legislators elected from each of the member countries.
6 For references, peruse the list of European wars: http://en.wikipedia.org/wiki/List_of_conflicts_in_Europe. It is a long list. The only good things to come out of WWI and WWII was the fact that the right side won in each of them.
7 Labor Market Mobility in a Transatlantic Perspective, Conference Report, European Foundation for the Improvement of Living and Working Conditions, 2008
8 A good deal of intra-European worker migration is temporary and, often, illegal. As an anecdote, we point to Michael Lewis’ new book on the current economic crisis, Boomerang: Travels in the New Third World, in which he tells the story of car park attendants noticing that dozens and dozens of cars remained parked, permanently, in the car park at Dublin Airport. It turned out these were cars purchased using Irish bank loans by Polish construction workers who had simply abandoned them on the way back to Poland in the wake of the Irish economic bust when construction work evaporated.
9 In fact, the EU declared 2006 to be “The European Year of Workers’ Mobility”.
10 We also note that the all 38 European nations have enjoyed tremendous freedoms since 1989 and the fall of the Berlin Wall, accomplished without a single shot being fired.
11 In previous decades and centuries, intra-European tensions of this nature would almost certainly been accompanied by threats of the mobilization of armies. We note that the disarmament of Europe after the World War II was largely possible because of the U.S. military presence in Europe, paid for by the U.S. taxpayer. To the extent that the Europeans are not rattling sabers in this debt crisis, it is largely because they have no sabers to rattle.