February 11, 2010 The Sick Men of Europe: the challenges of a monetary union in middle age It might seem

odd that Greece is surfacing questions about European public debt and the sustainability of the European Union. After all, Greece is only 2% of EU GDP. But whats in play here is an idea: can a region with very different economic and cultural characteristics form a durable monetary union? Bear Stearns was only 2% of broker-dealers and capital markets banks1, but its failure set in motion the end of a different idea: that very highly leveraged entities could own risky, illiquid assets and rely on wholesale funding rather than more stable customer deposits. We must explore as investors whether the end of an idea is dawning in Europe. The point here is not to engage in idle speculation, but to consider the un-thinkable, something that has been very worthwhile to do over the last decade in markets history. This is not the first time concerns on the Euro have surfaced. Milton Friedman and Martin Feldstein both questioned its viability2 years ago. In the following pages, some background, charts on the current state of affairs and some thoughts on what happens next. Irrespective of whatever subsidies may be extended to Greece, this problem will be hard to resolve. Implications for European government bonds, the Euro and equity markets are substantial. The Euros predecessor: the failure of the ERM The creation of the Euro came on the heels of a prior attempt at achieving monetary stability in Europe, the European Exchange Rate Mechanism (ERM). Member countries had independent central banks, but currencies had to float within pre-specified bands. The ERM virtually collapsed in 1992, since tighter monetary policy that suited Germany at the time was too painful for countries like the U.K. (which suffered from a recession and 10%+ unemployment), as well as Italy, Spain and Portugal. The bands of the ERM were widened in 1993 to the point that these currencies effectively became floating again. The Euro is born: Der Wrfel ist gefallen3 Even before the ERM collapse, the idea of a more durable currency union was put in motion. Member countries would yield monetary policy decisions to a Central Bank, and adhere to tight budget deficit criteria. But according to people like Bernard Connolly (see box), the die was cast when member countries were allowed to join the Euro at possibly elevated exchange rates, despite divergent economic circumstances, productivity and income levels. As shown below, the currencies of Greece, Italy, Portugal, Spain, and Ireland (the GIPSI countries) fell sharply in the aftermath of the ERM failure, and then stabilized when the contours of the European Monetary Union (EMU) were put in place. Note how the Irish Pound and Italian Lira actually rallied during the era of Euro convergence (1996-1997).
GIPSI currencies vs. Deutsche mark
Index, Jan 1990 = 100
110 Euro exchange rate fixed 100 Ireland 90 Portugal 80 70 60 Weaker 50 1990 1991 1993 Source: Bloomberg. Greece 1994 1996 1997 1999 2000 Stronger Spain Italy

I had a long conversation with Bernard Connolly while preparing this paper. Bernard is the former Head of Monetary and FX Policy for the EU Commission, where he worked from 1978 to 1995 (with a brief 18-month stint at JP Morgan in the late 1980s). His book Rotten Heart of Europe, which deals with many of the issues discussed here, resulted in his firing by the EU in 1995. The European Court of Justice described his book as aggressive, derogatory and insulting, and upheld his firing. Im not surprised the EU chose to fire someone who wrote a book about its shortcomings; I dont plan to do the same about JP Morgan. What I find valuable is that his views are colored as much by experience as by ideology. Bernard is founder and Managing Director of Connolly Global Macro Advisors Ltd. in London.

Allowing other countries into the Euro at elevated exchange rates was seen as a win-win situation at the time, since this would increase the purchasing power of savings held by GIPSI citizens; and for Germany, as the region's industrial export power, it created a large "captive" group of wealthy consumers of German goods. [Note the similarities to the circumstances around German unification: some East German savings were converted to Deutsche marks at a rate of 1.8 M to 1 DM, vastly exceeding the real value of the East German mark. This sowed the seeds of the 1992 German inflation/ERM crisis.]
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Bear Stearns was 2% of the December 2007 market cap of the largest broker-dealers, global capital markets banks and asset-based lenders. Feldstein, Martin. "EMU and international conflict". Foreign Affairs, November/December 1997, and Milton Friedman and the Euro, Cato Journal, Spring/Summer 2008. 3 German for The Die is Cast, as uttered by Julius Caesar as he and his army crossed the River Rubicon

February 11, 2010 The Sick Men of Europe: the challenges of a monetary union in middle age The problem with this conversion: it set the European Union on a course in which GIPSI countries would consume a lot, but not produce much, as their workers would be too expensive to hire. This would eventually prove to be a Faustian bargain for Germany, as they are now expected to mitigate the recessions impact and subsidize debt burdens of member countries. Were initial currency conversion rates too high? The evidence says Oui / Si / J / Sim / Ne How can one tell if the initial currency conversion rates were too high? If the GIPSI countries remained competitive with Germany, then the answer would be no. However, the evidence suggests that right off the bat, the GIPSI countries started losing ground. I will spare you the economic jargon, but real effective exchange rates from the OECD and the EU Commission are two measures of relative competitiveness. When a line in either chart is rising, that country is losing competitiveness relative to the countries below them. The charts tell the story here.
Real effective exchange rates: labor costs
Index, Jan 2000 = 100
130 Less competitive 120 110 100 90 More competitive 80 2000 2002 2004 Source: EU Commission. 2006 2008 Germany More competitive 90 2000 2002 2004 Source: OECD. Ireland Italy Portugal Spain Greece France 130 120 110 100

Real effective exchange rates: goods prices

Index, Jan 2000 = 100
140 Less competitive Ireland

Spain Greece Italy Portugal France Germany

2010

2006

2008

2010

Despite losing ground in terms of competitiveness, the GIPSI countries went on a consumption boom, fueled by lower interest rates set by the ECB, and funded by external capital4. As shown below (left), consumption took off in Italy, Spain and Portugal (Greeces numbers are off the chart). Another look, in the chart at the right: GIPSI countries all ran sizable trade imbalances relative to Germany, highlighting the captive consumer connection between Germany and the GIPSI countries.
Household consumer credit growth
Index, Dec 2002 = 100
250 Greece Italy Portugal Spain Ireland France 100 Germany 50 2002 2003 2004 2005 Source: Deutsche Bundesbank.

Current account balance as % of GDP

Percent
10% Surplus 5% 0% v -5% -10% Deficit -15% Germany France Italy Ireland Spain Portugal Greece

200

150

2006

2007

2008

2009

1992 1995 Source: OECD.

1998

2001

2004

2007

2010

The recession hits and the party ends The onset of the first global consumer recession in 17 years now puts Friedman/Feldstein concerns to the test. With the collapse in economic activity, GIPSI budget deficits are soaring, since governments have been forced to provide fiscal stimulus to offset sharp increases in unemployment and business failures. What makes the crisis worse is that Europe does not have a lot of ammunition; some member countries have consistently run budget deficits and debt/GDP ratios in excess of what was agreed in
4

Fitch computes net external debt relative to foreign currency receipts, a measure of the net external burden of each country. For 2009: Greece (291%), Portugal (209%), Spain (275%); this compares to France (94%), UK (82%) and Germany (net creditor position of -4%).

February 11, 2010 The Sick Men of Europe: the challenges of a monetary union in middle age the EU Stability and Growth Pact. Even with all the temporary stimulus, the Eurozone looks to have grown at 0% in Q4 2009. Unlike the U.S. and Japan, European industrial production and retail sales have still not bounced from the bottom. Prompted by Greeces challenges with rolling over its debt, concerns about broader GIPSI public debt burdens are rising, as demonstrated by the increasing cost of default protection in the CDS markets.
Gross sovereign debt as % of GDP
Percent
140% 120% 100% 80% 60% 40% 20% 1992 1995 Source: OECD. 1998 2001 2004 2007 2010 Italy Greece France Portugal Ireland Germany Spain

Cost of default protection

5 year spreads, bps
400 350 300 250 200 150 100 50 0 Sep-08 Jan-09 Source: Bloomberg. France Germany May-09 Sep-09 Jan-10 Portugal Ireland Spain Italy Greece

The Greek adjustment Few market participants believe Greece will be able to carry out the fiscal adjustment it proposes. Greece plans to make one of the largest fiscal contractions on record, around 10% of GDP over 3 years, without any clear incentives or penalties for not achieving their goals, and is a country with a history of failed fiscal consolidations in the past. Strikes announced so far: tax officials, doctors, teachers, civil servants, etc. Euro area policymakers have stated that Greece wont be expelled, wont be allowed to default, and that the IMF wont be invited in to help (yet). Greece is looking to borrow another EUR 50 billion in 2010, after having borrowed EUR 8 bn in January. The United States of Europe? Will the European Union bail out its most profligate member in Greece? It wont be easy to explain to EU citizens. Greece revised its 2009 budget deficit to be 3x prior releases, prompting Swedish ministers to describe the data as fraudulent. Greece has the lowest ranking in the EU on Transparency Internationals Shadow economy as a % of GDP for OECD countries Corruption Perceptions Index, and has the largest underground United States Switzerland shadow economy in the entire OECD (see chart), creating Japan Austria endemic problems with taxation and economic efficiency. United Kingdom The crisis takes on broader implications as well: it has surfaced support for a more powerful federalist government in Europe. EU President Van Rompuy proposed giving the EU more "economic governance" powers in the aftermath of the recession, perhaps without explicit agreement from national delegations. More direct calls for a pan-European government with powers of economic enforcement, bond issuance and civilian deployment come from Guy Verhofstadt, President of ALDE (the 3rd largest group in the European Parliament) and author of United States of Europe.
New Zealand Netherlands Australia France Canada Ireland Germany Denmark Finland Sweden Norway Belgium Portugal Spain Italy Greece

0% 5% 10% 15% 20% 25% 30% Source: "The Shadow Economy and Corruption in Greece", South-Eastern Europe Journal of Economics and Ionian University, 2006.

Within Germany, the Finance Ministry appears to be against a bail-out5, while the Foreign Ministry appears to be for it. Germany will be interesting to watch: Angela Merkel is the first Chancellor born after WWII. Her predecessors (Kohl, Schmidt, Schroder) were less able to assert German nationalism; the same is not the case for Merkel and Finance Minister Schaeuble. A 2009 poll shows 70% of Germans opposed to bailing out Ireland or Greece6; they are joined by Otmar Issing (former Chief Economist at the ECB), Karl Otto Pohl (former President of the Bundesbank) and Current ECB Chief Economist Jrgen Stark.
While there is some hyperbole involved, Connolly estimates that to offset regional disparities, transfers required from Germany to the rest of the EU would be 7% of its GDP per year, which he sees as being not that different from the cost of Versailles reparations after WWI. 6 From think tank Open Europe, in collaboration with the Institute for Free Enterprise in Berlin
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February 11, 2010 The Sick Men of Europe: the challenges of a monetary union in middle age Now what? It looks like there will be an immediate effort by EU members to stave off contagion and a broader debt crisis, and provide some loans and debt guarantees to Greece. More details to follow next week. But as weve seen in the past, such solutions can be temporary if underlying structural conditions dont change. Heres a brief synopsis of the 5 options in play: [1] Deflation. European currency devaluations date back to 11th century England, when they were used to raise silver to pay off raiding Viking invaders. But when a country loses its ability to devalue its currency, theres only one option left when facing a loss of competitiveness: sharp declines in goods prices, wages and real estate. Hong Kong in 1998 is an example: the U.S. dollar anchored was so restrictive, that real estate prices fell 50% to restore some equilibrium7. Can Europe handle declining wages/prices and persistently high unemployment, economically or politically? So far, there have been some austerity measures announced in Spain and Ireland. Portugal is trying, but the current government does not have a majority in Parliament. * Ireland: Reduced public sector wages (from the highest levels in the EU), spending cuts and tax increases * Spain: 10% replacement rate on retiring public sector workers, spending cuts, labor unions agree to 1%-2.5% wage hikes * Portugal (proposed): public sector wage freeze, reduction of public sector employees and sales of government investments If these steps succeed, it would represent a political and economic validation of the concept of a monetary union in Europe. [2] A large decline in the value of the Euro. A further decline could help countries like Ireland. But for the Euro to fall enough to help countries like Greece and Spain, it would have to fall much more (perhaps below parity with the U.S. dollar), since their economies are more closed (see chart on trade to GDP), and require a bigger change in the terms of trade. Such a low level on the Euro might create inflationary issues for Germany, and we all know how they feel about that. [3] Regional subsidies. Bond guarantees are easy to provide, until they need to be funded. There are also EU infrastructure funds, bilateral country loans and IMF loans that can be provided to Greece. There are pages of EU treaties which prohibit bailouts, but in practice, they can be circumvented.
Exports plus imports as % of GDP
Percent
Brazil Greece Spain France Italy Indonesia Mexico Portugal Germany Ireland Hong Kong 20% 40% 60% 80% 100% 340% 120% EU countries Non EU countries

[4] Default but remain in the EMU. Countries like Greece Source: IMF. would default and effect a Brady-bond solution: debt forgiveness combined with an austerity plan to put it back on a sustainable path. But in Europe, banks own cross-holdings in member country sovereign debt (e.g., French banks owning Greek bonds). An unpleasant outcome, economically and politically. Fun Fact: France defaulted on its debts 8 times between 1500 and 1800; Spain did it 13 times8.

[5] A country leaves the EMU. A sovereign could leave, devalue by 30% and denominate its government bonds in the new currency. But legions of lawyers have analyzed the consequences for private sector companies (with assets that can be seized in other countries), and dont know the answer. Germany could also withdraw and allow the rest of the EMU to find a sustainable currency level. It would result in a Full Employment Act for derivatives lawyers. This would be the nuclear option; unlikely. INVESTMENT IMPLICATIONS The European Union is a political concept 50 years in the making, and one that benefits from substantial support from many of its citizens. It would be premature in the life cycle of the EMU, now in its middle age, to succumb to a debt crisis in its periphery. The voices calling for greater European economic and political integration may win out, taking a line from Obama advisor Rahm Emanuel: never let a serious crisis go to waste. However, if GIPSI public sector debt burdens are not addressed, we may be right back here later this year or next. It pays to consider the pricing of credit risk in those infrequent situations that end badly for bondholders: Argentina (2001), Russia (1998), Conseco (2002), Parmalat (2003) and the 2008-2009 crop (CIT Group, Lehman Brothers, GM, Washington Mutual, etc.). In each case, there were interim periods when stop-gaps were put in place, rescue financing from the IMF or interested governments and white knight companies was just around the corner, analysts declared the crisis over, bond prices rallied for a while, and everyone took a sigh of relief. But it was only temporary.
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The Hong Kong Monetary Authority also stepped in and bought a large chunk of the Hong Kong equity market. Costs of Sovereign Default, Bank of England, July 2006; Reinhart and Rogoff, Debt intolerance, NBER Working Paper #9908.

February 11, 2010 The Sick Men of Europe: the challenges of a monetary union in middle age We wrote in December 2009 that we believed that the dollars decline vs. the Euro was over; that we are overweight U.S. equities vs. European equities; that we pulled in our OECD bond durations; and that we are generally taking less risk in portfolios than normal at a time of rebounding global corporate profits and manufacturing. None of these positions has changed, and are reinforced by the latest round of uncertainty coming from the European Union. Michael Cembalest Chief Investment Officer JP Morgan Private Banking

What about the United States as an example of a monetary union that can survive severe recessions? There are substantial differences between the United States as a monetary union and the EMU. There are three worth highlighting: Higher labor mobility in the U.S. At a meeting in Spain in La Coruna in 2007, I asked a client why his idle workers would not move to Frankfurt where there were job opportunities. His reply: Frankfurt? They would not even move to Barcelona. Compared to Europeans, U.S. citizens are 10 times more likely to move in response to unemployment differentials, and 2 times more likely to move in response to wage differentials. [Source: The European Immobility Puzzle and the Role of Migration Costs", Michle Belot, University of Essex, European Commission "Employment in Europe" conference]. Borrowing constraints on U.S. States. Unlike European member states, U.S. states generally adhere to balanced budget policies. With the onset of the recession, U.S. states needed a substantial transfer from the Federal government ($180 bn) to prevent large tax hikes and spending cuts. But at least the starting point for most U.S. states is closer to balanced, unlike European member states. Higher U.S. tolerance for regional subsidies. The U.S. is much more accustomed to the kind of regional subsidies that the EU is now debating. Fiscal transfers in the United States eliminate as much as 40 percent of a decline in regional income, while fiscal transfers between EU member states are only a tiny fraction of that amount. [Sources: Xavier Salai-Martin and Jeff Sachs, Federal Fiscal Policy and Optimum Areas; Barry Eichengreen, One Money for Europe? Lessons from the U.S. Currency Union.; and The United States as a Monetary Union and the Euro, a Historical Perspective, Michael D. Bordo, Cato Journal, Spring/Summer 2004].

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