U.S. Fights Global Hangover: Getting Drunk in the Process?
To understand how the ongoing global credit crisis may evolve, let's look at some cultural and structural considerations. Last decade, despite being told that there may be no money to fund retirement, American consumers ramped up vast amounts of credit card debt; the European consumer, in contrast, reined in spending. Presently, European countries have recognized their debt burdens and are committed to austerity measures - contrast this with U.S. approach: despite Federal Reserve (Fed) Chairman Bernanke's warnings about unsustainable deficits, policy makers in the U.S. have proposed a $200 billion mini-stimulus package, advising the world to stimulate consumption now, with little apparent concern over future deficit implications.
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The cultural divide in approach between the U.S. and much of the rest of the world did not start with the Greek debt debacle, but has roots dating back decades. Bernanke, for example, has testified that going off the gold standard during the Great Depression allowed the U.S. economy to recover faster than those countries that held on to the gold standard longer. Of course he is correct: debasing a country's purchasing power through devaluation may lead to top-line GDP growth; after all, when the population has its purchasing power cut in half, people have an incentive to work harder. In contrast, Germany's experience with hyperinflation twice last century affects European politicians to a greater extent: given the choice, German policy makers appear likely to risk depression over runaway inflation.
The divide is more than cultural; it is also structural. In our assessment, it is far easier to spend and print money in the U.S. than in much of Europe. In the U.S., a Treasury Secretary can stuff a trillion dollars into the banking system comparatively easily; in the eurozone, bailing out a bank typically requires a regional government to inject billions of euros - something far more painful than when coming from a central government. Similarly, on the monetary side, the Fed has been quite willing to print money to buy mortgage-backed securities (MBS); the European Central Bank (ECB), in contrast, provided "unlimited liquidity", an arrangement where the ECB provides 1, 3, 6 and 12-month loans to the banking sector. The ECB support programs, unlike the Fed approach, naturally run out if not renewed within a year; the MBS on the Fed's balance sheet, in contrast, may take many years to wind down. The ECB, unlike the Fed, had actually engaged in an exit strategy; for now, the ECB had to back peddle and re-introduce some liquidity programs previously scheduled to be phased out as credit conditions worsened once more. (View our recent discussion on Yahoo! Tech Ticker questioning the path chosen by the Federal Reserve).
Some say both approaches are doomed: cheap money in response to a debt bubble is not a solution, as it simply encourages the country to pile on of more debt. Conversely, austerity measures may lead to abysmal growth, exacerbating the debt problems; further, liquidity crises can easily flare up in regions where the policy makers show more restraint in spending and printing money.
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Let's keep in mind that governments always have a choice; one that sounds simple enough to address their ills: countries could live within their means. In practice, that's of course easier said than done, as it is far easier to ramp up spending than to cut it. Also remember that countries are not like investment banks: they don't simply blow up or evaporate; countries bleed. And a bailout does not cure the ills of a country. California is a prime example. If California were to receive a "bailout", it would still leave the state with a dysfunctional budget process (a 2/3rds majority is needed in the California State Legislature to pass any bill with fiscal implications). Or take Greece: it will take years to reduce its structural deficit. Greece, or any other country, could of course default on its debt today; if that were to happen, however, no one, not even the IMF, is likely to give Greek a loan tomorrow, causing a tremendous shock. If Greece is able to get its structural deficit under control over the next few years, it may be in Greece's interest to restructure (default on) its debt at that time, as it can then stomach the shock while wiping out painful interest payments.
Looking around the world, what motivates countries to get their act together? Sometimes, such as Switzerland, it's prudence: after rising deficits in the 1990s, Swiss voters imposed a "budget brake", enshrining it in the Swiss constitution in 2003 (the rule imposes a balanced budget on a full business cycle, allowing for deficits during recessions). As a result, Switzerland is now in the enviable position where fiscal discussions revolve around whether a 1% deficit for the 2013 budget is acceptable.
More typically, a sense of urgency gets countries to act. Take Finland: after the fall of the Soviet Union, trade with its Eastern neighbor (on which Finland was heavily dependent) collapsed. Adding to the woes was a banking crisis in the early 1990s as a result of a housing bust. The housing bust had followed an economic boom in the late 1980s fueled by cheap credit. In May 1994, unemployment reached 20%. Banking crisis, high unemployment, housing bust - sounds like Spain, right? Well, Finland cleaned up its banking system through massive consolidation. These days, Finland is the poster child in the European Union, having the lowest premium for credit default swaps (CDS) in the eurozone. Note that Spain's total national debt is one of the lowest in the industrialized world, so Spain will be able to reform, if Spain only has the will. And Spain has taken this sense of urgency seriously, not only passing substantial austerity measures, but also tackling the ills of its banking sector: by the end of July, the local banks (cajas), with their substantial real estate exposure, will have to tell the government whether they need to merge or obtain government assistance.
What Switzerland and Finland have in common is that they are both comparatively small countries where it may be easier to get the country to embrace major reform. In our assessment, the bigger the country, the greater the need for a sense of urgency to provide the appropriate "motivation." It's not surprising to us that while Italy, Spain and Portugal have not only announced, but passed legislation for real reform, France is merely considering to raise the retirement age from 60 to 62; France also has a history of discarding reform plans as soon as a few trucks block the major highways. Similarly, in the U.S., as the sense of urgency has passed, the financial reforms under consideration appear not to properly address the issues that lead to the crisis in the first place.
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Germany's sense of urgency, however, is real, yet of a different form. Germany is concerned about the "European project". Ever since World War II, Germany has worked hard on European integration in an effort to promote peace and social stability. Germany has subsidized the European Union (and its predecessors) for decades; we don't see this about to change. However, Germany sees its own stability threatened by the crises in weaker European countries. What has changed is that Germany has started to throw its economic weight around, attaching teutonic terms to any aid offered. Combining the domestic sense of urgency in weaker countries, none of which like to have the IMF dictate their policies, with Germany's tough new vision for fiscal responsibility, may lead to long overdue reforms. In that context, it may be helpful to have France as another heavyweight on the table - French pragmatism combined with German rigor might make a good match.
For exporting countries like Germany, the weak euro has been very good for their exports. Incidentally, while everyone focuses on the malaise in Europe, few have noticed that the unemployment rate in Germany, currently at 7.7%, is approaching lows not seen since 1992. Structural reform is real, albeit slow.
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What happens if you combine austerity measures in Europe and measures to cool the housing market in China? Amongst others, you have U.S. policy makers urging the rest of the world to boost consumer spending. After all, who is going to buy U.S. goods if so many around the world emphasize spending, not to speak of U.S. consumers that themselves would rather save than spend in the current environment. While many criticize the lack of fiscal coordination in the eurozone (a deficiency that's rapidly being addressed through the dynamics put in place as a result of the massive backstop facility as of a few weeks ago), the downside of central fiscal management is that it is far easier to spend money. And it's not only on the fiscal side. While we have argued for some time that the Federal Reserve may need to ease further down the road, the Wall Street Journal now discussed this scenario in a cover page article; a few months ago, few believed us when we raised this possibility.
A likely outcome is that the U.S. may be left to do the heavy lifting to get U.S. and global economic growth going again. Given the domestic headwinds of a credit bust that has not been allowed to run its course, this has already been a rather expensive undertaking. In a nutshell, policies that fight market forces are not very effective. To boost the economy, trillion dollar deficits are employed; rather than merely cutting interest rates, trillions of dollars are printed by the Fed. All the money has to go somewhere - gold, commodities, projects abroad may be the main beneficiaries; if enough money is spent and printed, a few U.S. jobs may also be created along the way, but it is a very, very expensive undertaking.
This may lead to yet another phase in this crisis: protectionism. U.S. policy makers are already all over China for 'unfairly' keeping its currency weak; now the euro is also weak. Politicians may well call to 'level the playing field' by imposing tariffs on imports. What politicians don't realize is that trade barriers may hurt the U.S. dollar and U.S. businesses most: in our analysis, countries with a substantial current account deficit (unlike China or the eurozone), have currencies that are very vulnerable when trade barriers are imposed. Also note that protectionism hurts businesses and economies that have learned to adapt to a trade based world.
If indeed protectionism will be a new phase, we are adopting yet another attribute of how the playbook ran during the Great Depression. Talking about which, Newfoundland during the Great Depression could be substituted for Greece (Newfoundland's industry was heavily dependent on fishing; the country's debt load was too high to stomach the Depression). At the time, Britain did not want Newfoundland to default on its obligations and basically administered the then sovereign country (think IMF involvement in Greece); nowadays, Newfoundland is part of Canada; Canada does quite well, even as Newfoundland continues to be a poor province. We would not be surprised to see the eurozone doing well in the medium-term in spite of poor performers along the fringes.
In summary, as the U.S. is fighting the global debt hangover, the U.S. may be at risk of getting more drunk (on credit and spending) itself. Ensure you sign up to our newsletter to stay informed as these dynamics unfold. We manage the Merk Absolute Return Currency Fund, the Merk Asian Currency Fund, and the Merk Hard Currency Fund; transparent no-load currency mutual funds that do not typically employ leverage. This analysis is a preview of our annual letter to investors; to learn more about the Funds, please visit www.merkfunds.com.