Europe and the US are on very different routes to resolving excessive debt. Each will have wide ranging economic and political consequences, both foreseen and unforeseen.
In January 1979 right in the middle of the ‘Winter of Discontent’, James Callaghan, returned to the UK from an economic conference in the West Indies. Complete with suntan he was asked to comment on the record number of strikes that winter. In response he said, ‘I don’t think other people in the world would share the view that there is mounting chaos’. The Sun headline writer thought otherwise and published the infamous misquote which helped usher in 18 years of Conservative government.
I recently attended a thought provoking conference in Banff, Alberta organised by Kinnear Financial. My task was to present a European perspective on European sovereign debt problems and in particular to comment on the PIIGS (Portugal, Italy, Ireland, Greece and Spain). Alberta is well known for its commitment to free enterprise, supported by a strong banking system and fuelled by high energy prices. I expected to be given a hard time – in a polite Canadian way of course. In the event although Europe is seen to be a problem, it is the US that topped their ‘concern league’ by a considerable margin.
Fixed interest markets support the ‘crisis in Europe view’ with the well publicised problems of the PIIGS dominating the headlines. Greece, Ireland and Portugal are all candidates for sovereign debt restructuring or default in one way or another. As an example of the level of concern about solvency, Greek government 2 year debt rewards investors with a yield of over 25% at the moment. US Treasuries with the same maturity continue to attract buyers at only 0.6%.
In contrast foreign exchange rates tell a different story. The Dollar Index which is a measure of the value of the Dollar against a basket of other leading currencies suggests much less confidence in the US. Over the last year the Dollar has fallen by 11%.
This apparent contradiction has arisen because of the actions of governments, their central banks and the institutions that they regulate such as pension funds. All are active buyers of sovereign debt. This is what Quantitative Easing (QE) in the US and the various European crisis management tools ranging from the European Financial Stability Facility (EFSF), bilateral loans, Emergency Liquidity Assistance (ELA) and ultimately the European Stability Mechanism (ESM) are all designed to achieve. They may have been created for different purposes, but the result has been a false market for government debt.
Foreign exchange markets are far harder to control with average daily turnover of $4 trillion. It is unproductive to blame speculators for foreign exchange moves although governments have been doing it for years. On the contrary a better explanation is that currency rates reflect the collective judgement of the ultimate users of money – all of us – and at the moment it is the US dollar rather than the Euro that is weak. Why is this?
Before addressing this question, a few numbers. Europe and the US are now of similar size economically as measured by GDP. The BRICS (Brazil, Russia, India and China) are not far behind.
Collective action is, however, much easier in the US than Europe. The complication of trying to obtain an agreement between the 27 EU countries (17 are in the Euro) far outweighs the ’minor’ differences of opinion between Democrats and Republicans in the US.
It is also interesting to compare the different sizes of European economies with the larger US states. Perhaps the PIIGS are small in global economic terms, but then again the bankruptcy of Lehman was thought to be containable prior to the event.
Despite political and cultural fragmentation what is becoming clear is that Europe has chosen austerity as the route to salvation from excessive debt. European interest rates are now on a rising trend as core Europe, with Germany in the lead, establishes a framework for the future. Eventually this will involve restructuring the debts of the peripheral European economies, support for the European banks that currently own this debt and higher interest rates. In the 40 year period up to the handover of responsibility to the European Central Bank in 1999 the Bundesbank delivered low inflation, average real interest rates of 4% and a strong currency. No wonder German industry is doing so well at the moment, with negative real interest rates of 1% and a currency that is a lot cheaper than the Deutschmark would have been if it had still been in existence. A judgement has been made that it is too late to return Greece, Ireland and Portugal to normal by conventional means –interest rates in these countries have little to do with the official rate – so best to normalise core European rates before inflation becomes a problem.
The US, in contrast, has chosen growth. Interest rates remain low, the deficit continues to expand give or take spending cuts of a few trillion dollars spread out over several years and material tax increases are not on the agenda. Importantly for the re-election of the President, job growth is on a rising trend with 268,000 new private sector jobs reported in April which is back to the levels of past periods of sustained economic growth.
Fighting inflation is way down the list of priorities for the US administration. Monetary and fiscal policy is for the benefit of the US and it is up to the rest of us to deal with the consequences.
Crisis? Which crisis?
In Europe austerity is leading to high unemployment particularly in the under 25 age group.
Governments have chosen this path, but where the voters have been consulted they have opted for change. We already have a new Irish government and there will be others. In addition there are indications in the fiscally prudent part of Europe whether in Finland or Germany that the voters disagree with their elected representatives.
The crisis, if there is to be one in Europe, is now more likely to be persistently low growth, high employment and perhaps social unrest similar to what was seen in the UK during the 1980’s, rather than anything that financial markets may impose. It will be a close call, but on balance it seems that Germany will decide to use its financial strength to maintain the stability of the Eurozone.
In contrast the US has decided to call the markets bluff and this is what was causing the most concern in Banff. It is a dangerous game as it requires a number of different interested parties to agree to continue to finance the US deficit at extraordinarily low interest rates. The US has been in debt before, but to countries that relied on the US for national security such as Germany and Japan. China is thought to own over $1 trillion US Government debt, but has no such security needs. For the moment the Chinese are grappling with how best to slow their domestic economy and reduce inflation without creating unemployment. Fortunately, chaos in the global financial system is the last thing that they want as the latest 5 year plan is rolled out. It contains some extraordinary ambitions including average GDP growth of 7%, the building of 36 million new homes and the creation of 45 million new urban jobs. Included in the fine print is the plan to build 29,000 kilometres of railway track which puts the UK high speed link between London and Birmingham (225 kilometres) into perspective.
Despite recent volatility there is evidence in financial markets, whether it is in foreign exchange rates or the price of gold, that sentiment towards US assets has shifted. In particular the US need to remember that owning dollars, which are still used to settle 62% of world trade, is a voluntary activity for many in the newly wealthy emerging nations. To quote a Brazilian businessman who I met recently, ‘we may think in US Dollars, but we are not Americans’.
It will come as no surprise to see investors including the Chinese continuing to use their dollar reserves to buy a wide range of global assets including equities and perhaps surprisingly, given the headlines, European debt.
Governments around the world are making choices. In Europe it is prudence, low growth and political risk whereas in the US domestic concerns have trumped market risk .Whether voters or financial markets will comply is another matter. After the Great Moderation comes the Great Reckoning.
