Friday, 15 June 2018

The beautiful game: world cup 2018 forecast (with perfect foresight)

Today, for something completely different. The World Cup 2018. Spoiler: you will see the future.
I can feel your sense of anticipation. The excitement. And relate to the sleepless nights in search of answers to the supreme existential question: is there any meaning to life beyond seeing your team winning the football world cup?

Well, life is good. And today is your lucky day - here are all the existential answers you have been looking for (you're welcome):

1. Italy won't win the world cup. They have bigger plans for the summer: leave the Euro without anyone noticing.

2. Holland won't win either. They decided some months ago not to participate in this year's tournament. Despite not having any plans at all for the summer at the time. Now they are considering going to Italy on holiday and organise daily football matches with the locals. There is hope for the Euro's survival.

3. The US will contribute as much to raise football's quality standards as President Trump to make a rules-based world great again. It will be beautiful!

4. Putin is a man of vision. Why participate in a G7 +1 summit when you can host the world cup? Russia's football team will play with the same flair, diversity and success that characterises the Russian economy.

5. England won't win. Nothing new but at least England has an excuse this summer: there is no time for distractions - the nation has to focus all its energy in turning the Boris-Rees Mogg Brexit master plan into a major success by mid-July. 2018. No one really knows what the master plan looks like, starting with Boris and Rees-Mogg, but there is no reason to panic as the deadline is still a distant five weeks away. Well informed sources in Westminster say that Brexiteers have never been more confident about delivering a successful Brexit and destroy the Euro along the way. After Boris has been spotted ordering a Pizza Margherita in Islington yesterday, rumours are rampant that he plans to invade Italy to kick the Dutch out of the country.

6. Belgium is the secret favourite. So secret that no one will miss them when they head home after the quarter-finals. The Belgium chocolate pralines remain world class though. Then again, that's not a secret.

7. Portugal will start the world cup as European Champion. And finish the world cup as European champion. If anyone wants to bet against it, please call me.

8. Spain will play Portugal in its first match. It's an early final. What would be the point to have the same match in the final again? Right....

9. France has a fantastic team. It's true that Napoleon suffered an history changing defeat in Russia (calm down Boris and Jacob, we know: Waterloo was epic) and that it still weighs heavily on the Grand Nation's collective memory. However, France has now an Über-President who can turn the nation around: young, dynamic, competent, eloquent, an ex-investment banker, a broad thinker with attention to detail. From my generation. Just like me in fact. Ok, France won't win.

10. Germany. It was in Stalingrad in 1943 that the new cool Germany was born (sure Boris and Jacob, we know: Churchill was magnificent). Who said that a devastating defeat can't mark the dawn of a much brighter and happier era? Cheer up Neuer, Kroos, Özil & Co: Germany's football will become even better following your performance in Russia.

11. Argentina has Messi. Messi! Messi! Messi! The clinical magician. Cruyff on the bench and Messi on the pitch have been a generation's football heroes. The ones who radically reinvented the game and in the process took us to places no one ever thought could possibly exist. It's a pity that Messi has Argentina.

12. Brazil has nothing in common with Russia, except being an emerging market. Brazil is Southern hemisphere; Russia is Northern hemisphere. Brazil is hot; Russia is cold. Brazil is a chaotic, lively democracy; Russia is an organised, sombre authoritarian state. Russia meddles in other countries elections; Brazil can hardly keep track of what is happening in its own elections. Brazil has Neymar, Coutinho, William; Russia doesn’t. Opposites attract. Brazil is the top favourite.

Tuesday, 10 April 2018

What's up with Portugal?

Matthew Klein, from FT's creative department (FT Alphaville), did a very good analysis about Portugal's economic journey post-Euro adoption in 1999. Here the link to Matthew's article: FT Alphaville looks at Portugal
And a few remarks:
1. The increase in Portugal's household debt in the post-Euro period was to finance consumption. Not real estate acquisitions (mortgages). There was no real estate boom in Portugal over the period. The increase in household debt combined with the increase in government debt (part of it directed to infrastructure spending / construction) led to the massive increase in foreign debt pre-Eurozone crisis.
2. The phenomenal improvement in Portugal's current account balance since 2011 is a combination of three factors
a) luck: tourism picked up to a large extend due to competing destinations' troubles (North Africa, Turkey,...)
b) sheer need: PT's export companies had to expand into new geographies as demand from Spain & Co collapsed
c) FDI: reforms made PT more attractive. Some foreign companies established operations in the country (e.g. Rocket Internet); already present ones expanded their existing operations (e.g. Siemens, Bosch, Peugeot, BNPP...)
3. Reforms (read tax incentives) implemented post-2009 attracted many EU-citizens as permanent residents. Golden Visas attracted non-EU residents (Chinese, Brazilian, Angolan. And more recently Turks). These individuals are the main force behind the boom in the Lisbon / Porto real estate markets. The ECB has little to do with it.
Tourism boom and VIPs as permanent residents (Madonna, Michael Fassbender, Cantona, Monica Belucci, Philippe Starck....) doing high profile marketing of the country - for free - led to an international (re)discovery of Portugal. And have created a positive feedback loop for tourism and investment.
The main gap in the whole story: a much more aggressive FDI attraction strategy (a la Ireland) is needed. FDI is the only way for Portugal to massively broaden its export base, increase productivity and raise living standards sustainably over a reasonably short timeframe (10 years).
An Eurozone private sector transfer union based on a FDI core-periphery bridge is what the EU(rozone) authorities should focus on. It would be a win-win situation for core and periphery. And therefore a no-brainer:

Thursday, 21 September 2017

Tesla vs. BMW – all you need is imagination

Equity investors seem to regard Tesla as the future leader of the global affordable luxury car segment. The company’s current market capitalisation already roughly matches that of BMW - nothing that a giant dose of imagination and creativity can’t possibly justify.


We are in September 2027. The electric car revolution made Tesla the world’s leading affordable luxury carmaker – the new BMW. Tesla’s 2027 car sales are expected to reach USD 120 billion (matching BMW Group’s sales in 2017).

Tesla has a similar net profit margin (7.4%) and is trading at a similar PE multiple (7.4x) as BMW was 10 years ago. Its market capitalisation just hit USD 68 billion. It was USD 61 billion in September 2017. As no dividends were paid out over the past 10 years, Tesla shareholders earned a 1.2% annualised return in 2017-2027. They are disappointed.

When buying Tesla shares in September 2017, they had a vision: Tesla would become the new BMW in 10 years time. Accordingly, they expected to make a 10% annualised return on their investment. They would have made it – if they had bought Tesla shares 56% below the then prevailing market price.

That’s not a very realistic vision of Tesla’s future, some enthusiastic Tesla investors may now argue. BMW’s current PE multiple is depressed. In 2027, a very successful Tesla will trade at higher multiples.

Ok. Let’s think about an alternative future. In September 2027 the new BMW – aka Tesla – will trade at 10x earnings 2028 (post dotcom bubble BMW only traded, on average, higher in phases of depressed earnings during recessions). This would translate into a 2017-2027 annualised return of 4.3% - assuming that no further equity or quasi-equity financing will be needed over the coming years. Factor in a 10% capital increase (i.e. USD 6bn - Tesla’s cash burn rate in 1H2017 was USD 2.4billion, USD 3 billion of cash is left on the balance sheet) and the resulting dilution would lead to an annualised return of 3.3%.

But, hold on, Tesla is not only cars! What about the energy generation and storage business? Sure - currently it accounts for 10% of Tesla’s sales. Therefore, even if it was able to mirror the growth and profitability of the car business in the Tesla-is-the-new-BMW scenario over the next 10 years, it would hardly move investors’ return-on-investment needle.

Imagination and optimism are good things. They cannot change the big picture: even if Tesla turns out to be the new BMW, with a successful energy and storage business attached, it is doomed to be a poor investment. 

It’s what usually happens when a stock is priced for perfection.

Wednesday, 14 June 2017

Modigliani-Miller, Warren Buffett, gravity and US equity valuations

Given the high levels of debt, the world's main central banks can't afford to rise interest rates dramatically over the coming 10 years. Thus, 10-year government bond yields in the US, EU and Japan will reach maximum 2%. If we add a 2% equity risk premium - historically rather low but justified by the low equity market volatility that is supposedly here to stay - we end up with equities being fairly priced at an earnings yield of 4%. A P/E of 25x.

This is the standard explanation many give to justify that equity markets, starting with the US, are currently far from overvalued. Then again, what do we know about the relationship between debt levels and the cost of equity (i.e. the equity risk premium)?

We know, from the Modigliani-Miller theorem, that a firm's capital structure has no impact on its valuation. Contrary to what many argue, the increase in a company's level of (low cost) debt vs. (high cost) equity - an increase in leverage - doesn't lead to a meaningful reduction in the average cost of capital. The reason is straightforward: an increase in leverage by increasing the company's insolvency risk leads to an increase in the company's cost of equity (the equity risk premium goes up). The increase in the cost of equity in turn fully offsets the lower cost of debt, resulting in an unchanged average cost of capital. As changes in the capital structure don't have any impact in a company's operating free cash-flow generation potential, it follows that a change in a firm's capital structure doesn't have any impact on its fair value. There is only one minor caveat: given that interest payments are tax deductible, an increase in leverage leads to a minor change in the average cost of capital via the debt tax shield (e.g. if (i) 50% of the firm's capital structure is made up of debt, (ii) the corporate tax rate is 25% and (iii) the average cost of debt is 4%, the average cost of capital is.......0.5% lower vs. a capital structure with zero debt and 100% equity. Only 0.5% lower!). But even then there is a limit to the benefits of leverage: at some point (dependent on the cyclicality of the underlying business) further increases in leverage lead to an increase in the risk of insolvency and cost of equity that starts to offset the tax shield advantage. Keeping adding debt once that point is reached starts to increase the average cost of capital instead of slightly reducing it.

By the way, that the capital structure has no meaningful impact on a firm's average cost of capital and valuation is one of the few things on which Warren Buffett, Charlie Munger and financial academics agree on. So we better take it seriously.

With this is mind, where does the world economic system stands now? This is how the world's debt levels have evolved since the year 2000 (courtesy of MGI - McKinsey Global Institute):

The world economy is today more leveraged than it was in 2007. This must surely mean that the aggregate risk of insolvency is today greater than it was back then. And knowing what happened in 2008, it is reasonable to conclude that the resulting increase in the cost of equity more than offset any tax shield advantage from the additional debt the system accumulated in the meantime. So, the risk-adjusted average cost of capital should be higher today than it was in 2007.

What does this mean to valuations in the world's leading equity market, the US? Assuming, very optimistically, that (i) today's average cost of capital is only 10%, (ii) the US economy will grow at 5% nominally per annum in perpetuity (2.5% real growth + 2.5% inflation) and (iii) companies' average dividend pay-out is 75%, US equities would be fairly valued at a P/E of 15x (with a pay-out of 65% the fair value P/E would be 13x).

The S&P 500 is currently trading at a cyclical-adjusted P/E of 29.9x, trailing P/E of 24.1x and 1-year forward looking P/E of 19.0x. If this is fairly valued, what is overvalued?

And remember: gravity does exist. In financial markets too. It's just that it is not Newton's gravitational principles that rule financial markets - it's Wile E. Coyote's: markets can deviate from fair value for a long time, but eventually the power of gravity takes over.

Tuesday, 16 May 2017

Macron(omics) missing piece - a private sector-based Eurozone transfer union: the core-periphery FDI bridge

The Eurozone suffers from a structural economic problem. An imbalance: a centre traditionally running current account surpluses, a periphery traditionally running current account deficits. Admittedly, the peripheral countries' current accounts are now balanced but as unemployment keeps falling it is difficult to see how this won't translate into a rise in imports and current account deficits resurfacing again. The classic response to address such imbalances is via the creation of an EU transfer union. In theory, it would make sense.

But theory is not always very practical: it is almost impossible to gain political support at the EZ's national level to transfer taxpayers money from the centre to the periphery. However, doing nothing is not an option either. And this begs the question: what to do? The answer: create a centre-periphery FDI bridge. The idea's rational being reasonably straightforward:

Problem: Peripheral countries (Spain, Portugal, Greece) have traditionally (i.e. since WWII) run current account deficits - the resulting accumulation of foreign debt leading sooner or later to an inevitable “sudden stop”, financial and economic crisis. Just like in 2009/2010. 

Solution: These countries need to broaden substantially their export base and implement an export-driven growth strategy. The way to do it in an effective and reasonably timely manner (5-10 years) is by attracting massive amounts of foreign direct investment (FDI): that the Siemens, L'Oréals, Googles of the world set up production/service units in the countries (or expand the already existing ones) to serve (mostly) clients abroad. For it to happen structural reforms at the national level are needed – no doubt. But it will not be enough. The European Union has to create a mechanism that incentivises the flow of private capital (simply said “Germany’s excess savings”) from the centre to the periphery to finance the FDI projects. This should comprise:

- tax incentives, e.g. FDI projects not paying corporate tax for the first 10 years;

- a pan-EZ legal & institutional framework, e.g. FDI courts at EU level investors could resort to in case of legal issues arising with their projects. Thus overcoming the potential lack of trust in the national legal frameworks & judicial systems.

In short: create special economic zones in the EU periphery offering investors a highly attractive and reliable fiscal, legal and financial return framework

Result: A win-win situation - the periphery expands its export base and generates strong export-based sustainable growth; the centre can invest its surplus in economically sustainable projects at an attractive rate of return (instead of investing in US-subprime or Spanish overvalued, excessively supplied, real estate assets as in the pre-2008 period). 

Cutting a long story short, the centre-periphery FDI bridge is an incentive mechanisms at the EZ level to channel private sector monies from the surplus centre to the deficit periphery, to finance FDI projects in the latter. It is both politically more feasible and economically more efficient / sustainable than creating a classic transfer union.

Combined with (i) a limited common EZ budget (managed by an EZ finance minister) to finance investment projects across the EZ, (ii) evolving the ESM into a fully-fledged European Monetary Fund for crisis resolution situations, (iii) full implementation of bank bail-in mechanisms and completion of EZ's banking union, the FDI core-periphery bridge would complete Eurozone's required institutional framework and make it a sustainable and prosperous economic construct. The Euro would definitely become a success story.

Emmanuel, are you reading? Thanks to you, we - the Erasmus generation - are in charge now. Let's make Europe great. Again.

Monday, 20 February 2017

Hard-core Brexiteers' investor sentiment: Germany is stupid enough to let the Euro collapse...

Germany's current account surplus is estimated to have reached 8.6% of GDP in 2016 (Source: Ifo Institut).

The Deutsche Mark (DM) was Germany’s currency from 1948 to 1999. How often did Germany in the DM period have a current account surplus of 8.6% of GDP? Zero. How often a current account surplus of 5% of GDP? Zero. The highest current account surplus ever recorded during the DM period was approx. 4% in two years in the 1980s. During the rest of the time, Germany’s current account surplus always peaked in the range of 2%-2.5% of GDP. This includes the years of Germany’s economic miracle in the 1950s and 1960. Check it out for yourself:

Source: Bloomberg

[Please note: chart only depicts Germany's current account balance data from 1970 to 2015. Full data from 1950 to 2015 for Germany's trade balance can be found under German Trade Balance 1950-2015 and for Germany's GDP under German GDP 1950-2015 - data source for both links: German Statistisches Bundesamt. To calculate the German current account balance please take into account that 1%-2% of GDP have to be subtracted from the trade balance. Reason: Germany's current transfers are negative (EU net transfers accounting for approx. 0.6% of German GDP + monies transferred by migrants living in Germany to their countries of origin more than offsetting Germany's positive income balance)]
Is today’s German 8.6%-of-GDP current account surplus sustainable? No. During the DM period it would have been swiftly eliminated before it even came into existence via an appreciation of the DM (r-e-m-e-m-b-e-r: with the exception of two years in the 1980s, the German current account surplus never surpassed the 2%-2.5% mark during the over 50 years long DM-period). With the Euro, this market-based adjustment mechanism ceased to exit. What to do? There are two options:

  1. Break up the Euro and return to national currencies in today’s Eurozone
  2. Put in place a transfer mechanisms from Eurozone’s surplus to deficit countries via the public and/or private sector
What are advantages and disadvantages of option 1 for Germany?

The only advantage of Option 1 I can see is the lack of need for economic co-ordination among Eurozone member states, which can often be painful. A veritable pain-in-the-neck. I can see, however, many disadvantages both cyclical and structural.

Let’s start with the cyclical: Germany would undergo a recession - then again, who cares? Many young well educated citizens from EZ’s periphery would head back home - one of the best performing asset classes in Germany over the past 5-6 years has been real estate. A fall in real estate prices would be unavoidable. There is no asset class where the average investor is as leveraged as real estate. What would that mean for the German financial system? Bail-ins or bail-outs - do we start to care now?

On the structural side: how many decades would the resentment and lack of trust between Germany and France last following France’s crash-out of the Euro? Could the EU survive a break-up of the Euro? If not, what would the end of the EU's single market mean for the German economy? With 80 million inhabitants and a Eur 3.1tn GDP, Germany is Europe’s heavyweight. It accounts for roughly 1% of the world’s population and 4.5% of the global GDP - how much weight would stand-alone Germany have in the world (the US accounts for 24% of global GDP, China 15%, the EU 23%, the EU ex-UK 19.5%)? How much influence would stand-alone Germany have in forming and shaping international treaties and world trade agreements? Could NATO be a credible tightly knit military alliance with no underlying mutual trust among its core European members?

By choosing option (2) Germany would agree to transfer a large part of its current account surpluses to the Eurozone periphery. In return it would continue to have the full benefits of the existence of the Euro and a stable, sustainable and prosperous European Union. Given that Germany’s giant current account surpluses wouldn’t exist without the Euro, Germany would give up something it wouldn’t have anyway in return for having something extremely valuable and tangible. This is the closest you will ever get to a free lunch: get great value in return for giving up de facto nothing.

We can discuss if in the end Germany will push for an Eurozone-wide public sector based transfer mechanism between surplus and deficit countries (Eurobonds and an Eurozone finance ministry). Or a private sector based one, i.e., create incentives at the Eurozone level to incentivise massive amounts of foreign direct investment (FDI) in the periphery financed with German private sector surpluses – the periphery widens its export base and German investors obtain attractive returns for their savings (my favourite option). Or if Germany simply starts to spend more via a mix of public investments with a positive impact on the economy’s supply side (infrastructure, education…) and larger pay rises, which would increase German imports. Or if Germany will push for a combination of all these (the most likely option).

But saying that Germany, in the end, will let the Euro break up is saying that the country’s top-decision makers are economic and political illiterate. And absolutely stupid. Or that they are not intelligent enough to convey the message of the Euro’s and European Union’s importance and extremely high benefits for the country to German voters. Meaning: they are really stupid. Or that the vast majority of the German public wouldn’t understand the message. Meaning: the Germans overall are really stupid. Or that the German political system would not comply with article 23 of the country’s constitution. Meaning: German top decision-makers are not only stupid – they cannot even read. And on top of it, Germany’s political and judicial institutions are a fraud.

No, no, boys and girls. No, no, hard-core Brexiteers. I know that it is unpopular to say it these days, and I’m sorry to disappoint you, but the Euro will not collapse. In Germany’s wisdom and quality institutional framework you should trust. Even if you don't like it.

Wednesday, 7 December 2016

Monte dei Paschi di Siena - parliamo deutschiano?

Matteo Renzi was defeated in Sunday's Italian constitutional referendum and quickly resigned as Italian prime-minister. The Italian banking sector, led by Monte dei Paschi di Sienna (MPS), became more than ever front and center of investors' and press' speculations.

One day, MPS will collapse, trigger a new Eurozone banking & financial crisis and the break-up of the Euro. The next day, it will be bailed-out by the Italian government and its shares (and bonds) are a screaming buy. This is all an excellent reflection of markets' and financial press' "action bias": be busy all the time even if it achieves nothing.

What about looking at the numbers and regulatory framework first and express opinions later, guys? Not very popular in the post-fact world in which we are now living? Let's be unpopular then:

1. According to the EU's Bank Recovery and Resolution Directive (BRRD), that entered fully into force in January 2016, national governments cannot recapitalise a bank before a bail-in of an amount equal to at least 8% of the bank's total liabilities including bank's own funds (capital) has taken place. Meaning: we're basically talking about 8% of total assets. In the case of MPS, that means a bail-in of an amount of approx. EUR 12.8bn;

2. MPS' total equity is approx. EUR 9bn; junior bonds face value amounts to approx. EUR 5bn, of which approx. EUR 3bn is held by retail investors. Bailing-in retail investors is politically untenable. The challenge then is to treat all junior bondholders equally while avoiding bailing in retail investors. And the elegant solution would be to define a bail-in free face value amount of EUR 100k per bondholder - everyone would be treated equally while MPS 40k retail junior bondholders were de-facto excluded from the bail-in. This would leave EUR 2bn of junior bonds to be bailed in. Not enough. MPS needs at least EUR 5bn of additional equity. On top of it, bailing in all shareholders and junior bondholders only amounts to EUR 11bn, almost EUR 2bn short of what is needed for a state participation in the recap efforts. What to do?

3.  The straightforward answer would be to bail in senior bondholders as well. But it's probably not a good idea many will argue: MPS senior bonds are currently trading at close to 100% of face value. Senior bondholders are not expecting to bear any losses in the MPS recap process. If a bail-in of senior bondholders did occur scared investors would drop senior bonds of other Italian (and non-italian) banks, leading to massive contagion and a collapse of the Italian financial sector. Whatever one thinks of this line of argument, the good news is that a bail-in of senior bondholders is not a pre-condition for the Italian government to participate in the recapitalisation of MPS. The reason is article 32 (4.d) of the BRRD.

According to this article "extraordinary public financial support" is allowed "in order to remedy a serious disturbance in the economy of a member state and preserve financial stability". It is the so-called precautionary recapitalisation and considered a case of state aid. In case of state aid a bail-in is still required before the Italian government can participate in MPS' recap. But the degree of burden sharing is lower: only shareholders and junior bondholders are required to participate in it (see points 15, 40 and 41 of European Commission's Banking Communication from August 2013).

Will the Italian government invoke BRRD's article 32 (4.d)? You bet it will.

What are the implications? On the one hand, MPS will survive. An Italian fully fledged banking crisis will be avoided. The Euro will not break up. On the other hand, MPS shareholders will be wiped out.

Investors buying MPS banking shares expecting a giant Christmas present from the EU/Italian authorities should think again. And MPS senior bonds currently trading at close to par, and yielding 3% to 5%, are not a prime example of an investment with a spectacularly positive asymmetric risk-return profile.

To reach all these conclusions you only need to understand what makes the EU great: a combination of German rule-based institutions with embedded Italian flexibility. Learn deutschiano and you will be just fine.

Monday, 31 October 2016

Hillary, Donald and Investment Management

Based on current betting odds and Nate Silver's fivethirtyeight polls analysis (link here), the probability of Trump winning the US Presidential election is only around 25%. With such favourable odds, the easy conclusion would be: let's go long on US (and global) equities and secure the 1-week 3-5% celebration rally that will tend to follow Hillary Clinton's victory.

But it would be too easy. And bad decision making.

Investing is not really about the probability of success vs. failure. It is not even about expected values and expected returns. It is all about assessing the consequences of failure. Binary outcomes and risk-return asymmetry.

In this case, we have a binary outcome: 0 - Hillary Clinton wins; 1 - Donald Trump wins. If Hillary wins the US equity market's upside is arguably 3-5% over a 1-week period; if Donald wins the downside is possibly 10-15% over the same period. Do you really want to be exposed to a binary outcome were you can win 3-5% if things go your way at the risk of losing 10-15% if they go against you? This is an highly unfavourable asymmetrical risk-return profile. The negative consequences of failure way outweighing the positive consequences of success. Thus, the sensible answer can only be no.

The more academic types among us could always argue that if the potential upside is 5% and the downside is 10% (after all you can exit before the losses reach 15%), with the currently implied 75% probability of Hillary winning the election, the expected 1-week return of building a long exposure to US equities the day before the results are announced is 1.25%. All nice and dandy. However, we should never forget that a 75% ex-ante probability of success can easily become a 100% ex-post probability of failure; a 1.25% ex-ante expected return become a 10% ex-post loss. And that in the age of "the rage against the establishment", the polls' - and implied probabilities - accuracy is not what it used to be.

Wouldn't actually a short position in US equities have a much more attractive risk-return profile ahead of the election than a long one? Yes, it would. Then again, if Trump wins there is enough time to make money with equities. 

Don't be too greedy. Think binary. Think negative asymmetrical risk-return profile. And stay away from the US (and global) equity markets ahead of the US election day.

Monday, 12 September 2016

Richard Koo, please mind the gap: the Eurozone is not Japan

Richard Koo is well known for his balance sheet recession analytical framework (here a link for one of his most recent and detailed presentations: Richard Koo at May 2016's Acatis Conference in Frankfurt).

His analysis points to the fact that once a debt fuelled asset bubble bursts, leaving the private sector in a highly indebted and over-leveraged position (with many individuals and corporates in negative equity territory), monetary policy becomes ineffective. Following the implementation of a highly expansionary monetary policy, private households and corporates will take advantage of very low interest rates to repay down their debt burden faster. Not to consume more. Not even to maintain their consumption at pre-asset bubble burst's levels. The private sector unavoidably retrenches.

In such an environment, the only way to avoid an economic depression is to combine an expansionary monetary policy with an expansionary fiscal policy: the government has to step in, run large deficits and increase public spending. This is what the Japanese government has been doing following the burst of the country's real estate and stock market bubbles in 1989. Once the private sector has completed its deleveraging process, and monetary policy becomes effective again, the government can then revert to a normal fiscal policy and the central bank normalise monetary policy.


So far, so good. Richard Koo's analysis is insightful and his recommended expansionary fiscal policy sensible. For Japan.

But does it really make sense to apply the expansionary fiscal policy strategy to the Eurozone over the coming years as he proposes? At first sight, it does. After all, the Eurozone, on aggregate, suffers from the "Japanese disease": an over-leveraged, over-extended private sector in parts of the periphery that needs to de-leverage; national governments that need to step in and spend more to offset the private sector's retrenchment. However, once you look at things into more detail the picture changes. And you realise that Richard Koo's Eurozone analysis overlooks a few things. Namely:

1. And this is fundamentally true for any balance sheet recession scenario (Japan included) - if you have a private sector balance sheet whose left side is suddenly smaller than the liabilities on the right side (as a result of the burst of a debt fuelled asset bubble), you have two ways to correct the problem of negative equity. One is by inflating the left side via an ultra-expansionary monetary policy while slowly reducing the liabilities on the right side - this is part of Richard Koo's proposed strategy. But contrary to what Richard Koo argues it is not the only feasible strategy available. There is another option: to radically and swiftly shrink the liabilities on the right side via debt restructuring and haircuts. This will lead to massive impairments in the banking sector and arguably the financial sector cannot be let implode. But that doesn't imply bail-outs and debt transfers from private investors to the taxpayer. All what is needed are bail-ins. Bank shareholders and debt-holders, who freely decided to invest in bank shares and bonds, bear the pain as would investors in any other private firm in a similar situation. There will be massive turmoil in financial markets while this process is ongoing but once it is finished financial markets' will recover quickly. And with private debt restructured and a swift de-leveraging process having occurred, monetary policy will be effective again. No need for ZIRP, no need for QE. No potentially dangerous financial, economic and political distortions as a result of an ultra-expansionary, unconventional and highly experimental monetary policy. Ok, I know, the Eurozone has descended way into unconventional monetary policy territory by now. But just making the point that there are alternatives to the path followed by ECB & Co. And endorsed by Richard Koo.

2. Japan is a fiscal union with a current account surplus. The latter means that it is not dependent from external financing - Japan's private sector savings are directly or indirectly (via pension funds or private bank purchases) financing the country's large public deficits. The Eurozone is a multi-sovereign state entity. Not a fiscal union. The EU's peripheral countries, which according to Richard Koo should implement an expansionary fiscal policy, have just about reached a balanced current account after many decades running current account deficits. An expansionary fiscal policy would unavoidably generate current account deficits again. Meaning: widening fiscal deficits in the periphery would have to be financed by international investors. How many would be ready to do it? And for how long? With fiscal and current account deficits ballooning again, a sovereign credit rating downgrade to non-investment grade and a sudden-stop in international financing would likely occur sooner rather than later. An expansionary fiscal policy strategy in the periphery is not really a sustainable option;

3. The Eurozone is structurally an economic unbalanced entity, with the core running historically current account surpluses and large parts of the periphery current account deficits. The adjustment process that the peripheral countries pursued over the past seven years to balance their current accounts was an uneven one: only 1/3 of the current account adjustment is explained by an increase in the countries' exports; 2/3 is due to a fall in imports - the reflection of economies operating way under full capacity and with high levels of unemployment. Having large parts of the periphery mired in a state of semi-economic depression is not a sustainable option either - the Eurozone would fall apart. So, what to do? The peripheral countries (think Spain, Portugal, Greece) need to return to high economic growth. But it has to be an export-led growth. Not one led by increased public spending. On the other hand, the Eurozone's core countries are awash in savings and in need of attractive investment opportunities to deploy them (think German pension funds). This makes it easy to create a win-win situation for both sides.

How? Simple: the peripheral countries need to attract massive amounts of foreign direct investment (FDI) to significantly expand their export base, create jobs and generate sustainable growth; these FDI projects in turn can be financed by the surplus countries's savings - international companies can issue Euro denominated bonds to finance their investment projects in the Eurozone periphery, which can be bought by the savers from the Eurozone's core (yes, the German pension funds). Surely a more compelling investment opportunity than US subprime real estate and overvalued Spanish real estate in the past or Eurozone government bonds today.

What needs to be done for a FDI-led growth strategy to pan out in the Eurozone periphery? To attract massive amounts of FDI (i) the peripheral countries have to continue to implement structural reforms to become an attractive location for international firms; (ii) the European Union needs to support them by creating incentive mechanisms for international firms to locate some of their operations in the countries (e.g. by classifying these countries as "special EU investment zones", which would offer, among others, exceptional tax advantages to investors for a 10-year period); (iii) on top of it, the European Union needs to finance a yield top-up on Euro bonds issued by international firms to finance their investment projects in the periphery. Thus creating an appealing investment proposition to channel the savings from the core to the periphery via financing of FDI projects.

After seven years of an economic structural adjustment process in the periphery carried out with varying degrees of conviction across the different countries, it is time for the European Union to start thinking about incentive mechanisms to support massive amounts of FDI to flow to the Eurozone periphery financed by the core's high savings. Thus creating a win-win situation for both sides. This has to be the EU authorities' top economic priority. Not an expansionary fiscal policy in the region. Remember: short-term fixes cannot, and will not, solve long lasting structural problems. Only buy time to fix them. 

Boys and girls, dear Eurozone leaders: it's fixing time.