What are you smoking? The macro-economists supreme weakness: flows vs. balance sheets

In 2008, the financial sector was on the brick of collapse. Even if it accounted for only 4% to 10% of GDP (depending on the country), you could not let it implode. It's not the size of a sector itself that is relevant for assessing its economic importance. It is its connectivity with the rest of the economy. And no other sector is more at the centre of the economic system in a market economy than the financial sector. A feature it arguably shares with the electricity grid. So unless you think that because the electricity industry only accounts for 2% of GDP you can let the electricity grid collapse without causing a devastating damage on the rest of the economy, you cannot let the financial sector implode either (that instead of rescuing it via bail-outs you should rather do it via bail-ins is another story). This is the point that Larry Summers very correctly made at the latest IMF conference (8 November 2013). So far, so good.

But then he goes further and argues that monetary policy became ineffective in the developed world ("liquidity trap") because the equilibrium real interest rate is actually negative! Meaning: the FED, BoE, ECB & Co should keep their ultra-loose monetary policy for many years to come and try to create asset bubbles as without them there isn't any hope for economic growth to take place. On top of it, governments of developed countries should run large deficits and launch a massive programme of public investment financed by central banks monies for many, many years.

Here Larry Summers' "performance" in all detail:
- the video: http://www.youtube.com/watch?v=KYpVzBbQIX0&feature=youtu.be
- the text version: http://www.fulcrumasset.com/files/summersstagnation.pdf

Paul Krugman, even goes further. He argues that it would be desirable for the private corporate sector to invest in all kinds of projects, even when their rates of return were likely to be negative at inception (and way, way below their cost of capital), because it would generate employment.

Here Paul Krugman's "performance" in all detail:
- Paul Krugman: http://krugman.blogs.nytimes.com/2013/11/16/secular-stagnation-coalmines-bubbles-and-larry-summers/?_r=0

Negative real interest rates as the ideal asset allocation mechanism in a market economy? Asset bubbles as a way to generate sustainable economic growth? The government as a better investor and resource allocator than the private sector? Private companies pursuing projects with negative rates of return to generate demand and employment in the short-run and forgetting the mid-term consequences of it, i.e., sound companies today going bankrupt tomorrow as a result of bad investment decisions and....well...creating unemployment?

Larry Summers' and Paul Krugman were some of my heroes as I was an economics student. What happened? What are you smoking, guys?

To be fair, I don't think that they are smoking anything that they were not smoking years ago. But we all are the product of our education, training and experiences. Paul Krugman and Larry Summers included. And they happen to be academic (macro-)economists by education and training. Their views are simply the result and perfect example of macro-economists' supreme weakness: excellent at analyzing flows, terrible understanding balance sheets.

The reason why US and European monetary policies are ineffective is because the economies are over-leveraged. Balance sheets are impaired across the whole economy. When that happens no matter how low interest rates are, no one is neither willing nor able to take on more debt. The absolute priority is to de-leverage. Banks are impaired (even if they say otherwise) as a high percentage of the credits they conceded are de facto non-performing loans as a result of having been used to finance projects that turned out to have negative rates of return - why else would the borrowers not have been able to pay them back and in fact had to increase their levels of debt over time?

In such a scenario, a debt restructuring across the board is the only quick and effective solution. Followed by a recapitalization of the banking sector via-debt-to-equity swaps (bail-ins). Once this is done, all the problems are solved and monetary policy becomes effective again. Interest rates will start functioning, again, as the signaling mechanism for financial resource allocation across the economy they are supposed to be. Or would anyone not borrow money if he/she suddenly had no debts and lending rates were 2%?

Putting it differently: increasing leverage is a powerful economic growth accelerator until over-leverage is reached. When leverage turns into over-leverage is an interesting academic discussion for which there is no clear ex-ante answer. However, it is very easy to spot when that point is reached.....once it is reached: monetary policy becomes ineffective ("liquidity trap") and debt restructuring across the board is needed.

You don't solve the problem of an impaired balance sheet by trying to artificially increase the value of the assets - if a balance sheet is impaired that must mean that the quality of the assets is bad, i.e., they were not and are not able to generate sustainable positive returns. The result of bad investment decisions. You solve the problem of an impaired balance sheet by accepting that the assets are worth much less than they are accounted for and restructuring the balance sheet's right side, where equity and debt sit.

That public investment in areas where clear positive externalities exist, able to generate a positive impact on the economy's supply side (improvement of education system, internet / telecom infrastructure, transport infrastructure, R&D) and lead to an increase of potential GDP does make sense is undisputed. No one with a reasonable degree of common sense challenges that. But it has to be a complement to a comprehensive balance sheet restructuring in the private and public sector. Not a substitute for it.

PS Look at the Japanese total level of debt (both public and private) at the beginning of the 1950s and in 1989, when the country's two lost decades started. Do the same for the US and Europe: in both cases starting at the beginning of the 1950s up to 2007.

What do you see? A continuous increase in total debt as a % of GDP and since 1989 in Japan and 2007 in US / Europe a completely ineffective monetary policy in terms of generating economic growth. These were the points in time were over-leverage and impaired balance sheets finally revealed themselves.

DCF (II): a far more sensible approach to valuation than a detailed DCF

As said in my last post, a detailed DCF is a highly valuable M&A and marketing tool. But not a sensible approach to value a company. The question then is: what is a sensible approach to valuation?

One that meets the following conditions:

1. Keep it simple. Forget the 50 variable detailed DCF. Focus on sales, profit margins and make sure that the company's asset base is in line with your growth assumptions

2. Focus on the big picture. Just focusing on three variables may seem to be superficial. It is not. If you have a highly complex problem to solve you don't develop a highly complex model to analyse and solve it. That would only create confusion, intellectual distress and lead to poor decision making. It would be the planning fallacy at its worst.

The solution is to follow simple principles for complex problems. And broad framing: take a step back, think hard about what are the critical factors to understand and solve the problem and focus on these. For any problem, explanatory factors 8, 9 and 10 are always pure, simple and irrelevant details. Factors 1, 2 and 3 will explain (almost) everything you need to know in the vast majority of the cases you will be confronted with. And factors 8, 9 and 10 will tend to be highly correlated with 1, 2, 3 anyhow making them redundant. Besides, if you start to focus on 10 explanatory factors you will end up i) not really focusing on any, ii) spend time paying attention to things that are irrelevant, iii) missing out critical information because you are too busy dealing with irrelevant details. Allocate your time to understand what is key. To understand it really, really well. The rest are peanuts.

And what is key? Quality of the business and quality of the management.

Does the business benefit from a moat? Has it true pricing power? (first quick test to answer both questions: has the return on capital employed been consistently above the cost of capital over the entire economic cycle?) Is the entire industry potentially exposed to disruption from outsiders? Is the management team of high quality, i.e. intelligent people with high ethical standards? Are the top managers interests aligned with that of the shareholders? Does the pay structure incentivise managers' long-term thinking and decision-making (way, way beyond the next quarterly report)? Are the top managers respected and admired by the vast majority of their employees or rather resented?

3. Quantify! If you can't quantify reality, your understanding of it is very shallow. When it comes to valuing a company, it is easy to find people that use a detailed DCF and put a number on 20 different variables. However, it is very difficult to find people that actually quantify and challenge the underlying assumptions of the valuation model.

Typically, in detailed DCF modelling there is a macro or mega-trend underlying sales growth assumptions. But this trend is verbose and vaguely quantified. And usually relying on research reports from well know institutions. Something like "Industry experts estimate that the demand for German solar equipment is likely to grow 30% annually over the next decade. The European slowdown won't impact German solar equipment manufacturers as their main clients are Chinese solar panel manufacturers and the Chinese market will keep growing at high double digit rates. The Chinese in turn while being the world's leading solar panel manufacturers, won't be able to compete with the German solar equipment manufacturers (note: solar equipment is, simply said, the equipment needed to produce solar cells for solar panels) because they don't have the technological know-how to do so. They will remain the German solar equipment manufacturers best clients for many years". The issue is that if you simply read tens of research reports and use their main findings to derive a company's sales estimates, the chances are that you will end up way off the mark. And if you are way of the mark for the top line you will be way off the mark in your bottom line estimates as well (and trying to put numbers on 20 variables won't make it any better).

You have to quantify, pin things down, and challenge, with numbers, all aspects of reality. Reading research reports is nice and all you need to do if you are a salesperson wanting to tell your clients a persuasive investment story. But if you are an investor you have to do better. And more. You have to do your own research. Go directly to the sources of information. Get the numbers. Speak with a broad range of people holding different opinions. And challenge the underlying assumptions others are putting forward before you incorporate them in the valuation of the company you are analyzing:

a) The Chinese solar panel producers won't be impacted by the European slowdown as China will continue to grow strongly? Really? How much of their production is sold into Europe? 80%-90%? Interesting....

b) The Chinese won't be able to develop their own solar equipment technology as they don't have the know-how? What do the top Chinese students study? Philosophy or natural sciences? Natural sciences (even because discussing philosophical ideas freely in an one-party system is not really a good idea for career advancement). What's the percentage of Chinese students in post-graduate science programmes in the western world's top universities? 15% to 20%? And China will still not be able to develop its own solar equipment technology quite fast? Interesting....

4. Be sceptical and respect the power of history. Companies, like people, don't change easily. A company's past behaviour - over a 10 year timeframe (one entire economic cycle) - in terms of capital allocation efficiency and return on capital employed will tell you much more about what you can reasonably expect from it in the future than whatever the company's management says and would like you to believe

5. Operate with a margin of safety and learn to say "no". Once you have an estimate for normalized operating results and free cash flow - reached following the principles outlined above - you can start performing a company valuation. Calculate the multiples and compare them with peers' multiples, currently and over time. Try to assess the company's liquidation value whenever you can. And by all means: use discounted cash flow techniques and perform sensitivity analysis - but please forget a detailed DCF. And never, ever forget that performing a company valuation is not an exact science. Therefore, allow for a margin of safety. Don't invest if there isn't at least a 30% discount to what you reckon to be the company's fair value.

The ability to say "no" is no mean feat. And it is one of the most remarkable skills great investors share.

6. Don't overpay for growth. No matter how much a company is able to grow, if the return on capital employed is not above its cost growth has no value. On top of it, even if the return on capital employed is currently above the cost of capital it will tend to converge to the latter over a 5-6 year period, maximum. The exception to the convergence rule only occurs is if you are dealing with a true franchise business, i.e., a company that benefits from sustainable barriers-to-entry in its market. How many companies are true franchises? Let's be optimistic and say that 1% of all companies are. Do you really think that your are one of the greatest investment genius in the history of mankind and able to spot the real franchises, at least most of the time? Think again. And act accordingly.

And hey, if you do are an investment genius (or have a team and investment process in place that allows you to look like one) you just cash in the full benefits of not overpaying for growth.

7. Put in place a decision-making process that explicitly deals with the two mothers of all behavioural biases and bad decision-making: confirmation bias and loss aversion

This means putting Karl Poppers "falsification principle" at work: stimulate an open debate culture within your organisation to foster as many independent, uncorrelated opinions as possible with the aim to reject wrong assumptions and poor investment cases at inception. Remember that good writing leads to good investments: write down the investment case with its main assumptions, potential upside and risks. Especially write down the risks - and how to act in case they materialise to avoid that cognitive dissonance takes over when things start to move in the wrong direction. And learn from Kahnemann and Tversky: explicitly integrate reference-class forecasting and pre-mortems in your decision making.

Finally, accept one advise: be an optimist in all domains of your life. Except when it comes to investing. This will prove to be true genius.

DCF (I): a great negotiation and M&A tool; a great valuation lie

A detailed Discounted Cash Flow (DCF) model is all we need to assess the value of a company, isn't it?

Let's start with a few simple questions:

1. How many variables do we normally have to estimate in a typical detailed DCF model? Sales, COGS, SG&A, R&D, D&A, capex, change in working capital, tax rate, growth rates, interest rates......and all this for several years into the future. Let's be optimistic and say that only 10 variables need to be estimated.

2. For each of these variables, what's the probability that we estimate them accurately (less than 10% estimation error)? Let's say that we are the world's greatest economic & business forecasting geniuses ever and that the probability is 80%.

3. Given (1) and (2), what's the probability that we end up with the right estimate for the value of the company (less than 10% estimation error)? The answer is: 10.7%.

If we actually have to estimate 20 variables instead of 10, the probability drops to some fabulous 1.2%. And if we do just have to estimate 10 variables but our forecasting accuracy instead of 80% is just 65% for each of them (we would still be the best economic & business forecasters ever) the probability that we end up with an accurate result for the value of the company is a spectacular 1.3%.

Meaning: a detailed DCF is an excellent tool to simulate the impact on valuation of different and very detailed economic & business scenarios. However, given the intrinsic difficulty in forecasting the future any detailed economic & business scenario taken as the basis for a company valuation is doomed to be proven wrong. And, alas, so is the derived company valuation.

Nevertheless, and funny enough, a detailed DCF is an excellent negotiation and M&A tool. After all, what is a successful M&A deal but a negotiation process at the end of which a company is taken over by another one? And what is a successful negotiation process but a mutual agreement on a future economic & business scenario and the resulting valuation for the company to be acquired? By allowing to simulate such a detailed scenario and derive the corresponding company valuation, a detailed DCF model allows buyer and seller to agree on a transaction value in an apparently scientific way - which provides much comfort to both parties.

The only problem is that this comfort is based on both the planning fallacy and the supreme illusion of control: "the more detailed we plan and forecast, the better are we prepared to deal with the future". Big mistake.

The future is inherently uncertain, with the degree of uncertainty increasing more than proportionally with the increase in the planning / forecasting horizon. This means that the higher the degree of detail with which we try to forecast the future, the higher will be the probability that we will be proven wrong.

Now let's combine a potential buyer's tendency to be optimistic about the economic & business environment for the business he is targeting in an M&A deal (why would he otherwise be willing to acquire it?) - and the seller's ambition to maximize the proceeds of his disposal - with a detailed DCF model. What do we end up with? A very detailed future economic & business scenario, on which both negotiation parties agree, that is biased to the upside. The buyer overpays. And this explains why 2/3 to 3/4 of M&A deals end up being value destructive for the acquirer.

Cutting a long story short: a detailed DCF model may be a great negotiation (and marketing) tool. But it is a philosophical and mathematical mistake.

If using a detailed DCF model to value a business is nonsense, what's an investor's alternative to perform a sensible valuation? A few cues: keep the focus on the big picture. Quantify it. Quantify it. Quantify it. Keep it simple. Look for inconsistencies.  Remember that it is better to be roughly right than precisely wrong. Think twice before paying for growth. Allow for a margin of safety. Understand that less is more.

More about this in my next post.

Eurozone survival: transfer union, yes. Fiscal union, no

There is no sustainable monetary union without fiscal and eventually political union.

The argument goes like this: when there is a negative economic shock impacting some regions of a monetary union much more severely than others (an asymmetrical economic shock), the negatively impacted ones will have no autonomous monetary policy to respond to the shock. They will have no currency of their own to devalue, increase competitiveness and eventually restore economic growth to overcome their problems. Therefore, a fiscal union is needed to transfer resources from the "strong" to the "weak" countries of the union in such circumstances - this being the only way to restore growth in the latter. And since a democratic system has to comply with the principle of "no taxation without representation", a fiscal union cannot exist without a political union backing it. 

In the case of the Eurozone, this would mean:

a) Issuing Eurobonds (fiscal union)

and

b) Transferring competences from national parliaments and governments to a directly elected Eurozone parliament and government. The end of Eurozone national states as we know them and the birth of an Eurozone superstate (political union)

And here is where the problems really start: the German government and German citizens (via a referendum) would even most likely agree to the introduction of Eurobonds as long as it was accompanied by a political union of the Eurozone. 

But who else is ready for a political union of the Eurozone? Spain? Italy? France? The answer can only be: almost no one else. None of the other three Eurozone large countries. And certainly not the Grande Nation - for the French establishment, Paris is still the centre of the world.

Given this set of circumstances, the logical and straightforward conclusion is that the Eurozone will fall apart and implode. This is the reasoning behind the doom & gloom views about Eurozone's future often found in the Anglo-Saxon press and investment circles.

The Anglo-Saxon view of the (Eurozone) world is however likely to be proven wrong.

A transfer union from the surplus to the deficit countries is undoubtedly necessary to solve the current Eurozone crisis and for a sustainable monetary union. However, the Anglo-Saxon approach to Eurozone's crisis resolution is missing one important point: you can have a transfer union without a fiscal union. The transfer of funds from the surplus to the deficit countries can be done via the private sector:

1. Debt restructuring across the board for both public and private debt in the deficit countries.

2. The then unavoidable recapitalization of the Eurozone banking sector done via debt-to-equity swaps: insured depositors are protected, shareholders wiped-out, unsecured creditors become the new bank shareholders (if this is not enough, Eurozone public monies can then and only then be used to close the remaining recapitalization gap). This way breaking the vicious circle between the national banking systems and the respective sovereign.

3. With excessive debt - in both the public and private sector - eliminated and the Eurozone banking system well recapitalized, economic growth will come back. Swiftly. Eurozone's financial crisis will be solved for good.

Given that the deficit countries' and Eurozone banks' creditors are mainly citizens of the surplus countries (they are the ones with the savings that financed directly and indirectly - via the banking system - the deficit countries), this mechanism will in practice lead to a transfer of funds from Eurozone's center to the periphery. From the "strong" to the "weak" countries.

So, for those who like to frame the issues at stake in the Eurozone in terms of Germany against the rest, the message couldn't be clearer: relax. Germany will pay the bill. But it will be the German investor, who freely decided to invest in the periphery, that will pay. Not the German taxpayer. Which means that for the German taxpayer, always very much worried about the prospect of being forced to bail-out the entire Eurozone, the message couldn't be clearer either: relax.

The private transfer union mechanism just described, can also be called differently: a banking union (with a minimal degree of fiscal union - public monies necessary to close the Eurozone banking sector's recapitalization gap). And it is, roughly speaking, what has been agreed to be implemented by the European council of finance ministers in their 27 June 2013 meeting, with the directive to be approved by the European parliament by the end of 2013 (http://register.consilium.europa.eu/pdf/en/13/st11/st11228.en13.pdf)

In summary, there are good and bad news coming out of the Eurozone:

Good news: old Europe is about to implement a market economy compliant private sector transfer mechanism to break the vicious circle between national banking systems and their respective sovereigns. And in the process solve its financial crisis. It is highly unlikely that the Eurozone will fall apart. The Eurozone is highly unlikely to collapse.

Bad news: with heavy losses being imposed on Eurozone banks' shareholders and unsecured creditors, massive volatility will return to financial markets as soon as Eurozone's debt and bank sector restructuring starts. The ECB will have to step in to provide banks with liquidity during the restructuring process.

Good news amid the bad news: once the Eurozone debt and bank restructuring process is over (9-12 months after its start, if done in a coordinated manner), markets will recover fast.

This leaves us with one question: who said that old Europe is not an exciting place to live in?

Why stay in the Euro anyway?

What are the advantages of being part of the Euro? This is the question many people, especially in Southern Europe, start to ask these days. The typical answer revolves around the following arguments:

1. The Euro eliminates transaction costs related to currency conversion from which both companies and consumers benefit

2. It enhances price transparency of goods and services across the Eurozone creating more competition among companies from which all Eurozone citizens (consumers) are beneficiaries

3. It eliminates exchange rate risk, which allows for a higher degree of certainty in terms of investment planning and fuels cross-border investments

4. It allows to smooth the disruptive impact of financial crisis by avoiding overnight currency devaluations and allowing Eurozone banks to access ECB's refinancing mechanisms

5.......and we could go on with more technical arguments along the lines of the previous ones

They are all valid arguments. And the perfect example of the adverse consequences of too much focus on detail and complete lack of big picture thinking: in the big scheme of things these arguments are, on aggregate, valid but irrelevant. Peanuts.

The overwhelming reason to be part of the Euro is another one: a sustainable and continuous rise in living standards.

Let's see why:

1. The only way to increase living standards sustainably over time (which necessarily involves increasing real salaries sustainably over time) is via a continuous increase in productivity

2. A continuous increase in productivity requires continuous investment in both human capital (formal education, training / re-training on the job) and physical capital

3. What to do to incentivise companies to continuously invest in human and physical capital?  Simple: put them under constant competitive pressure. Only constant competitive pressure will force them to be innovative, come up with new and distinctive products, improve their production processes and reduce unit production costs. All of which, in turn, require a continuous re-investment of part of the annual profits generated in the business, i.e., in human and physical capital.

4. How to put companies under constant competitive pressure? By having a "strong currency". Meaning: a stable currency, that doesn't devalue as soon as there is some loss in the countries external competitiveness. The moment that the corporate sector realizes that it will not benefit from currency devaluation to restore potential losses in competitiveness, it will do everything it can not to lose competitiveness in the first place. And therefore, instead of paying out the entire annual profits in dividends to buy a few new Ferraris and yachts, entrepreneurs will reinvest part of the profits in their businesses. In human and physical capital.

Over a 1 or 2-year period buying another Ferrari or reinvesting part of the profits in human and physical capital won't make a big difference. Over a 10-period the difference will be like day and night. It will be the difference between a country with unchanged living standards, relying on currency devaluations to stay competitive, and a country with highly competitive and innovative companies able to pay high and rising salaries to its well-educated and well-trained workforce.

5. How to "create" a strong currency? Have a fully independent central bank whose only mission is to keep price stability. Such a central bank will not be subject to political pressures. Will not monetize public debt. And its single goal of ensuring price stability will translate into a "shadow goal" of exchange rate stability. A "strong currency". Thus, very low exchange rate risk for international investors. This in turn will translate into low interest rates.

In a nutshell: a stable currency ("strong currency") will create i) the incentives for a permanent high level of investment in physical and human capital by the corporate sector and ii) the conditions for these incentives to be materialised by generating a low interest rate environment. The mid to long-term result of this mechanism is economic prosperity.

This is THE reason why the Euro should be embraced by the citizens of its member countries.

But let's not fool ourselves: short-term, staying in the Euro will continue to impose heavy pain on Eurozone's peripheral countries. However, the fact that a currency devaluation is not an option, is building up a phenomenal amount of pressure on the countries to reform. Without the option of a currency devaluation, mismanagement by the political-administrative apparatus becomes suddenly very obvious and visible. The pressure to change the system is there and will not go away. The system's "fat cats" are and will continue to be under fire. This is very good news.

Especially when taking into account the power of history in shaping the future: countries, political systems, corporate cultures don't change easily. Just like people's behaviour doesn't change easily. For change in behaviour to happen powerful incentives have to be put in place.

The Euro is the most powerful incentive mechanism for change that Eurozone deficit countries could wish for. With it in place, structural change and a break with the past "modus operandi" are real possibilities. The younger generations being the main beneficiaries of it.

Boys and girls, the Euro is your friend. Embrace it!



PS Ludwig Erhard, Germany's legendary post-war II economics minister (1949 - 1963) always defended vehemently a politically absolute independent central bank (Bundesbank) and a stable currency ("the strong Deutsche Mark"). Now we all know why: to keep the competitive pressure high on the German industry and eventually rise German citizens living standards. Sixty years later, we all know the results.

Eurozone periphery: one deficit that counts. And the coalition of the unwilling

A popular view these days is that Eurozone's peripheral countries will not consider leaving the Euro as long as they run a public primary deficit (deficit before interest payments). Leaving the Euro would force them to adjust their public finances even faster than staying in the Euro as they would be suddenly cut off from international financial markets and unable to finance the public deficit. It would be austerity at the power of 2. As soon as the primary public deficit is eliminated, however, leaving the Euro will become a serious option. No additional adjustment in public spending would be needed and the devaluation of the new local currency relative to the Euro would quickly improve external competitiveness allowing for a speedier economic recovery.

As popular as it might be, the focus on the public (primary) deficit is misplaced. Analysts are looking at the wrong deficit. The deficit that counts is not the public one. It is the external one: the current account deficit.

This is why:

1. If a country decides to leave the Euro and re-introduce its local currency, it will be easily able to finance its public deficit. Not matter how large it is. The central bank can buy as much government issued debt as needed to finance the deficit. It's classic public deficit monetisation at work.

2. What the central bank cannot do is to finance the country's external deficit. For that to happen it would have to be able to issue foreign currency (Euro or USD) to pay for the "excess imports" of goods and services - something it cannot do. This means that leaving the Euro while running a current account deficit would force the country to immediately cut down its level of imports. Given that many of the imports are of an essential nature (energy, pharmaceutical products, chemicals, equipment) the pain would be felt straight away. Capital controls would have to be imposed to ensure that essential imports could be financed. The currency would devalue (25%-40% depending on the country). And while the currency devaluation would restore external competitiveness it would take time for its effects to be fully felt (18 to 24 months).

Meaning: leaving the Euro while running a current account deficit would lead to an immediate increase in social discontentment and unrest. Hardly an attractive perspective for any national government considering leaving the Eurozone.

To assess the likelihood of a country leaving the Euro, the relevant question than is: where do the EU's peripheral countries currently stand in terms of current account deficit?

And the answer is: in 2014 all of them are expected (IMF data) to achieve a current account surplus. Ranging from 0%-1% (Greece, Portugal), 1%-2% (Spain) to around 4% (Ireland).

Given that

a) all of them will still be running public deficits in 2014 ranging from 4% (Greece) to 6.5% (Spain)

b) Greece, Portugal and Spain will have to reform their political-administrative apparatus (call it bureaucracies) - including cutting pensions of retired former members of the apparatus - to bring the public deficits sustainably down, reform their tax system and attract foreign direct investment

c) there will be a lot of resistance from the political-administrative apparatus' insiders to reform

the outcome can only be one: a public campaign led by the bureaucracy insiders (countries' local and regional politicians, public servants, organisations with close ties to the public sector) to exit the Euro will gain momentum over the next 18-24 months in Greece, Portugal and Spain. The insiders know that leaving the Euro and monetising the public deficit will enable them to keep the status quo. The fact that the countries are running a current account surplus will further allow them to avoid the disruptions caused by leaving the Euro while running a current account deficit. And thus sell the whole strategy as a way to increase the countries external competitiveness and enable a faster economic recovery to take place.

More remarkable is that they are likely to be joined on their "Euro exit campaign" by the at first sight most unlikely of allies: major shareholders and top management of the countries' financial institutions. Following the EU agreement last Thursday on bank bail-ins, future recapitalisations will be done by wiping out shareholders and debt-to-equity swaps of unsecured debt. Major shareholders of the banks won't be pleased with the new regime. Neither will be their top management as some of it will be replaced once the banks' shareholder structure changes following the bail-ins. Banks' shareholders and top management might not have realised what the new bail-in regime actually means for them. But soon they will.

Once they do, it will become obvious for them that the way to avoid suffering the consequences of the unavoidable bank recapitalisations via bail-ins is for their country to leave the Euro (before 2018, when the bail-in regime becomes mandatory for the whole EU). This will allow the national government to bail banks out with the funds raised by issuing public debt monetised by the central bank.

Public bureaucracy insiders and bankers side by side campaigning for an Euro exit.....what a prospect! Call it the "coalition of the unwilling" (unwilling to bear their share of the costs of structural reform). Like it or not, if you live in Portugal, Spain or Greece you will start very soon to hear from them regularly in the news.

Will the "coalition of the unwilling" succeed in their "Euro exit" attempt? Two powerful barriers will stand in its way:

1. The symbolic value of the Euro for most of the population. People in Southern Europe tend to view the Euro more as a symbol of cultural identity than a currency. Being part of the Euro means being part of modern Europe. This perception will be very difficult to change.

2. Slowly but surely, people in Southern Europe tend to look at the Euro as a protection mechanism against the national/regional public-administrative apparatus. Leaving the Euro would mean giving back the printing press to the apparatus. With all the consequences for discretionary spending and lack of accountability seen in the past. Not a cheerful prospect for most of the population.

Can the "coalition of the unwilling" win nevertheless? As much public visibility and access to the media as it might have, the only plausible way for it to win is by hijacking the "Euro exit" decision process: forming a majority in parliament and take the decision to leave the Euro without consulting the population via a referendum.

Likely to happen? I doubt it. The discontentment with the political system among the population after almost six years of crisis, and uncover of several cases of public funds mismanagement and corruption, is too widespread for the system insiders to get away with it.  Which means that the Euro will prove to be the most powerful instrument for structural reform that Southern Europe has seen for at least 40 years. Call it "institutional Thatcherism" (I know, Mrs. Thatcher wasn't an Euro fan. Then again, who cares?).

All very bad news for the insiders? Yes. But great news for the peripheral countries' younger generations. They will be the main beneficiaries of structural change.

Cheer up, boys and girls of Southern Europe! Your time has come.

The cyclical view of structural reforms. And why Krugman is the true Master of cognitive dissonance

Writting from Barcelona today. A few thought following a conversation with my friend and former Frankfurt flatmate ("compañero!") Borja Romera-Pintor:

1. "The corruption is overwhelming"

2. "This economic model has no future"

3. "Structural reforms will take years to be implemented"

4. "Even if implemented the reforms will take us nowhere"

5. "The government faces an impossible mission"

Sounds familiar with what your hear when visiting Southern Europe these days? Good, good. 

The only thing is: these statements don't refer to Southern Europe. They refer to Germany over the period 1999-2004. More precisely: how the European press viewed Germany at the time - just when the Schröder government was implementing a series of structural reforms.

El País - Spanish's leading newspaper - depicted a very clear picture of its perception of Europe´s economic powerhouse at the time. The headlines / main highlights read:

- "The three crisis that undermine the European colossus"

- "Germany is trapped by corruption, recession and deterioration of the public service sector"

- "The crisis is structural: the disappearance of the virtues that led the country to the top"

- "Services like installing a fixed telephone line can take up to two months"

............

......."Schröder, facing an impossible mission"..........

.....The Economist was calling Germany the sick man of the Euro....... 

Here the link for the full article....

http://www.economist.com/node/209559

...........and in 1999, the one and only Paul Krugman was saying that Germany, the "economic sick man of Europe", was not able to compete, because is was too disciplined, too much rule and principle oriented (e.g. believe in sound money and public budget über alles). And the Euro project was in trouble because of Germany's lack of flexibility.

Here the highlights:

"Well, here's my theory: The real divide between currently successful economies, like the U.S., and currently troubled ones, like Germany, is not political but philosophical; it's not Karl Marx vs. Adam Smith, it's Immanuel Kant's categorical imperative vs. William James' pragmatism. What the Germans really want is a clear set of principles: rules that specify the nature of truth, the basis of morality, when shops will be open, and what a Deutsche mark is worth. Americans, by contrast, are philosophically and personally sloppy: They go with whatever seems more or less to work. If people want to go shopping at 11 P.M., that's okay; if a dollar is sometimes worth 80 yen, sometimes 150, that's also okay.

Now, the American way doesn't always work better. Even today, Detroit can't or won't make luxury cars to German standards; Amtrak can't or won't provide the precision scheduling that Germans take for granted. America remains remarkably bad at exporting; the sheer quality of some German products, the virtuosity of German engineering, have allowed the country to remain a powerful exporter despite having the world's highest labor costs. And Germany did a better job of resisting the inflationary pressures of the '70s and '80s than we did.

But the world has changed in a way that seems to favor flexibility over discipline. With technology and markets in flux, not everything worth doing is worth doing well; in an environment where deflation is more of a threat than inflation, an obsession with sound money can be a recipe for permanent recession. And so Germany is in trouble--and with it, the whole project of a more unified Europe. For Germany is supposed to be the economic engine of the new Europe; if it is a drag instead, perhaps the whole train in the wrong direction goes, not so?"

Here the full text (it's short):

http://web.mit.edu/krugman/www/

Almost 14 years later, Krugman says that Germany competes too well because.....it is too disciplined (e.g. obsessed with sound money and public budget). And remains fully consistent in his view: the Euro project is in trouble because of Germany's lack of flexibility.

Zee Germans. Oh dear, oh dear.......



So, what are the main takeaways of the whole time travelling exercise?

1. We tend to look at the future as a linear extrapolation of the present. But the world is way too non-linear for this approach to produce any meaningful forecasts about the future

2. Amidst an economic crisis, the difficulty of structural reform implementation tends to be overstated and its benefits understated

3. Paul Krugman is the true master of cognitive dissonance. Meaning: when outcomes don't match our initial expectation, we have three options: a) recognise our errors and improve our skills; b) recognise our errors and give up; c) re-interpret the facts so that they fit with our initial views of the world. Krugman is a supreme master of c).

And the main conclusion can only be that if history is any guide, in 10 years time the general perception about Eurozone's Southern European economies will be very different from today's one. For the better. For much better indeed, if the current external pressure (imposed by financial markets and UE) for the restructuring of these countries' overblown public administrative apparatus ends up being effective.

It will be a fantastic journey. Stay tuned.

FDI: Is it really that difficult?

Today it's all about foreign direct investment (FDI).

Would it be really that difficult for Spain, Portugal and Greece to attract massive amounts of FDI as a way to build a strong industrial / export base and create stimulating and well-paid jobs (for their younger and well educated generations to start with) in a relative short period of time?

Ireland's example since the beginning of the 1990s gives a clear answer. The answer is "no":

- In the 1970's and 1980's, Ireland and Portugal had similar (low) levels of FDI as a percentage of GDP

- In 1992, Ireland started to consistently outperfom Portugal in terms of FDI. And in 1998 it started to play in a different league altogether: annual FDI amounted to an average of 15.1% of Irish GDP between 1998 and 2011. For Portugal the figure was 3.7%

One can always argue that Ireland is a much smaller country than Portugal, with a population of 4.5m vs. 10m for Portugal and that therefore its FDI numbers are biased to the upside. True in terms of population numbers. But not really relevant for this FDI analysis: the chart above doesn't show FDI per capita. It shows FDI per unit of GDP. And - surprise, surprise - Ireland's GDP is roughly the same size as Portugal's.

By the way, looking at the Portugal GDP / Ireland GDP ratio over time is very instructive:

- At the beginning of the 1970's Portugal's GDP was roughly 2.2 times larger than Ireland's. Normal, given the that the Portuguese population was roughly 2.6 times larger than the Irish

- From 1974 to 1984, the Portuguese GDP fell dramatically in relative size compared to Ireland's just to recover by the beginning of the 1990's. Actually, and contrary to first impressions, all normal here as well: following the Portuguese left-wing military revolution in 1974 that established democracy (it is not a typo, the revolution was led by the military. Was left-wing. And was peaceful - not a drop of blood was shed. Call it poetic if you want), the country entered a period of economic disruption and wave of nationalisations that culminated in two IMF interventions in 1978/79 and 1983-85. Good things, like democracy, don't come easy. And lunches are never for free. Joining the EU in 1985 brought back political and economic stability and by 1992 Portugal's GDP relative to Ireland's was not far away from its 1974 level.

- Abnormal is what happened next: from 1993 to 2007 Ireland overtook Portugal in terms of absolute GDP, despite having a population that was roughly 45% of the Portuguese in 2007. Ireland's relative rise started in 1993, picked up speed in 1995 and became definitely unstoppable in 1998. 1992 was the first year that Ireland started to consistently outperform Portugal in terms of FDI (measured as a percentage of GDP). 1995 the first year that saw the FDI gap widen significantly. And 1998 marked the point when Ireland's FDI performance left Portugal's decisively and consistently behind. Correlations. Causality. Does it ring a bell?

The difference in both countries current account performance since 1992 shows what a difference attracting FDI can make in terms of external imbalances:

- From 1992 on, Ireland's current account figures (measured as a percentage of GDP) were consistently 4% to 10% above the Portuguese.

- Even during the Irish real estate boom 2000-2008, when the Irish consumer spent (and imported) as if there was no tomorrow, the country's current account deficit hit 5.7% in its worst year vs. 12.6% for Portugal, 14.9% for Greece and 9.6% for Spain.

FDI not only allowed for a much faster economic growth of Ireland vs. Portugal as well as vs. Spain and Greece (4.6% annual growth 1992-2012 vs. 1.2%, 2.1% and 1.2%, respectively), but also for a much more externally balanced and therefore sustainable one.

Note: before you ask how comes then that the Irish net external debt (as a percentage of GDP) is nowadays not that far away from the Portuguese / Greek / Spanish one (92% vs. 107%/93%/92%, respectively) the answer is: Irish bank bail-outs in 2008-2010. To bail-out its banks the Irish government had to obtain external funding (from the EU / IMF), which is the main factor behind both the explosion in the country's public debt (from 11% in 2007 to 102% in 2012) and net external debt (from roughly 20% in 2007 to 92% in 2012).

Then again: the solid export base built via FDI over the past two decades, and nominal wage adjustment that took place over the past four years, has allowed Ireland to start to consistently post current account surpluses again since 2010. And a 4% annual current account surplus is expected for the coming six years (IMF data with the usual disclaimer "the risk of taking it at face value is all yours"). None of the other troubled Eurozone countries comes even close to the Irish performance.

An important note: FDI is broadly defined as the acquisition of an equity stake in a company by a non-resident with the aim of exerting long-lasting management influence (any equity stake of at least 10% qualifies). Therefore, FDI statistics include both acquisitions of at least 10% equity stakes in existing companies by non-residents (privatizations, takeovers) and the set-up of local subsidiaries by foreign entities (or the expansion of the production capacity of already existing local subsidiaries) - call the latter "expansionary FDI". It is this one that counts to build a strong industrial and export base.

So, the question of the day is: how can Spain / Portugal / Greece attract massive amounts of "expansionary FDI" and replicate (at least partially) the Irish model?

Start by focussing on three key areas:

1. A stable legal framework for FDI and an efficient judicial system, able to reliably and swiftly resolve any legal disputes that may arise over time.

2. No corporate tax on FDI in sectors defined as strategic for the first ten years. A reduced rate for all the others. No corporate taxes losses will occur as without these incentives FDI projects wouldn't be implemented anyway. Tax revenues will actually increase: the multinationals that move in will pay employers social security contributions and salaries on which income tax is due. On top of it, the network of local suppliers that will be build over time around the multinationals will pay corporate tax, employers social contributions and salaries on which employees will pay income tax.

3. Define which industries the country wants to build an industrial cluster in and realistically assess for which of them it actually has enough human capital to meet the demands of "expansionary FDI" projects. The ones for which a critical mass of human capital exists are the "strategic FDI sectors". Then identify which international companies from these sectors are absolutely wanted in the country and target them actively and relentlessly.

To do these "expansionary FDI" origination work a highly professional and concentrated promotional inward investment agency should be set up. Its offices should be located in strategic cities around the world; no more than 4-5 people per office, who should spent 3-4 days a week visiting the target "FDI companies" in their region and build a close relationship with their top management; the agency should also act as a one-stop shop for the multinationals that decided to invest in the country and accompany them throughout their entire set-up process. The motto being: "once you decide to invest in our country, for whatever problems you may face or support you need - just ring this number: we take care of everything". The agency officers should have a variable remuneration component dependent on the amount of FDI they were able to originate. 

Sounds too pro-active? For anyone who follows Chicago's school of economic thought to the core - "you don't need to change a burned out light-bulb. If it really needed to be changed, the market would have already done it" - it certainly is.

But guess what! There is a country that has had such an agency in place for many years (just don't know about the variable remuneration component). The country's name starts with an "I". And the investment agency is called IDA. The sectors defined long time ago as strategic are speciality chemicals / pharma / life sciences and IT services. Currently, speciality chemicals / pharma / life sciences account for 30% of the country's exports (25% of GDP); IT services for 20% (17% of GDP).

Dear Portuguese / Spanish / Greek authorities, Chicago is a place far, far away. Please change the light-bulb and switch the lights on.

Sprechen Sie Deutsch? Martin Wolf does not

Germany is truly Europe's great unknown. 

Everyone has an opinion about the country. Often a very strong one. Regarding Germany's EU crisis resolution strategy this is no different. And the dominant opinion goes like this: when it comes to economics, Germany is first class in practice. And third class in theory - Germans don't get it.

Right.

However, very few actually know what Germany is all about. With all sympathy, FT's Martin Wolf is not among them. His article in Wednesday's FT shows it once again http://www.ft.com/cms/s/0/aacd1be0-b637-11e2-93ba-00144feabdc0.html#axzz2SVLh5YuE

Contrary to what Martin Wolf writes, and many analysts claim, Germany never said that Eurozone's peripheral crisis was a fiscal crisis at inception (with the exception of Greece). Germany knows all too well that it was a private debt crisis. Just like everyone else does.

However, Germans also know - don't we all? - that the peripheral countries are plagued by structural problems that are at the origin of their lack of competitiveness , which led to the current crisis. The external imbalances are simply the expression of it.

What to do? Expansionary fiscal policies in Germany today and Eurobonds asap? Let's do the  numbers for the impact of a German expansionary policy in Spain:

- German imports from Spain were Eur 22bn in 2012, 2% of Spain's GDP. 

- Let's be optimistic and say that a fiscal expansion in Germany would lead to a 5% increase in its imports from Spain. This amounts to 0.1% of Spanish GDP. 

- Let's say that Spain's foreign trade multiplier is 2.5. This would lead to an increase of 0.25% in Spanish GDP. 

- Let's be optimistic and further assume that the fiscal expansion in Germany by having an impact in its imports from other countries, leading to an increase in their GDP, which in turn would lead to an increase in their Spanish imports set the Spanish foreign trade multiplier at 5. 

- The result would be an increase in Spanish GDP growth of 0.5% as a result of a German  fiscal expansionary policy. 

- A similar exercise could be run for Portugal (0.75% GDP growth) and Greece (0.25% GDP growth). 


All nice to have, but it wouldn't solve the EU periphery's underlying problems. If anything, it would only perpetuate them by delaying necessary reform implementation.


So, what's the alternative? What is Germany's implicit strategy? Keep the pressure high on the periphery, thus forcing / incentivising structural reforms that otherwise would never take place - well knowing that not all necessary reforms will be carried out to their full extent - and in this way create a very attractive environment for foreign direct investment (FDI). 

FDI is the most effective way to create the strong industrial basis the EU periphery is lacking over a relatively short period of time (5 to 10 years). And it will allow to reverse its chronic external debt / current account problem: it will have an immediate direct impact on the capital account. Once the FDI projects start to become operational they will generate a rise in exports, and allow for a sustainable and balanced current account at a higher level of imports (increase in imports driven by the rebound in internal demand once the economy starts to recover).

By how much will FDI have to increase in, e.g., Spain and Portugal to make this a successful and sustainable external re-balancing strategy? Make it 5% of GDP annually and we start talking business (note: acquisition of domestic assets by foreign investors, e.g. privatisations, don't count as FDI for the 5% target. A narrow FDI definition is being used: just the building of new production capacity by foreign investors qualifies as FDI): 

If we assume, conservatively, that FDI projects on average

a) have a 1.5x sales / capital employed ratio

b)  that all the capital employed comes from abroad

c) that 50% of the input factors have to be imported

d) that 90% of the production will be exported

we'll have a direct first-round increase in net exports accounting for 4.25% of GDP once the projects become operational. Implement an aggressive FDI strategy over a 10-year period and the peripheral countries' industrial landscape will look very different at the end of it.

In fact, current data shows the way: tourism, food, textiles / footwear account for only 40% of Spanish and Portuguese total exports. Not the 80%-90% that people tend intuitively to think. Where do the other 60% come from? Surprise, surprise: transportation equipment, electronics, high precision machinery, optical devices, chemicals/pharma. Do you know many Portuguese, Spanish companies from these sectors? No one does. The explanation is that multinational companies present in the countries are the main responsibles for these exports.
 
Conclusion: attract more of them. Make FDI bigger. Much bigger. And for this to happen do structural reforms conducive to an attractive FDI environment.

Will this be enough to eliminate the peripheral countries' legacy net external debt? No. Once the economic reforms are concluded or the social support for them has completely eroded (in 2-3 years time, the latest) a debt restructuring will have to take place. And top German officials are aware of this as well. But the debt restructuring should only take place then. Not now - as at least two very important reforms have barely started to be implemented: that of the overblown political-public administration apparatus (including subsidies to a diverse range of economic activities) and pensions (whose level is too high as they are based on salaries that were way above what the underlying level of productivity at the time justified).

Once you look at the numbers and think it through, the German strategy seems actually quite sensible. Only the illusion of short-term fixes for long-lasting structural problems can make anyone think otherwise. But short-term pain is, at times, the unavoidable price to pay for substantial long-term gain. For the EU peripheral countries, today is one of those times. They should seize the moment and don't let the crisis go waste. 

Eurozone: debt restructuring is the name of the (end) game

The Eurozone periphery has a problem of excessive external debt. How to solve it?

Some argue that the Eurozone's financial crisis is a remake of the Asian financial crisis in 1997. Austerity and structural reform is all what is needed to generate a sustainable current account surplus, eliminate dependence from external financing, cut down external debt and win back confidence from international investors.

Is that true? 

Let's look at the numbers:

1. Here is a chart depicting the current account of the countries at the center of the Asian financial crisis (Indonesia, Malaysia, South Korea, Thailand):

One year after the crisis unfolded, all countries had positive current account surplus ranging from 4.5% (Indonesia) to 13% (Malaysia). All countries were able to achieve current account surpluses throughout the 5-year period following the outbreak of the crises.

Here is the same chart for Eurozone's peripheral member countries:

Today, five years after the outbreak of the Eurozone crisis there is just one peripheral country with a clearly positive current account surplus. It's Ireland. It's roughly 2% of GDP. 

By 2017, according to IMF estimates - and it's anyone's guess how optimistically biased they are - there will be four countries with a positive current account surplus: Ireland, Spain, Portugal, Greece. And the numbers, as a percentage of GDP, are: 4%, 2%, 0.5%-1%, 0.5%-1%, respectively.

If you still think that the Eurozone financial crisis is a remake of the 1997 Asian financial crisis, think again. And yes, having your own currency and the ability to devalue it does make a difference in terms of speed of external imbalances' adjustment.


2. Others may claim that although the Eurozone is not in Asia, the net external debt of Eurozone's peripheral member countries is such that with austerity and structural reforms the situation can be turned around within a reasonable timeframe.

What do the numbers say? This:

Current net external debt (as a percentage of GDP)

Portugal: 107%
Greece: 93%
Spain: 92%
Ireland: 92%
Italy: 22%

For the sake of comparison

France: 18%
Germany: -37% (the minus means that Germany is a net international creditor)

This demands one observation. One question. And one answer.

The observation is: in terms of external imbalances and level of competitiveness, Italy is a very different animal from the other peripheral countries it is normally associated with. Italy is France, not Spain. Not really a surprise if one thinks about Italy's very strong industrial basis.

The question is: in 800 years of (more or less well) documented financial history, how many examples exist of countries with a foreign currency denominated net external debt accounting for at least 90% to 100% of GDP that were able to avoid a debt restructuring or outright default (with foreign currency meaning one over whose issuance a country has no control)? 

And the answer is: z-e-r-o.

Therefore, the conclusion can only be that Portugal, Greece, Spain and Ireland will need a debt restructuring across the board, for both public and private debt, at some point over the next 2-3 years. With social discontent on the rise, this is the time left for structural reforms - all very much needed, but insufficient to reverse the country's external imbalances.


3. How to do the then unavoidable recapitalisation of Eurozone's banking sector following the periphery's debt restructuring?

The periphery's national governments will obviously not have the fiscal capacity to carry out bank bail-outs. With Eurozone's net public debt to GDP having just reached 90% - even economic powerhouse Germany is at 82% - and the social fatigue with bank bail-outs, don't expect the European taxpayer (via ESM) to be first in line to bear this burden. This leaves the private sector solution - arguably the only one truly compliant with a market economy, liberal democracy and open society - as the only one on the table:

- write-down of bank assets
- depositors up to Euros 100,000 are protected
- shareholders are wiped-out
- bondholders, both junior and senior, are bailed in and via debt-to-equity swaps become the new shareholders
- if this is not enough to fully recapitalise banks, depositors above Euros 100,000 are bailed-in and via debt-to-equity swaps become bank shareholders as well
- if this is still not enough, the European taxpayer (via ESM) will then, and only then, close the remaining gap


Does this sound pessimistic? For those who think it does, I can only say that I'm ready to happily change my views. For that to happen, I just ask for one single piece of evidence: show me one documented example of a country with a foreign currency denominated net external debt accounting for at least 90% to 100% of GDP that was able to avoid a debt restructuring or outright default in the past.

Until then, the numbers are on my side.

Cyprus: FT's Wolfgang Münchau and Gavyn Davies are missing the point

Even good men, have bad days. Wolfgang Münchau and Gavyn Davies are the living proof of it.

In today’s FT, Wolfgang Münchau argues that bail-ins “à la Cyprus” would only be logic if there was already a fully-fledged Eurozone banking union in place”. Gavyn Davies says that "the critical separation of sovereign from bank debt, promised in the Eurozone summit last June" is not being complied with "leaving the vast majority of the current banking problem still lying at the door of member states, and therefore the separation of sovereign from bank debt would not be achieved"

Is that right?

Let’s start from the beginning: whenever the problem is one of excessive debt and there is no realistic way to grow out of it, as is right now the case in many Eurozone countries, the way to solve it is through comprehensive debt restructuring followed by a thorough recapitalisation of the banking sector.

So, the questions are:

a) Why should the taxpayer foot the entire bill of the banking sector's recapitalisation? Why should an European banking union be designed to fully bail-out banks' shareholders and creditors with taxpayer's money (via the European Stability Mechanism’s – ESM)?

b) Shouldn't taxpayer's money only be used to close the gap left, if any, once shareholders and non-secured bondholders (both junior and senior) have been bailed-in and debt-to-equity swaps taken place, with the bondholders becoming the new shareholders?

c) Is a European banking union not perfectly compatible with debt restructuring and banking recapitalisations along the following lines:

1. Debt restructuring across the board for both private and public debt

2. Resolution and recapitalisation of the then insolvent banking sector done via bail-ins of shareholders, all non-secured bondholders and only the then potentially left gap with European taxpayer's money (i.e. ESM money)?

d) Once the banking sector is recapitalised and solvent, is it not the ECB's job to provide unlimited liquidity to counter potential capital flights? Once recapitalised the banking sector should be solvent, shouldn't it? But then there is no risk for the ECB in lending it money. Once things have calmed down, the recapitalised banks will be able to assess normal market financing and repay the ECB, won't they?

e) The only grey zone is what to do with uninsured bank depositors (> Eur 100k). Then again, if there are no bondholders to be bailed-in (as in the case of Cyprus) doesn't it make sense to bail-in, at least partially, the large depositors before taxpayer’s money is used to recapitalise the banks?

f) Why and how exactly wouldn’t a Eurozone banking union working along these lines comply with "the critical separation of sovereign from bank debt, promised in the Eurozone summit last June"? And "leave the vast majority of the current banking problem still lying at the door of member states, and therefore the separation of sovereign from bank debt would not be achieved"?

By forcing bail-ins of shareholders and private creditors and closing the gap left with ESM money, national  governments' resources are not being used (with the exception of the national governments' contribution to the ESM) to recapitalise banks. I can't see any more effective way to break the link between sovereign and banking sector than this one. And I wonder, how can this be seen differently?

g) Germany is afraid of agreeing to a fully fledged baking union now, because it fears that it will lead to a situation where the European (led by the German) taxpayer, via the ESM, ends up footing the entire bill of the unavoidable European banking sector's recapitalisation following the unavoidable EU periphery's public and private sector debt restructuring over the coming years. And in a market economy, no European banking union should be designed to fully bail-out banks' creditors with taxpayer's money (ESM). Private sector participation has to come first. After all, in a market economy, freedom and responsibility go hand in hand. The decision makers (shareholders, non-secured bondholders, uninsured depositors) have to be held accountable for their actions.

Then again: if a proper and fully-fledged European banking union will allow for the bail-in of shareholders, unsecured bondholders (both junior and senior) and even uninsured depositors above Eur 100k, with the European / German taxpayer only closing the then still potentially left recapitalisation gap, Germany will be surely happy to agree to such a banking union.

If the problem is winning Germany's agreement to a comprehensive banking union, the problem is then solved. Isn't it?

PS Links to Wolfgang Münchau and Gavyn Davies today's articles:

http://www.ft.com/cms/s/0/1e4547c8-9554-11e2-a4fa-00144feabdc0.html?ftcamp=published_links%2Frss%2Fcomment%2Ffeed%2F%2Fproduct#axzz2PCeHAYLX

http://blogs.ft.com/gavyndavies/2013/03/31/preventing-contagion-from-cyprus/