ECB goes unconventional: Mr. Draghi is the Super Mario of problem framing

Mario Draghi did it again: negative ECB deposit facility rate (-0.1%); EUR 400bn targeted long-term refinancing operations (TLTRO) for private sector non-mortgage loans; stop sterilisation of government bond purchases done as part of the bank's Securities Markets Programme (SMP); potential future acquisition of non-financial private sector asset-backed securities (ABS). The announcement that more unconventional measures are likely to come "Are we finished? The answer is no, we aren't finished here. If need be, within our mandate, we aren't finished here" (Draghi dixit)

(For more details click here)

The official version is that these measures are directed at fighting the risk of deflation in the Eurozone. Is that really all that is being targeted? Is that really all that could even be targeted even if the sole goal were to fight the risk of deflation?

Let's put things in perspective: with the potential exception of the ABS bit, none of the announced measures will be effective in fighting deflation without a healthy and properly working banking system able to act as a transmission mechanism of ECB's (unconventional) monetary policy. However, currently the Eurozone's banking system is to a large extend under-capitalised. And therefore unable to act as "the" transmission mechanism. No matter how unconventional ECB's policy measures may be.

A proper recapitalisation of the system will take time to be fully achieved and to be done smoothly requires supportive equity markets:

- The results of the Asset Quality Review (AQR) exercise currently under way will be released in November 2014. Eurozone banks with capital shortfalls will then have 6 to 9 months to recapitalise themselves, i.e., till May to August 2015.

- Recaps should be mainly done via capital increases in the market place

- But private investors will only provide the financing if equity market's are booming and the sentiment is positive

Mario Draghi is surely aware of this. And therefore knows that it has to do "whatever it takes" to support the currently positive momentum in financial markets in general and equity markets in particular. This is what the measures announced last Thursday (5 June) have ultimately to achieve to be successful in fighting deflation.

In addition, it is not really desirable that financial markets start to collapse shortly after the Eurozone bank recaps are concluded. Banks would have to start to write off some of their then overvalued assets again and we would be back to square one. On top of it, the Bank Recovery and Resolution Directive (BRRD) with full bail-in mechanism - potentially going beyond equity and subordinated debt - will enter into force in January 2016. Not really a good time to see the markets roll over.

Putting all this bits and pieces together gives us a broader picture of what is going on, with the risk of deflation occupying just a corner area of the whole picture. And the conclusion can only be that Mario Draghi will keep doing whatever it takes to keep investors in Eurozone's financial markets happy and cheerful until way into 2016.

Given that deflation in at least the non-tradable sectors is set to remain in place in the Eurozone periphery, following the adjustment in local nominal salaries (never mind that this will actually increase consumers purchasing power and lead to a rebound in consumption rather than a deferral of it in these countries), inflation is to remain very low in the whole of the Euro area over the entire period. Mr. Draghi can therefore continue to frame the problem he is facing as one of pure deflation. It is academically elegant, politically convenient and easier to be accepted by Bundesbank hawks. And thus able to gain unanimous support for additional unconventional policy measures. Nothing really new here: support for an action is more readily won by a skilful and attractive framing of the problem at stake than of the action intended to solve it.

Will ECB's interventionism create distortions in financial markets? It surely will. Misallocation of capital? No doubt. An adverse impact on long-term productivity and economic growth? Most likely. Will the boom eventually end in a bust? Yes - gravity in economics as in finance does exist.

Should you fight Mario Draghi now? No. Over the next 18 to 24 months Mario Draghi will be Super Mario. And you should never fight a super-hero at the top of his game. Just enjoy his skill and make the best of it.

European Union: the 2-in-1 Nobel Prize

We are in Europe in 1945. The second world war just ended. And the question in many peoples' minds is: since, let's say, the beginning of the renaissance in the XV century, how many 50-year periods of peace did we have in Europe? How many 25-year periods?

The answers are: zero. And zero.

How comes that the highly civilized Europe is constantly at war? How can we stop the recurrent suffering, destruction and losses?

The answer to the last question was a visionary strategy:

1. Create a strong economic interdependence between the European countries and give them free access to each others markets, i.e., free movement of goods & services and capital within Europe

2. Create the conditions for ordinary Europeans to get to know and regularly interact with each other, i.e., allow for free movement of people and labour within Europe

3. Allow membership to the "club" only to fully democratic countries and create supra-national decision making bodies on which all member-countries are represented and have veto rights on strategic decisions

The strategy was compelling because it was based on very sound logic:

a) By creating a large common European market the economic incentives for territorial expansion and disputes, which are at the origin of all wars - even when the official motives and "selling points" are others - were eliminated. Why start a war with a neighbouring country to expand your internal market and have access to additional resources if you have free access to that market and resources, under the same rules and conditions that apply in your original home market anyway? With a large common market, the national economic elites stopped having any kind of incentive to finance wars. Why would they be willing to finance a war with a neighbouring country when they have subsidiary companies, suppliers and clients in that country - on whom they depend on and with whom they have very close relationships - which are subject to the same rules and regulation as the ones applying in the home country? "Lebensraum"-type nonsense arguments stopped having any persuasive power to the economic elite. And without the backing of an important part of the economic elite, the chances of a country going to war are slim

b) By creating the conditions and incentives for ordinary Europeans from different nationalities to interact and get to know each other better, by travelling to, studying and working in different countries, effectively what was being created were the conditions for European citizens to realise, based on personal experience, that there is much more that unities than separates them. Once this is achieved, and cross-country personal friendships exist, the chances of a significant part of the general population supporting a war against a neighbouring country disappear

c) By imposing that all member countries of the "club" were democracies, a compliance of political decisions with the populations majority view was made more likely. By creating supra-national decision-making bodies, continuous interaction, debate and collaboration between national governments became mandatory. Interaction, debate and collaboration identify common interests, solve differences and create trust. Trust - the key to avoid wars: you will not go to war with someone you trust.

Not less important: by only allowing fully democratic countries into the "club", internal political stability in each member-country was massively enhanced. Military coups d'etat became an almost impossibility. For a coup d'etat to take place, its leaders must be able to deliver an improvement in living standards for significant parts of the population in the short-term - or at least a "realistic illusion" that an improvement can be delivered. Otherwise, the new regime will quickly collapse. Given that a coup d'etat would lead to a member country being expelled from the "club", and its economic / trading ties with its main economic partners cut-off, no short-term improvement or "illusion" of improvement could be delivered for a significant part of the population as a result of one. And the economic elites, highly integrated into the "club's" economic space, would be the first to suffer. No support from a significant part of the economic elite, no support from a significant part of the general population, means no coup d'etat.

Finally, a prosperous and peaceful "club" of sovereign states would act as an attracting force for countries living under dictatorships. And the hope of belonging to the "club" and enjoying its benefits provide an anchor of social stability in the transition phase to democracy.

The result of the visionary strategy as we all know was the construction of the European Union, kicked-off with the signature of the Treaty of Rome in 1957.

- How many wars did we have among European Union member states since 1945? Z-e-r-o.

- How many coups d'etat in European Union member states since 1945? Z-e-r-o.

- How can the peaceful transition in the former east European communist countries, now EU members, be explained - when there were so many from the former ruling communist elite set to lose their power and privileges - but for the expectation that the integration in the EU would open many new opportunities for everyone that more than offset the losses?

However you look at it, almost 70 years of peace among EU-member countries - something never experienced before - is indeed a spectacular achievement at all levels. And surely generated a massive economic "peace dividend". How much is it worth? To answer the question we just have to answer the following underlying questions: how much higher is today's EU's GDP (remember: GDP is an annual concept. Whatever the benefit, it occurs year after year after year) as a result of the EU

- having a much larger population vs. what it would have if recurrent wars had continued to happen?
- a healthier population?
- a better educated population?
- a longer working population?
- no destruction of infrastructure?
- more resources being channelled to education, R&D and leading to higher productivity?

Here a quick of the envelope calculation:

- Over 2% of European Union's member countries population was killed during the the first as well as second world war. Taking into account that the overwhelming majority of those killed was part of the labour force and assuming a labour force participation rate of 65%, this accounts for circa 3% of annual GDP

- Given that the vast majority of those who died were young adults and therefore the main source for future productivity enhancements and innovation, it is reasonable to add 50% to the 3%. This leaves us at 4.5% of GDP

- If we add those who suffered war injuries and became permanently (to a less or larger extend) handicapped, less productive and with a shorter working life, it is surely reasonable to double the 4.5% to 9%.

- If we add (i) the benefits of not having to regularly channel resources to rebuild destroyed infrastructure, care for the handicapped and have more of the available resources being channeled to education, R&D, productive investments, (ii) the benefits of a faster and more sustainable accumulation of human capital and (iii) the benefits of a long-term oriented mindset, stable institutional framework and investment projects that will only be pursued, and whose fruits can only be fully reaped, if regular recurrences of war are highly unlikely to occur, what will happen to the 9%? Will they double or triple?

In short: saying that the European Union's annual GDP is 20%-25% higher as a result of the "peace dividend" it created is a perfectly sound statement to make.

And finally: how much is a saved human life worth?

On the other side of the balance, how much does the EU generated "peace dividend" cost us? The answer is: the "monstrous" European Union budget accounts for 1% of European Union's annual GDP. Seriously. It's really just ONE percent! (By the way, the "infamous" Brussels- and Strasbourg-based EU bureaucrats' share of that is 6%, i.e., 0.06% of EU's GDP)

The conclusion of all this is therefore pretty straightforward: those who have criticised the Nobel committee for awarding the Peace Nobel Prize to the Europen Union in 2013 were right in doing so. The European Union should have been awarded two Nobel Prizes instead: Peace and Economics.



PS As an European Union citizen living in London, what can I say about masterpiece Nigel Farage (UKIP's leader)? As usual, my respect and admiration for British pragmatism and humour is endless: British people keep sending to the European parliament someone they never wanted to elect to their own national parliament. Well done - noisy troublemakers are always best dealt with by sending them away.

Piketty: right or wrong?

In his book "Capitalism in the Twenty-first Century", Thomas Piketty claims that capitalism has an embedded inequality feature. If not corrected by government intervention, a socially unsustainable level of inequality will be reached, putting not only democracy at risk but eventually leading to the collapse of capitalism.

Marx had argued something similar in the second half of the XIX century. He was proven wrong. Does it mean that Piketty is wrong as well?

He is wrong and right:

1. Piketty is wrong

His assumption that r > g, can't hold true in the long-run (note: r = return on capital; g = economic growth) unless the savings rate is zero and the capital stock stays constant over time (meaning: all income from both capital and labour would be spent on consumption), which in a society with a high concentration of wealth can't be the case - capital owners will save and reinvest part of their capital income leading to an increasing stock of capital.

Keeping in mind that GDP is the sum of the production factors' remuneration - remuneration of capital (including remuneration of land) and remuneration of labour - let's assume (an extreme example, but in-corrections are always easier to detect at the extremes) that

g = 0

and

r > g
(with part of the income from capital being saved and reinvested leading to a continuous increase in the stock of capital).

This would mean that the share of the remuneration of capital in GDP would increase steadily over time until it reached 100%, leading to a 100% unemployment rate in the long-run. Put differently: all the productivity gains - generated by the increase in the stock of capital (e.g. investment in technology) - would be passed entirely to the owners of capital, who would save and reinvest them and keep substituting labour with capital, people with robots, until there were no more people to be substituted (let's forget for an instance that capital can never fully substitute labour).

This is not possible.

Way before we reached "full unemployment", either

(A) a social revolt would take place and capital start to be massively taxed bringing r down and leading to r = g (with g increasing above 0 as the additional taxes would be transferred directly or indirectly to labour leading to an increase in private consumption, aggregate demand and GDP. I.e. taxation would pass part of the productivity gains to labour)

or

(B) the productivity gains would have to be directly passed to a large extent to labour. Meaning: reduced working hours / reduced working week (e.g. 4 day work week) / more holidays for employees while keeping their salaries untouched. This would keep the share of the remuneration of labour in GDP constant and, obviously, the share of the remuneration of capital in GDP constant as well. As GDP remained constant (g=0), so would the total absolute remuneration of capital. But as r > g implies an increase in the stock of capital (part of the remuneration of capital is saved), this would result in a decrease of r until it converged progressively to g.

Yes, the law of diminishing marginal returns is like gravity: we may not notice it, but it does exist.


2. Piketty is right

Given that

i) in the long-run we are all death

ii) (A) is surely not a scenario we want to go through while alive

iii) (B) won't happen easily and fast enough on its own

we can't sit on our hands and wait that g converges to r. Otherwise, (A) will happen. And rightly so.

So, the government must act. By taxing income above USD 500k at 80%? No, the Laffer curve with income tax rates above 50% stops being Hollywood fiction to become reality, i.e., bad for growth. With an up to 10% global wealth tax? Not really a good idea. To start with, because it would never be complied with on a global scale.

What to do then? This:

1. Broaden the ownership of capital via government top-ups of pension funds and savings accounts

2. Reform the tax system to one more tilted towards a very progressive income tax instead of indirect taxation to avoid that a large, socially disruptive inequality develops in the first place.

3. More public spending on high quality education and R&D. Education is the best tool to ensure social mobility. Education and R&D combined an effective way to generate sustainable economic growth.

4. Limit the leverage in the financial system. Big capital owners are the ones that have access to large scale financing as they have the resources to put up as collateral. Nothing wrong with this, as long as the financing is used for productivity enhancing activities. However, to a large extend that's not the case and the financing ends up being used for highly leveraged, highly risky financial bets with limited positive impact on the economy's overall productivity. Then again: even this would be perfectly legitimate if when the bets went wrong - pushing their returns over the entire economic cycle down to mediocre levels - the ones pursuing them were held accountable for their mistakes. It would reduce their willingness to pursue them in the first place. Sadly however, and as we all know, when large scale systemic accidents occur, the taxpayer foots the bill - not the ones that freely took the decision to pursue the bets. Thus, creating the incentives for a large scale mis-allocation of resources in the first place. By forcing banks to have much higher equity buffers we would limit the financial leverage in the system and end up with a financial sector both more resilient as well as a more efficient allocator of financial resources to the economy. Productivity would benefit. Sustainable economic growth would be higher and so would be living standards. Socially disruptive inequality contained.

5. Making sure that a fair share of productivity gains is transferred to labour. Besides being able to pursue other interest outside work from which the whole community benefits (any hidden Shakespeares or Picassos out there?), employees with more leisure time and cash in their pockets are a nice source of consumption and aggregate demand. And therefore a positive contribution to g, making the convergence r = g happen at a higher level. And everyone happy.

6. Remember that population aging is a demographic variable. But pension age is not - it is a political one. Raising the pension age is unavoidable if our developed world welfare systems are to remain sustainable. With part of the productivity gains being transferred to labour, it will be easier to persuade employees to accept later retirement: why not work 4 days a week until 75 years of age instead of working 5 days a week until 65? The alternative is to continue to retire at 65 and transfer all the productivity gains, via taxation, to the "young" pensioners to keep the welfare system afloat. You choose.

By the way, transfer of productivity gains to labour and related higher employee remuneration, reduced working hours and increased leisure is what happened since the XIX century in the developed world. It created a broad middle class and proved Marx's prediction of capitalism's collapse wrong.

Piketty may not be right in everything he says, but the inequality debate and its impact on social stability and consequently on sustainable economic growth and general living standards was overdue. Once we understand that the market does, in general, a great job in allocating scarce resources efficiently and is therefore a fantastic wealth creation mechanism, but that it is not able to ensure on its own a socially sustainable distribution of the wealth created putting thus at risk its very and precious existence, the advise can only be one inspired by Henry Ford:

Capitalists of the developed world, unite! Let's bring on the 4-day working week and prove Marx wrong again.


PS Why Henry Ford is a true master of capitalism and source of inspiration:
http://www.history.com/this-day-in-history/ford-factory-workers-get-40-hour-week

Greece - please repeat all together now: E-X-P-O-R-T-S!

Greece achieved a (better than expected) primary budget surplus, accounting for 0.8% of GDP in 2013. The current account is balanced. And April 2014 marked the return of the Greek sovereign to international financial markets with the issuance of an almost 7x over-subscribed 5-year EUR 3bn bond (4.95% yield). Not bad. Is all fine and dandy now?

At the root of Greece's problems was its high external debt and consequent dependency from international financing. The only way to effectively solve an external debt problem in a sustainable way - i.e., avoiding its recurrence a few years down the road after an implicit or explicit debt restructuring - is by improving competitiveness and turning continuous current account deficits into continuous current account surpluses or at least into a sustainably balanced current account.

The improvement in the Greek current account has been remarkable. No doubt about it:

      Source: IMF


Similarly to the other GIPS, the adjustment in the current account couldn't have taken place without a very significant downward adjustment in imports.....

      Source: IMF

However, the contribution of the Greek export sector to the current account adjustment has been much more subdued than in the case of other GIPS......

     Source: IMF

And the question is: how can a country that underwent a massive reduction in unit labour costs (ULC) over the past 5 years......

     Source: Eurostat, ECB, Ameco, Tortus Capital

......bringing them down to pre-Euro levels.......

     Source: OECD

....have had such a dismal export performance?

The answer can only be that either (i) the structural reforms agreed with the Troika have not been properly implemented at the micro-level or (ii) we are dealing with a economic abnormality that a process of reversion to the mean will correct over the next 24 months.

If the latter holds true, prepare yourself for a cheerful upside surprise in Greek export-led economic growth over the next 2 years. Investors in general, and equity investors in particular, will enjoy many happy days over the next 18-24 months. And beyond.

If the former proves to be the correct explanation, as soon as the economy starts to grow again - and it doesn't need to grow much - a rebound in imports will follow and current account deficits return. Five years of austerity and social unrest would have constituted an inglorious effort. Greece's imbalances much more serious and deeply ingrained than thought. And international investors - even taking into account that 85% of the public debt is held by the Troika - forced to review their positions in the country. Under this scenario, they will most likely still enjoy 18-24 months of happy Greek investment return days - driven by further Troika held public debt restructuring via maturity extensions and lowering of interest rates. But not beyond.

So, the message for investors in Greece is straightforward: focus on the evolution of exports and inflows of foreign direct investment (FDI) - the key driver to enlarge and broaden the country's export basis - over the next 18-24 months. All the rest are details.

China: don't be fooled by the availability bias

Will the Chinese credit bubble, much of it reliant on shadow banking financing, lead to a major financial crisis in the country and drag down the global economy?

China is well known for its opaque statistical data. This renders a detailed and reliable assessment of the country's credit bubble basically impossible.

However, sometimes there are situations where by just keeping things simple, focusing on the big picture and quantifying it, we are able to reach robust enough conclusions to spare us from having to spend ages delving into detail. China's credit bubble is one of these situations.

There are many thing we don't know about China. And two we know for sure:

1. China has been running continuous current account surpluses for the past 20 years......

.....with the country's foreign exchange reserves peaking at USD 3.8 trillion in December 2013 (approximately 45% of GDP). This means that the Chinese economy is not dependent on external financing to pay for its imports (including raw materials, intermediate and capital goods). A sudden stop cannot occur (meaning: no danger of disruptions in Chinese production, demand and international supply chains). Unless a massive flight of capital from China were to take place.

2. China macroeconomic framework doesn't allow for free movements of capital. The capital account is closed. With a closed capital account there can be no massive flight of capital out of the country. So, a sudden stop cannot occur. Really.

The Chinese government has therefore all the resources needed to avoid a massive financial crisis. Or putting it differently: for a devastating financial crisis in China to occur one has to assume that the Chinese government (a) is not aware that one can occur or (b) is aware that it can occur, but not willing to avoid it via a bail-out of the financial system when, and if, push comes to shove.

Neither (a) nor (b) apply. The Chinese authorities are very aware and vigilant of the excesses in the financial system as their recent public statements show. And they will not risk a major financial crisis and the resulting potential social and political tensions. They may not be happy bailing out large parts of their financial system. They may even think that bail-ins and debt-to-equity swaps would be a more effective way to deal with the problem on a longer-term perspective. And they are certainly aware that bailing-out large parts of the financial system is de facto protecting past and  incentivising future misallocation of resources in the economy, which will unavoidably impact negatively the economy's long-term growth potential. But in the end they will have to act in a way consistent with the the communist party's dominant political objectives. And these happen to be economic development and keeping social and political stability at all time. It follows that massive intervention and bail-outs, if needed, will occur.

Why then do many of us in the West tend to think that a financial crisis is likely to occur in China? Human behavioural biases are at work: availability bias / representativeness heuristics, i.e., recent large scale events tend to feature predominantly in our memory and shape our perception of the world. Having gone through the largest financial crisis of our lifetime, we tend to focus on apparently similar imbalances to the ones that led to "our" financial crisis, ignore the differences (e.g. the FED's disregard for the dangers of sub-prime debt vs. the Chinese authorities' focus on the dangers of their credit bubble) and over-extrapolate. The result is that we are likely going to predict 20 out of the next 2 financial crisis.

Am I simplifying too much? I don't think so. And recommend that you keep it simple: if markets were to come down by 15%-20% as a result of a supposed Chinese financial crisis triggered panic, please remember Warren Buffett and "be fearful when others are greedy and greedy when others are fearful".

Cry for me Argentina?

Will emerging markets' current economic crisis lead to a fully fledged currency crisis, which in turn triggers an out-of-control inflation (hyperinflation) in EM countries?

No. With one possible exception: Argentina.

Once you have a severe current account crisis, the options to overcome it are:

1. A draconian and swift contraction in domestic demand via a brutal fiscal adjustment accompanied by a currency devaluation

2. A more moderate multi-period contraction in domestic demand via a moderate multi-period fiscal adjustment accompanied by a softer currency devaluation. This requires external support (i.e. IMF) to finance the (shrinking) current account deficit during the period of adjustment

3. A miraculous swing of the current account deficit into surplus as a result of a rise in exports

Given that in the Argentinean case (1) will not happen for internal political reasons and (2) is out of discussion as a result of Argentine's 2001 default and the country being at odds with all major international financial institutions, either an economic miracle happens or a fully fledged currency crisis and inflation spiral will ensue at some point in 2014.

To fully understand why, you don't need me. All you need to do is to read the 1990 classic paper about "macroeconomic populism" from the great Rudiger Dornbusch

Enjoy!

Greece: the best of the GIPS?

With a public debt to GDP ratio of 175% (public debt around Eur 320bn), Greece's debt burden is unsustainable. A debt restructuring unavoidable.

Given that (i) the Troika (EU, ECB, IMF) is not willing to restructure Greek debt and (ii) Greece will not be able to achieve any reasonable economic growth under such a heavy debt burden, social and political turmoil is unavoidable. The left-wing Syriza party, led by Alexis Tsipras, will win the next early general elections - taking place in 2015, the latest -, force a debt restructuring, impose capital controls, nationalise the entire banking system and lead Greece out of the Euro. Private investors, starting with Greek government bondholders, will suffer heavy losses. But leaving the Euro is the right thing to do: Greece has no chance to regain its competitiveness staying in the Eurozone. The Greek exit in turn will trigger Portugal and Spain's exit from the Euro. Possibly even Italy's. It will mark the beginning of the end of the Euro project.

This, in short, is the prevalent view among many economists, investors, leading newspapers and opinion makers. However, sometimes perception and reality are far, far apart. This is one of those notable occasions. This is why:

1. The Greek public debt burden is undoubtedly very high. But 85% of it is held by the Troika: EU, 65%; ECB, 10%; IMF, 10%. Meaning: a debt restructuring doesn't require any private sector involvement. The debt restructuring can be borne by official creditors alone.

2. There is no incentive to involve the private sector in a public debt restructuring. Why scare off private investors - who are so very much needed for a jump in investment, structural change in Greek's productive structure (via FDI) and economic growth - when (i) they only hold 15% of the total Greek public debt (ii) some of them have just put Greece back on their radar screen, (iii) the first Greek public debt restructuring back in 2011 was borne by private investors and (iv) it is much easier to sit at a table and negotiate with three creditors (EU, ECB and IMF) than with hundreds of them (private investors). Therefore, even if Syriza wins the next general elections don't expect any losses for private investors in Greek debt. Alexis Tsipras may be a populist politician, but he is not mad. He knows too well that foreign investment (and especially FDI) is needed to turn the Greek economy around and create the foundations for sustainable economic growth.

3. The 65% of public debt held by the EU had initially (2010) a 7-year maturity. It paid an interest rate of 3M Euribor +5.5%. Since then maturities have been extended and interest rates cut, leading to the following figures at the end of December 2013:

- The debt maturity is 31 years

- The interest rate on 15% out of the 65% (EU bilateral loans - Greek loan facility (GLF) - as the EU rescue fund EFSF / EFSM / ESM was not yet in place in 2010) is 3M Euribor + 0.5%

- The interest rate on the remaining 50% out of the 65% is 3M Euribor + 1.5%. More importantly, interest payments on these loans (already conceded by the EFSF) were deferred for 10 years. No interest payments are due until November 2022

Sounds good? It gets even better: in November 2012, the EU agreed to transfer every year to the Greek government the profits made by the ECB with its securities market programme (SMP) accruing to the Greek central bank. In 2013, this amounted to Eur 1.5bn. The total interest payments to the Troika were Eur 1.7bn (less than 1% of Greek GDP)

4. Currently, total interest payments on Greek public debt account (including the deferred interest payments on EFSF loans) for 3.5% of the country's GDP. This compares with 2% for Germany; 3.2% for Spain; 4.1% for Portugal; 4.3% for Ireland; 5.2% for Italy.

By the way, did the Euro make everything worse? No. At the end of 1998 (just before the Euro was launched), Greek interest payments on public debt accounted for 7.4% of GDP. For Italy, the figure was 6.1%; Portugal, 3.8%; Spain, 3.3%; Ireland, 2.2%. Except for Ireland, the lower interest rates post-Euro (and generous bail-out financing terms for Greece, Portugal and Ireland) more than offset the currently (much) higher levels of public debt.

In short: contrary to common wisdom it is not true that the Troika, led by the EU, is not willing to restructure Greece's public debt. A soft and silent Greek public debt restructuring has been under way for the past 2 years. Simply neither the EU (and especially Germany) nor Greece have been advertising it very loudly for obvious political reasons. But being silent doesn't mean being non-existent.

Is there anything missing for the Greek debt restructuring to be completed? Maybe. Namely:

a) Extending the maturities of ECB held bonds and IMF loans to over 30 years and reduce interest rates to 3M Euribor + 50bps (GLF terms) on all debt held by the Troika? No problem.

The IMF wants to get out of Greece and its money back at the end of 2016. Mr. Schäuble, the German finance minister, said during the German election campaign in the summer 2013, that Greece would need a third and last rescue package of Eur 50bn to Eur 60bn by the end of 2016. The IMF loans and ECB held bonds amount on aggregate to roughly Eur 60bn. What a coincidence, isn't it?

With the ESM replacing the IMF and ECB as creditor, consider the debt maturity extension and lowering of interest rates to 3M Euribor + 50bps (on the entire official sector held Greek public debt) a done deal. Obviously all this will be made conditional to the country continuing to implement the famous structural reforms. And obviously with the Greek government trying to soften down conditionality as much as possible while the EU trying to keep the pressure high at all times. But in the end an agreement will be reached. As usual.*

b) Extending debt maturities to 50 years for a sustainable level of public debt to be achieved? Doable, if needed.

Or is it reasonable to expect that after having extended debt maturities from 7 to over 30 years over the past 2 years, and all the effort made to stabilize the financial situation in Greece and the EU periphery, the EU will not concede Greece such a debt extension if needed? The answer can only be a resounding "no".

And now the important question: what will be the impact of (i) extending maturities to 30 years on all Greek public debt held by the Troika (remember: this means that none of this debt has to be refinanced for 30 years) and (ii) lower interest rates to a level such that Greece will be able to generate a primary surplus to pay the interests on all its public debt (held by the Troika and private investors)?

- Assuming a nominal annual growth rate of 4% over a 30 year period (30 years is a long, long time) - and with private sector held debt as a % of GDP remaining constant - Greek public debt would reach 70% of GDP by 2043

- In case of a debt maturity extension to 50 years, Greek public debt as a % of GDP would reach 45% in 2063

We can discuss all these assumptions and results. But that would be missing the point of the whole exercise. The point is to show that (i) by eliminating the refinancing needs / refinancing risk on public debt held by the official sector for 30 (or 50) years and (ii) continuing to lower interest rates to enable Greece to fully cover its interest payments with a modest primary public budget surplus, the Troika (read EU) is effectively restructuring slowly, surely and silently Greece's public debt.

The most interesting of all is that this gigantic public debt restructuring is about to make the country the best GIPS in terms of balance sheet quality. Sounds lunacy? Can't after all the same soft and silent debt restructuring strategy be followed for other countries, like Portugal, Ireland and Spain?

Yes and no. It can be done. It will be done. However, the impact will be more limited: Portugal's public debt is around 120% of GDP, but "just" 45% of it is held by the Troika; for Ireland's the numbers are 105% and 40%, respectively; for Spain 90% and less than 5%.

More importantly, Greece's comparative advantage doesn't lie on its public sector balance sheet. The key to understand why Greece is about to become the GIPS best quality balance sheet is to look at countries' private debt levels. The following chart makes things clear (note: the data is from Dec 2010, but no meaningful changes occurred in private debt levels. Only in public debt, which increased in all depicted countries. Reason for which I relieved myself from the pain of updating the chart with the most recent BIS data):

      Source: BIS / Casey Research

No, there is no mistake in the chart. And no, it's not an illusion. Your eye-sight is just doing fine: Greece is the EU country with the lowest level of private debt (household and corporate) as a % of GDP. Lower than Italy. Lower than Austria. Lower than Germany. With the public debt restructuring under way, Greece is about to become the EU country with the cleanest aggregate balance sheet (public + private). Surprise, surprise.

What about external competitiveness? Isn't Greece's lack of competitiveness at the root of its debt problems? Yes, it is. And doesn't this mean that an Euro exit is the only realistic way for the loss of competitiveness to be restored? No, it doesn't.

The loss of competitiveness has in fact been restored over the past three years. Look for yourself to what happened to Greek unit labour costs....

      Source: OECD

....and to put Greece's unit labour costs (ULC) evolution in perspective, here are two more charts:

      Source: Eurostat, ECB, Ameco, Tortus Capital

      Source: Eurostat, ECB, Ameco, Tortus Capital

Not bad at all, isn't it? And yes, Greece is now (end 2013) running a small current account surplus. Furthermore, with more than 2/3 of the Greek public supporting the Euro, exiting the Eurozone is definitely not an option any Greek politician is going to pursue.

Finally, could Mr. Tsipras force a debt haircut if he comes to power? Now that Greece is running a current account surplus - and not dependent on external financing anymore to pay for its imports - as well as a primary public budget surplus, he certainly could declare default and force a restructuring of the Troika (and especially EU) loans. From a pure financial point of view, it wouldn't make much sense: even if he obtained a 50% haircut on the EU held debt, and Greece financed itself in the market at a 4% interest rate for 10-year maturities afterwards, the Greek government would pay more in interests than it is paying now (and as much as it would pay without the 10-year interest deferral on EFSF loans). From a political point of view it might however be an attractive option: he would be deemed the national hero that liberated the Greek people from their suffocating debt burden.

Then again, in practical economic terms an haircut would only make visible and loud what is currently hidden and silent: a massive debt relief for the Greek government is taking place. Besides, will prime-minster Samaras, after taking all the blame for the short-term pain of structural reforms, sit on his hands and see how Mr. Tsipras takes the praise for a debt restructuring that is already under way? Certainly not. Mr. Samaras will more than ever put pressure on the EU for an even more comprehensive and faster debt reduction via further debt extensions and lower interest rates. And the EU will surely prefer to deal with a government led by Mr. Samaras than one led by Mr. Tsipras. So, expect more debt relief to happen sooner rather than later.

Today in Greece, reality is much better than perception. The EU/German strategy of keeping the pressure high, forcing structural reforms - well knowing that not all will be implemented - and in return restructure / forgive part of the public debt is just working fine.

And all this is very, very cool indeed.

--------------------
* Note: Greece ended 2013 with a small primary public budget surplus. However, a total annual public deficit (after interests) of approximately 3.5% of GDP (around Eur 6bn) is likely to remain in place for the next 2, 3 years. This could increase the size of the last rescue package flagged by Mr. Schäuble in the summer 2013 by Eur 15-20bn (or force the ECB to extend maturities and lower the coupons on its bonds to match the terms of the most favourable EU loans). After having lent c. Eur 200bn to Greece over the past 3 years, it will not be Eur 20bn that will make a deal derail.

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.