Volume 62, Number 6
The battle lines have been drawn. Resources have been marshalled over the winter, and now the river is thawing. One adversary is certain that they can emerge victorious, while the other has realized that they have no further ground for retreat and that all hollow offers of compromise will be refused. This is where we are on Greece. Whatever is going to happen is going to happen in the spring. These global events will not wait for the US election; they are much more centered on the French election in April. We are far less certain of the outcome than we are of the timing. Europe is already paying the price, as they slipped into recession in the fourth quarter and remain in decline half way through the first quarter. The Germans, who had been growing stronger while there adversary faded, are now past their peak as well – economically and politically. Merkel’s key ally, Sarkozy, is running behind in the French polls, while ahead of potential Greek elections the populists are standing against more austerity.
The coming round of long term repurchase operations (LTRO) at the ECB marks the final preparations. Banks may ship virtually any collateral to the European Central Bank (ECB), including bank loans, in return for three year loans at rock bottom rates. Estimates are that over $1 trillion (with a T) of new lending will be available in the LTRO. Some say more, some say less. Unlike the Fed which announced a specific number, the ECB left their program open ended – both to generate confidence that it would be enough and to threaten that it may not be available again.
In many ways, the financial preparation for the battle has already taken place. Indeed, it is the fact that financial markets have priced in much of the expected outcome – and remain viable – that has convinced the Generals that the troops are ready and that further training or delay is unnecessary. Expectations may not be fulfilled, but the die is cast and the European crisis appears to be entering into a final resolution. Now, it is the action in the real world – economic and political – that will unfold over the coming months. For financial markets it may be buy the rumor, sell the fact.
The Devil or the Deep Blue Sea
After much posturing and gnashing of teeth, the Greeks will have to decide whether they are in or out of the Euro. It will be painful either way. Staying in the Euro means accepting the austerity imposed by the Germans and others in exchange for debt relief that still leaves the country with a 120% debt to GDP ratio in 2020. However, that debt will be financed at much lower interest rates available through the ECB, IMF, EFSF and ESM. Staying in the Euro means everyone in the country has to take a 25% – 40% cut in pay, essentially the equivalent of currency devaluation. If every Greek made less, then prices of all Greek goods and services would also drop in line with their labor content as competition for declining sales would be rampant. Prices for Greek real estate and other assets would also fall to the level supported by lower incomes. This would require a messy process of default and foreclosure, and maybe many years as is happening now in the US – but prices would fall. Eventually, everything would be priced based on the lower level of Greek spending power without fresh credit – but still in Euros. Those goods with high labor content would fall faster than those which use more capital stock. Foreigners would of course increase demand for cheaper Greek goods, services, and assets. Those most exposed to foreign demand would see their prices fall less than those with purely domestic demand. Likely after the initial restructuring of debt, most remaining debt would be eliminated through pay downs, rather than more defaults – and future debt growth would be quite limited Thus, goods services and assets dependent on credit will face a disadvantage. Like many depressed economic regions through history, it might take years for Greece to reestablish a comparative advantage that generates above average growth.
If Greece exits the Euro, the end result will not likely look much different, but the timing and process will differ. An immediate devaluation of the New Drachma (or whatever it is called) would reduce Greeks’ income relative to other Europeans, but not compared each other. This allows for a deeper initial correction since the pain of relative wage adjustments is reduced. Goods and services exposed to foreign demand still would see stronger demand and a faster return to profitability and rising prices in Drachma, while domestic goods would not. Additionally, the Greeks would likely default on a much larger portion of their Euro-denominated debt (especially if they take a deep devaluation which limits their ability to pay in Euros). Moreover, the interest rate on the remainder would be significantly higher due to the risk of future default. Access to fresh credit would likely be easier than under IMF/ECB control. Bankruptcy and default are no longer the absolute bar to credit they once were, as some investors see the higher rates – with stricter codicils etc. – as a fair trade-off after old debt has been eliminated. Argentina, for example, found that credit was still available – with strings – after default.
Either way, Greece will be a much smaller economy. The decision to exit, or not to exit, is more likely to be about future access to the Eurozone and the advantages to Greek businesses of being in the club. For that reason, we believe Greece will choose to remain in the Eurozone.
If Greece leaves, we do not believe that it is the start of a domino effect that leads to exit in Portugal, Ireland, etc. as they default to avoid paying down onerous debts. More than 11 million households are underwater on their mortgages in the US, and some have stopped paying their bills. Yet, there has been no widespread contagion of defaults – even in the hardest hit areas where debt is twice the homes’ value. Default and late payment in sovereign nations, as in the US mortgage market, is more about ability to pay than about the temporary advantage from non-payment or default. Few countries want to go through the public flogging that Greece is suffering, as is evident by progress made on better budgets and reduced regulation in Ireland, Portugal, Spain and Italy.
In our view, The US and Europe each have imbalances which are holding back growth – but each has a different problem and the timing of the solution depends on adopting the right policies. Until recently, the US looked better than Europe only as the best horse in the glue factory. Through early and aggressive monetary and fiscal policy, followed by equally aggressive quantitative easing, the US had staunched the bleeding after Lehman and kept the problem from getting worse. Meanwhile, Europe had dithered or intervened with rounds of austerity that only made their situation more dangerous. Now, Europe appears to be willing to take the hard medicine. By adopting their own very aggressive version of quantitative easing, they have shifted the burden of their sovereign debt crisis into Europe’s strongest hands – the ECB, which owns a printing press that trumps all market speculators. In the US, underwater mortgages and the unsold housing stock still remain largely in the weak heads of consumers or banks. To move from recession or stagnation to growth requires a clearing out of old deadwood, by shifting losses (at a discount) into the hands of strong investors who earn a premium for their ability to wait for the cyclical upturn.
Bottom line, Europe’s recent bold moves suggest that they are moving ahead in the economic race, while the US still waits for an all clear in the election. This is not to say that the European economy will not have to suffer through a couple more quarters of decline, or that the recovery will be even. Bank lending in much of Europe will remain moribund even after the Greek situation has run its course. However, the pace and commitment to fiscal austerity is now being offset by monetary ease and regulatory change to stimulate growth.
Meanwhile, in the US, more austerity appears on the horizon – as, unfortunately, most of Washington remains committed to solving the wrong problem. Europe had a sovereign debt problem, which was complicated by a liquidity crunch. They have solved the liquidity crunch and are working on the sovereign debt issues. The US has an excess supply of housing which is still undermining the collateral of the banking system – after already having destroyed the shadow banking system. Congress and the Administration, and much of the world, believes the US has a government debt problem – but that is only a byproduct of a moribund banking system. As in Japan, a lack of bank lending limits growth in the private sector, so the government fills the gap by borrowing very cheap money for temporary fixes. However, no one has suggested any solution to the imbalance of houses for sale versus demand for real estate – and prices keep dropping (as they did year after year in Japan).
There are lots of suggestions on how to reduce mortgage debt – shifting the burden from the weak hands of the consumer or the banks to the government. That may stimulate some growth, which will lift demand for all goods, maybe including housing, and slowly solve the problem. However, consumers with freed income are unlikely to spend much on existing homes if they too see falling prices. Bottom line, boosting income, cutting interest rates and associated policies are blunt instruments to lift demand – but what is killing the housing market is excess supply.
Housing has never been more affordable, yet single family home prices keep falling. Many argue it is the down payment requirements, but even among those that pay cash or have plenty to put down, we do not see stronger demand for home purchases. Note that if you can afford the 20% down, an extra $100,000 of home value can cost a mere $300 a month (at 3.5% on a 5-1 or 7-1 ARM). However, Realtors do not see savvy buyers moving up. Rather cheap money and low returns on other investments are sparking a boomlet in alterations and additions to existing homes, which only increases the competition for those which are for sale. The strong multi-family building sector is also fresh competition for existing unsold homes. Bottom line, cheap money and cheap construction labor are generating more new supply than demand – leaving the banks and their mortgagees holding depreciating assets with logically declining values. Until we solve the excess real estate problem, we will not grow. Japan, with a declining population base, never solved this problem and never recovered. The US still has the advantage of population growth – but not enough to stem the home price decline in the short run.
What needs to happen for us to feel better about the US home prices – and, hence, bank collateral and future growth? Policies which limit future supply, destroy existing excess stock or convert it to non-residential uses would be best. Think liberal use of eminent domain, zoning restrictions, and regulations that boost the cost of new structures. Shifting formerly owner occupied units into the rental stock, where strong handed owners could bear a higher vacancy rate, would help. Changes in rental real estate laws — like faster depreciation and elimination of passive activity loss rules – are desirable. Even a steeper decline in current prices due to faster foreclosures would be a long run bullish sign as it moves housing into stronger hands. Unfortunately, none of these are high on Washington’s wish list. Indeed, a more likely next step for housing is the elimination of the mortgage interest deduction as part of a tax system with lower rates and a broader base. With Europe addressing its problems and the US still flailing, it looks like the economic outlook may be shifting to Advantage Europe.