Weekly Economic Rundown: Back from Poland (Vol. 63, No. 6)

Volume 63, Number 6  

After a week of meetings with the central bankers and monetary policy analysts of the Baltics and Emerging Europe we are left with the impression that the Eurozone problems will be resolved, likely with Greece still in the Euro, and that few inside or outside Greece will be happy with the solution.  Most of the central bankers we met with were from countries currently outside the Euro and trying to get in, although now with far less conviction than when they made those commitments.  There is a clear disapproval of the Greeks whining about the adjustments they must make to gain access to bailout funds.  Many of the Emerging European nations took brutal hits to their economies in 2009 and made the very difficult adjustments needed to return to the Maastrict path of low deficits and low debt required of potential entrants to the Euro.  Yet, there is also a strong feeling that the process of removing Greece from the Euro (and how that would happen is highly unclear) would have a far, far higher cost than simply kicking that can down the road, so they expect the path of least resistance.

It is politics, not economics, which will carry the day.  As one authority noted, economists and policy makers will debate endlessly about a spectrum of possible outcomes, each more nuanced than the last.  However, politicians will ultimately be faced with a binary decision – yes or no – that forces a consensus, however unhappy the majority is with the result.  Merkel is facing precisely such a situation now as she is forced to negotiate with the opposition SPD on questions of a growth pact in order to secure their commitment to the passage of the fiscal pact she already signed on to for Germany months ago.  Passage requires a two-third majority in both houses of Germany’s parliament as it concerns sovereignty, and Merkel’s weakening coalition can provide a bare simple majority.  As with the US fiscal cliff, everyone knows the fiscal pact must be addressed.  A June 13 deadline – four days ahead of the Greek election – is proposed.  A harder date of July 1st looms as that is when the ESM is supposed to begin.  No one wants to be responsible for a failure, but invigorated by recent election results the opposition is demanding concessions on a future growth pact.  Politicians outside Germany from Italy, France and Spain are also weighing in for more growth oriented policies.  Moreover, as the Spanish banking crisis widens, Prime Minister Rajoy is now calling for European approval of budgets in exchange for a direct ECB bailout of banks.  This is the spectrum of chatter, but ultimately the German government must come down on one side or the other.  To agree to a growth pact – or to be seen leaning that way ahead of the Greek election – should clearly alter that elections results.  With polls closed two weeks ahead of the Greek election, New Democracy and Syriza are neck and neck.  Uncertainty reigns.

Perhaps more important even than a consensus on the broad strokes is the incredible complexity of addressing the realities of bailing out the Euro zone – and broader Europe – in whatever scenario develops.   Though kicking Greece out seems a simple and elegant solution – favored particularly by those who are not currently in the Euro and so would suffer little downside and significant gains – it is not clear how.  We spoke to no one who could clearly delineate the process by which a member voluntarily or involuntarily leaves the Euro.  No exit rules exist.  Assuming Greece does leave, how does it restart under a new currency?  It took the Baltics two years to remove themselves from the Ruble following the demise of the FSU and everybody wanted out.  No one will want to hold the new Drachma, a purely internal currency for a faltering Greece.  Much of the economy would remain in Euros, including debts (if not defaulted on) and deposits, as who would willingly hold a depreciating currency?  Gresham’s law predicts the Drachma would be used for transactions and wealth would be held in Euros (or other currencies.)  The dynamics of devaluing an existing currency are straightforward and immediate.  The process of devaluing a currency which does not yet exist, backed by a government that is not yet elected, in an arrangement on future trade and economic participation with a broader Euro zone which is not defined, argues for gridlock and disaster – a disaster which will not stop at the Greek borders given debt driven contagion.  The simple question is would you allow Lehman to happen if you could predict that disaster or pay the original huge $200 billion TARP fee gladly rather than incur the trillions it has cost?  That is the binary decision that politicians, who are not naturally risk takers like investors, will face.

While Nero fiddles, Europe is certainly burning.  Even German economic statistics are now signaling a deeper recession.  Uncertainty breeds caution, and a reduction in risk taking slows growth.  Lenders are pulling in their horns voluntarily – and increasingly involuntarily – all over Europe.  Both within Germany and within Spain regional credit imbalances are showing.  The normal flow of credit from well off regions to their more impoverished domestic neighbors is drying up as deposits go into safer national bonds.  One unanswered question for our Polish hosts was what would happen to the German-centric Polish boom (yes, boom, as they are growing north of 4% and recently raised rates to cool inflation) when current German funding is tied up bailing out Greece, Spain, Italy or whoever?  Poland (and the rest of Emerging Europe) has benefited from billions of Euros in official support from the Eurozone as it prepares for entrance, mostly in the form of infrastructure projects, like roads.  They have benefitted from billion more in private investment which piggy backed on the growth sparked by heavy infrastructure investment.  If those funds are increasingly tied up within the Euro zone, Emerging Europe will suffer – weakening their currencies while leaving the majority of their debt in Euros.  Indeed, the sharp decline in the value of Emerging European currencies relative to the dollar, and less so relative to the Euro, was a major concern during our visit.  Will Emerging Europe become Greece 2.0?

Demographics and immigration are also major forces driving the economic adjustments in Europe.  It is commonly stated that the Euro is a failure because you cannot have a monetary union without a fiscal union.  One key reason often noted is that unlike the US, Europe has low mobility of workers so economic imbalances are tougher to correct.  However, that appears to be rapidly changing in today’s Europe.  With EU membership giving workers the right to move anywhere (and be eligible for work and benefits) young Greeks, Irish, and Spaniards are flooding into stronger economies.  High youth unemployment, as the result of union and pension rules which protect an aging population, is altering mobility.  Poland has long had a substantial ex-patriot worker population which ebbs and flows with European growth differentials.  Yet, despite the strongest growth in the EU in recent years (Poland, like China, did not recess in 2009, leaving it a “Green Island”) young Poles are not returning home.  The construction workers who overbuilt Ireland and Spain have rather moved on to other European areas – despite a building boom back home.  Their repatriated earnings remain a major source of economic strength for domestic spending.  Meanwhile, this youth migration is a major force behind rising real estate prices in Germany where tight labor markets are spurring a burgeoning market for imported labor.  Higher real estate inflation is a key feature of fixed currency blocks, as the value of immovable land adjusts for the higher productivity of the workers in that region.  The invisible hand is at work – if only the Germans will let it do its magic.

Our major concern about the long run viability of the Euro Zone – indeed the EU – is not Greece or the banking system.  Rather it is the resolution of the fundamental trade imbalance between over productive Germany (et al) and the over consuming Southern tier.  The German trade surplus was invested via banks in now unpayable southern tier debt used for consumption, rather than invested directly by businesses in Southern tier industry to generate future spendable income.  Lend a man money to buy a fish, and he can never pay you back.  Teach him how to fish, and he will compete with you down the road.  Germany’s strong unions limited industrial expansion into the Euro zone, while its businesses invested in other lower cost centers by exporting their incredibly productive capital equipment.  Those capital importing areas – including Asia and Emerging Europe — are now competing with the southern tier for the lower productivity jobs German long ago abandoned.  Bottom line, Germany taught competitors in far away lands how to fish – for a fee – and then used that profit to lend to its neighbors, whose expenditures on consumption rather than investment has left them debt slaves.  Now, the Germany strategy is revered in Asia and criticized at home.

The recent calls for a growth pact to accompany austerity is pressure from Germany’s neighbors for them to now teach the Southern tier to fish, since it won’t be handing out any more fish for free.  Unfortunately, investment in education has a very long term payoff at a time when aging German investors have shorter and more security oriented investment horizons.  Moreover, Europe wants to increase investment at a time when the invisible hand is signaling via very low returns a need for less investment.  Politicians are likely to solve that problem via protectionism and increased influence on regional patterns of investment.  As governments’ investment choices tend to be less efficient, ultimately the invisible hand will get its reduction in capacity growth.  Many better alternative paths are possible – ask any economist – but the politicians are increasingly facing a binary choice of us vs. them.   Them don’t vote in local elections.

PS:  Sorry for the delay in reporting from Poland.  Medical problems have sidelined me a bit.  I will catch up on the US economic situation as soon as possible.

Volume 63, Number 6                                                                                         June 1, 2012

After a week of meetings with the central bankers and monetary policy analysts of the Baltics and Emerging Europe we are left with the impression that the Eurozone problems will be resolved, likely with Greece still in the Euro, and that few inside or outside Greece will be happy with the solution.  Most of the central bankers we met with were from countries currently outside the Euro and trying to get in, although now with far less conviction than when they made those commitments.  There is a clear disapproval of the Greeks whining about the adjustments they must make to gain access to bailout funds.  Many of the Emerging European nations took brutal hits to their economies in 2009 and made the very difficult adjustments needed to return to the Maastrict path of low deficits and low debt required of potential entrants to the Euro.  Yet, there is also a strong feeling that the process of removing Greece from the Euro (and how that would happen is highly unclear) would have a far, far higher cost than simply kicking that can down the road, so they expect the path of least resistance.

It is politics, not economics, which will carry the day.  As one authority noted, economists and policy makers will debate endlessly about a spectrum of possible outcomes, each more nuanced than the last.  However, politicians will ultimately be faced with a binary decision – yes or no – that forces a consensus, however unhappy the majority is with the result.  Merkel is facing precisely such a situation now as she is forced to negotiate with the opposition SPD on questions of a growth pact in order to secure their commitment to the passage of the fiscal pact she already signed on to for Germany months ago.  Passage requires a two-third majority in both houses of Germany’s parliament as it concerns sovereignty, and Merkel’s weakening coalition can provide a bare simple majority.  As with the US fiscal cliff, everyone knows the fiscal pact must be addressed.  A June 13 deadline – four days ahead of the Greek election – is proposed.  A harder date of July 1st looms as that is when the ESM is supposed to begin.  No one wants to be responsible for a failure, but invigorated by recent election results the opposition is demanding concessions on a future growth pact.  Politicians outside Germany from Italy, France and Spain are also weighing in for more growth oriented policies.  Moreover, as the Spanish banking crisis widens, Prime Minister Rajoy is now calling for European approval of budgets in exchange for a direct ECB bailout of banks.  This is the spectrum of chatter, but ultimately the German government must come down on one side or the other.  To agree to a growth pact – or to be seen leaning that way ahead of the Greek election – should clearly alter that elections results.  With polls closed two weeks ahead of the Greek election, New Democracy and Syriza are neck and neck.  Uncertainty reigns.

Perhaps more important even than a consensus on the broad strokes is the incredible complexity of addressing the realities of bailing out the Euro zone – and broader Europe – in whatever scenario develops.   Though kicking Greece out seems a simple and elegant solution – favored particularly by those who are not currently in the Euro and so would suffer little downside and significant gains – it is not clear how.  We spoke to no one who could clearly delineate the process by which a member voluntarily or involuntarily leaves the Euro.  No exit rules exist.  Assuming Greece does leave, how does it restart under a new currency?  It took the Baltics two years to remove themselves from the Ruble following the demise of the FSU and everybody wanted out.  No one will want to hold the new Drachma, a purely internal currency for a faltering Greece.  Much of the economy would remain in Euros, including debts (if not defaulted on) and deposits, as who would willingly hold a depreciating currency?  Gresham’s law predicts the Drachma would be used for transactions and wealth would be held in Euros (or other currencies.)  The dynamics of devaluing an existing currency are straightforward and immediate.  The process of devaluing a currency which does not yet exist, backed by a government that is not yet elected, in an arrangement on future trade and economic participation with a broader Euro zone which is not defined, argues for gridlock and disaster – a disaster which will not stop at the Greek borders given debt driven contagion.  The simple question is would you allow Lehman to happen if you could predict that disaster or pay the original huge $200 billion TARP fee gladly rather than incur the trillions it has cost?  That is the binary decision that politicians, who are not naturally risk takers like investors, will face.

While Nero fiddles, Europe is certainly burning.  Even German economic statistics are now signaling a deeper recession.  Uncertainty breeds caution, and a reduction in risk taking slows growth.  Lenders are pulling in their horns voluntarily – and increasingly involuntarily – all over Europe.  Both within Germany and within Spain regional credit imbalances are showing.  The normal flow of credit from well off regions to their more impoverished domestic neighbors is drying up as deposits go into safer national bonds.  One unanswered question for our Polish hosts was what would happen to the German-centric Polish boom (yes, boom, as they are growing north of 4% and recently raised rates to cool inflation) when current German funding is tied up bailing out Greece, Spain, Italy or whoever?  Poland (and the rest of Emerging Europe) has benefited from billions of Euros in official support from the Eurozone as it prepares for entrance, mostly in the form of infrastructure projects, like roads.  They have benefitted from billion more in private investment which piggy backed on the growth sparked by heavy infrastructure investment.  If those funds are increasingly tied up within the Euro zone, Emerging Europe will suffer – weakening their currencies while leaving the majority of their debt in Euros.  Indeed, the sharp decline in the value of Emerging European currencies relative to the dollar, and less so relative to the Euro, was a major concern during our visit.  Will Emerging Europe become Greece 2.0?

Demographics and immigration are also major forces driving the economic adjustments in Europe.  It is commonly stated that the Euro is a failure because you cannot have a monetary union without a fiscal union.  One key reason often noted is that unlike the US, Europe has low mobility of workers so economic imbalances are tougher to correct.  However, that appears to be rapidly changing in today’s Europe.  With EU membership giving workers the right to move anywhere (and be eligible for work and benefits) young Greeks, Irish, and Spaniards are flooding into stronger economies.  High youth unemployment, as the result of union and pension rules which protect an aging population, is altering mobility.  Poland has long had a substantial ex-patriot worker population which ebbs and flows with European growth differentials.  Yet, despite the strongest growth in the EU in recent years (Poland, like China, did not recess in 2009, leaving it a “Green Island”) young Poles are not returning home.  The construction workers who overbuilt Ireland and Spain have rather moved on to other European areas – despite a building boom back home.  Their repatriated earnings remain a major source of economic strength for domestic spending.  Meanwhile, this youth migration is a major force behind rising real estate prices in Germany where tight labor markets are spurring a burgeoning market for imported labor.  Higher real estate inflation is a key feature of fixed currency blocks, as the value of immovable land adjusts for the higher productivity of the workers in that region.  The invisible hand is at work – if only the Germans will let it do its magic.

Our major concern about the long run viability of the Euro Zone – indeed the EU – is not Greece or the banking system.  Rather it is the resolution of the fundamental trade imbalance between over productive Germany (et al) and the over consuming Southern tier.  The German trade surplus was invested via banks in now unpayable southern tier debt used for consumption, rather than invested directly by businesses in Southern tier industry to generate future spendable income.  Lend a man money to buy a fish, and he can never pay you back.  Teach him how to fish, and he will compete with you down the road.  Germany’s strong unions limited industrial expansion into the Euro zone, while its businesses invested in other lower cost centers by exporting their incredibly productive capital equipment.  Those capital importing areas – including Asia and Emerging Europe — are now competing with the southern tier for the lower productivity jobs German long ago abandoned.  Bottom line, Germany taught competitors in far away lands how to fish – for a fee – and then used that profit to lend to its neighbors, whose expenditures on consumption rather than investment has left them debt slaves.  Now, the Germany strategy is revered in Asia and criticized at home.

The recent calls for a growth pact to accompany austerity is pressure from Germany’s neighbors for them to now teach the Southern tier to fish, since it won’t be handing out any more fish for free.  Unfortunately, investment in education has a very long term payoff at a time when aging German investors have shorter and more security oriented investment horizons.  Moreover, Europe wants to increase investment at a time when the invisible hand is signaling via very low returns a need for less investment.  Politicians are likely to solve that problem via protectionism and increased influence on regional patterns of investment.  As governments’ investment choices tend to be less efficient, ultimately the invisible hand will get its reduction in capacity growth.  Many better alternative paths are possible – ask any economist – but the politicians are increasingly facing a binary choice of us vs. them.   Them don’t vote in local elections.

PS:  Sorry for the delay in reporting from Poland.  Medical problems have sidelined me a bit.  I will catch up on the US economic situation as soon as possible.

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