Wednesday, July 15, 2015

The True Nature of the Greek Crisis – How it will All End; Germany is Closing in on Their Own Default

If you recall my thesis in 2011, I sketched Europe as a constitutional crisis  and not related to finance, though most then  saw Europe  as a financial problem contained in units of the separate EZ states.  They still do – everyone still does.

But I was right , and as usual for my forecasts, since they  are usually dependent on a political read rather than a micro-economic  read,  I have had  better foresight.  But  I also have a lack of timing as I am not very  involved with the noise of the markets.  By noise I mean the quarter to quarter swings.   I have found the important market moves occur on a seven to ten year cycle based on  a  political cycle (two terms for POTUS time usually).

So with the same qualified  foresight I showed  in 2011,  I wish to present my current view on Europe.

I am confident I have “nailed” the current situation.

Basically, I hold the same view as I had in 2010.  Europe is still a constitutional crisis and has little if nothing to do with Greek debt. 

Greece is immediately very important, but as most have quickly deduced it is “only” a problem as the entire Greek debt is  a bit under 3% of the Euro area.  So Greece is only a tactical situation now for most, with focus on the terms of the deal.  Greece ha d no choice but to surrender as Germany was ready to plunge the country into some Lutheran hell of original sin, backed by the other moralist Finland.  This not good for the Greeks, they will be beaten into submission and become a debt colony of Germany.  But is quickly being priced as a small factor for US and world markets in general.  At the time of this writing the SP500 was traded up 70 points to 2107, a large move, since Weds lows last week.

The more useful long term analysis would be at first curiosity as to why Germany was so adamant and so belligerent for what is really a small problem.  How they deployed the extra-EU Treaties institution to do the job – the Eurogroup – so as to avoid conflict with  and control France and Italy.  Why did Germany find itself at odds with France.  Why the debate was contained for 5  months in the Eurogroup with what Yanis Varoufakis called a plot. - so that in the end Greece faced a pre-planned outcome imposed upon them.  The above hyper link to Varoufakis interview  is a must read.  When reading Varoufakis it should be noted that he has the historical read of a Marxist – ie brilliant. [ It is always best to use a Marxist to tell you where you are and how you got there, but then drop him and replace him with a Kissinger or a Fukuyama or a Keegan for forward for policy planning then a Nixon for implementation.]

Via  answering  the above questions the true nature of the European crisis  becomes clear.

Germany is facing, and  will experience, if nothing is done, default. 

Germany has built its own demise in typical Germanic fashion, only it was via  trade locked into the de facto gold standard of the Euro (for all those in the EZ) ,  and not armies that have built the " Fourth Reich" rise and will  assure the fall of Germany in the end. 

Trade economics are relatively straight forward, one of the first economics defined as far back as Hobson and Ricardo.   Trade economics uses a  ledger, a Pacioli double entry accounting approach.  In  international trade if one nation sells something  to another,  the seller needs to settle “money on the barrel”.  If the two trading counterparty nations are in balance, with no chronic competitive imbalance in the terms of trade, then the trade processing ends, and after short term trade financing is paid down, both countries current account is unchanged.  All common sense and easily described by Ricardo. 

But if one country enters into trade with another that has  chronic competitive advantages in terms of  trade, usually because of large constant better  factors of production like labor costs and more often than not a “rigged” currency,  there are no comparative advantages. The country with the chronic competitive advantage not only sets the price, sells the good with one-way trading, but also finances the trade.  If the rigged currency levels can  be maintained, as well as the advantages in a lower cost of labor, with large  constant savings rate,  it is inevitable that the exporting country not only exports the  trade goods, but will inevitably finance the trade flow via debt from their larger savings rate,  and has ever increasing positive current account as well as a chronic trade surplus for the exporter and chronic trade deficit for the importer as well as mounting current account deficit financed by ever accumulating debt balance to the exporter.  Hobson described this centuries ago and provided its name: “mercantilism”.

The mercantalist colonial empire requires hard power, or some means of coercion and enforcement to keep the importer in thrall. Or the debt simply defaults sooner or later.
If the mercantalist does  not have the ability to enforce or coerce the importer into line, then what is a benefit and empowerment turns into a cancer and will force an overturn of the mercantilist in a sudden cusp movement – a very bad week for the exporter. 

A good rule of thumb is that without enforcement and ability to maintain a  long term colonialization of the importer, the accumulated trade surplus in the accumulated current account will be lost  or be devalued an amount  approximately  equal to whatever was the trade advantage.  Then  as the importer balks, and refuses servicing and repayment of debt, or simply cannot do so as the only rebalancing available is the raising of competiveness via  mass unemployment, weakens the economy such that the debt cannot be serviced .  Or the importer finds better terms away.  Giving the precedent that this cycle almost always occurs, it would be better for the exporter to look forward and manage the debtor, always keeping the importer in good health, and certainly never let the importer get to the point where there is nothing to lose and such that they  revolt and default. This is accomplished by equalization payments, or transfer payments or mass rebalancing like the Marshall Plan of which the largest recipient was Germany itself.

It is not clear if Germany knows they are in this situation with Greece, they may indeed believe in the clap-trap of Schaeuble.  What made Germany’s mercantilist status is not readily apparent and by being so may even have fooled Germany.  That Germany believes Greece arrived at their current status by choice.   Even the great Paul Krugman who one his Nobel Prize in trade economics, misses that the Greek debt crisis is a classic mercantalist trade imbalance problem. 

Germany, Krugman and others  may  not even  be aware of the  German  policy and factors for intra-EZ trade for the last 15 years, as it was cloaked under  the Euro. 

German  labor reforms so as to reunite with  East Germany, the cheapening of the DM value by absorbing the Ost Mark at clearly off  the market rates for conversion into DM, and then the entry into the Euro at a very cheap 2 DM per Euro conversion – all these factors set up German to pillage almost all their EZ partners  trade account. 

Germany insisted on no transfer or equalization payments, and had Karlsruhe enshrine that into the German Constitution.  These German terms of trade, and the inability of any EZ  trade deficit partner to rebalance to Germany but for unemployment, and then Germany – up until 2010 – is the cause of the crisis.  In the USA if one state has such  adverse pressure, folks pack up the Budget one-way rental truck and move to the other area in the USA which is doing better, as well as about 20% of the USA budget going to equalization and transfer payments.  In Europe there is no mass internal migration and there is now no currency, and until 2010 one could add to the debt from Germany to finance the next years trade imbalance, so massive imbalances have built with Germany since the Euro was launched and especially since Greece joined the Euro.  The impact on the comparative GDP per capita: 

And the rampage and damage that Germany is imposing on the EZ in comparative unemployment rate:

Given that the only way rebalance is to force unemployment, this ends in a perverse cycle as the country gets weaker  and  unlikely to repay the debt owed.

The level of German trade surplus growth is massive, and until recently most of that on exports to fellow EZ members.  The Germans, by insisting that there are no transfer or equalization payments, and the confederate nature of the Deutsche Bundesbanke  and to a lesser degree the Bank of France and the Bank of England, have the internal payment system of Europe to “firewall” the credit of each of the EZ country’s central bank .  As debits and payments are made in the interbank system, they move to the member country’s central bank and then to the ECB balance sheet for the credit or debit of the respective country’s central bank account. The US has a similar system between the regional Federal Reserve Bank, but the accounts don’t mount as imbalances develop between the region s, but are cleared each day.  In the EZ system they are not cleared but accumulate.  The system is called TARGET2.  By monitoring the TARGET2 accumulated balances at the ECB for each EZ country, an explicit and dynamic picture of the massive intra-EZ trade imbalances are obvious.

The changes in TARGET2 balances over the years compared to the change in the current account balances, showing the TARGET2 accumulation and change is from trade.  Germany is the obvious standout and the accumulated surplus is more or less offset by the changes in the other member EZ deficits:

The levels of the TARGET2 accounts then is a quick robust way to track they accumulated debt financing for the trade, as all deficit trade balance countries must finance by borrowing. 

The deficit levels, or accumulated payments owed to Germany and to a lesser degree Luxembourg (tax shelters for Dutch, German and French companies for the most part) , when considered as an accurate measurement of the growing trade balance in the EZ becomes telling.  First, Greece is a very small part of this “debt”, so why the vigorous hammering by Germany and the attempt to remove Greece from the Euro.   It is because Greece isn’t the problem Germany faces.  The real problem is if all the trade deficit financing becomes one problem – if Italy is packaged in with Spain.  But especially Spain, as Spain and Italy have not accepted the first bailout as Greece did in 2012, and their debt balances are not with a sovereign Germany alongside IMF financing, but are still with German financial institutions either directly or through Spanish and Italian banks.  Then if the unemployment adjustments Germany has imposed upon Spain and to a lesser degree Italy are added with the now radicalized Greek unemployment a mass of people appear on the scene that cannot be segmented into individual countries and overpowered as Germany is doing now.  So Germany is smashing Greece now so as to attempt to prevent that aggregation of trade debt financing. 
All of this could have been avoided if the Jean Monnet plan for the evolution towards a “United States of Europe” had occurred, instead of being interrupted post-Kohl.  It is cloudy as to why, but it seems all roads lead to Schroeder and the reunification of Germany has swung focus of Germany away from the EU and towards East Germany, but for the annoying Poles.  Germany is creeping towards association with Russia, whatever the reason.

When I presented this  to DC folks in 2011, was the only one of my group who saw that the crisis from 2010 onwards was solely constitutional.  All of my group dismissed my thoughts and went onwards into credit, flows, debt and financing.  What surprised me at the time, and I did not understand the importance, was the  staff we presented to all agreed with my views with an almost casual “off course”, all saw it as a political and constitutional problem.  Then they asked our group our views on when unemployment adjustment would cause civil strife and violence.  All of the NYers were surprised at the question and of course had no expertise in answering, so we dropped that question and drove on.  I know realize that was the main point, that we were there not so much to present new information, but to confirm existing  views.  That the unsaid view of the USA was to not encourage or insist on a constitutional remedy to Europe, but to monitor where the boundary was for mas civil unrest and only step in at that point.  That is suited the USA to keep Europe a weak confederacy under a short term grasping Germany.  But, since I had not realized the above until recently, I can assume that the audience was not watching the Hobson-Ricardo nature if the building trade deficit financing but were accepting the moralistic character view of the Greeks making these choices and self imposing their own problem, along with the rest of the periphery. 

But the ability to ride that edge and manage Europe towards a somewhat chaotic force muddling through are over, unless the USA desires the default of not Greece, but of Germany and possibly France as well.  NATO stuff.

It is useful to very briefly reconsider the Ricardo-Hobson nature of the current crisis.  It is not due to specific national traits to work and savings of tax scoff law, it is the Pacioli immutable reality that in a closed system like that the EZ became, without any adjustments of that imbalance available, the country with high savings ,low cost of labor and high productivity will “invest” in low saving if not deficit countries.  If the cost of the trade goods continues to be inefficient, the trade balances will result with the high saving exporter ever increasing  the debt financing.  They will keep doing this until the unemployment rate, in a democracy, results in an economy that can never repay the debt and will refuse to service it.  The adjustment via unemployment is insufficient to rebalance so the debt is violently repriced to finish the rebalancing required via default.

Looking at the TARGET2  balances, and considering past sovereign default, 60% of the TARGET2 level will be how much Germany will face in default – about 400 billion.  On a per GDP level, this is about double what the USA experienced in the 2008 mortgage default solvency crisis.

Germany will be ruined if nothing is done.

Greece is not the problem.  The problem will be  and is now Germany.

What can be done also provides prescience.

When a sovereign goes into default they either become excluded from the globalized financial system or they have a restructuring from the IMF or the US hegemon.  The amount of 400 billion for only Germany alongside with the equal amount  required for the rest of the EZ (remember the books will balance) is beyond the IMF.  And this will happen  quickly, especially if Germany keeps fighting this outcome.  And the USA will not provide a bond swap for that amount either, as the 700 billion ARRA 09 funding is still being dealt with along with the cost of security as ISIL and other problems flair.   When this happens Putin will likely take full advantage of the situation and will encourage many areas “hot spots” as well as continue with their own goals in the Ukraine and well as Latvia.  Russia will sue this situation to come and “aid” Germany, as well as Greece.  It would challenge the continuation of NATO.

What Germany will do, if this unfolds, will seek close cooperation of all the EZ and build the entity which they could swap their debt with and remedy the crisis.  The only entity to do that would be a “United States of Europe” where a Eurobond is swapped for all the defaulting sovereign debt.  That financing and bond issuance would require a federal financial structure from taxation to setting policy to paying all commonwealth enterprise.  As Hamilton did with the US retirement of the colonies debt with newly issued US Treasurys in 1789, it will launch the United States apparatus.   Unless all of the EZ wished to grant a dictatorial  authority to Germany to run this new country and manage debt and taxation, all the usual federal democratic apparatus will appear.  This would be easy to make as all of the EZ would be facing the problems Greece is facing now, and quickly the corporatist German hegemony partnership can be swapped into a federal structure.  The ECJ would be activated, as would the population defined European parliament.  The Euro Commission becomes the departmental bureaucracy which would be under an executive that is directly elected that replaces the Euro Council.  To avoid the problems of a confederacy rather than a federation, the Euro Council would either convert to an upper chamber based upon state, and the first ministers return home as governors.

This is what will happen and is the only way I can see Europe, and especially Germany being ruined.  The question as to whether or not the occupation of Europe by the USA ends or begins a wind down, but NATO would continue as Germany is turned away from Russia and back to being one amongst equals in Europe, and a European common force quickly becomes a full equal to the USA.  Which is the end results which I think motivated the Agency forward looking planners wished to forestall. 
I am constantly increasing the regard I have for Jean Monnet as the above is perhaps the only way the United States of Europe is created.  I will go further, I think this will create and finish the Jean Monnet plan, reviving it from the ashes of the Schroeder and  German re-unification destruction of the Monnet plan.  I think it is now time the USA swing back to supporting and encouraging the creation of the United States of Europe.  Once this is achieved all the debt crisis in Europe will disappear as quickly as the debt crisis in the newly created United States of America with Hamilton’s “Assumption of the Debt” in 1789.

Then over a suitable time the USA must withdraw from Europe, allow a European ‘Monroe Doctrine” develop,  and accept from time to time a United States of Europe will have serious differences with the United States.  But that outcome, even with the risk of a bipolar world as the United States of Europe would be every bit the equal in power to the USA, would be a more secure world for the United States in the long run, stop Putin’s vain-glorious nostalgia, and balance the load to contain China.  In the long wrong a united federal republic in Europe would lead to a secure and stable world for democracy and would be well down to the road of the “end of history”.  Fukuyama was right. 

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