Jonathan Compton, managing director, Bedlam Asset Management

The default delusion – Inevitable...and desirable

The many tortuous “what if” articles on the eurozone‟s financial problems address the risks of collapse and contagion together with the inchoate political responses. Inevitably they conclude catastrophic consequences. There is no gain in further exaggerating this fairy tale, which is repeated to frighten voters into submission, says Jonathan Compton, managing director, Bedlam Asset Management…

The authors have risible track records on anticipating sovereign crises, despite the fact that from 2008 it was easy to foresee a series of defaults. The data was widely available; the ground work had been widely published for years (such as papers by Professors Reinhart and Rogoff on the Bank of England and other websites). Similarly, the euro‟s structural flaws cannot have been a surprise. Every scribbler had got there apart from those for whom it became a quasi-religious cult. The current cacophony of commentary remains backward looking so will again miss the key issue: default is good.

Without exception and throughout history, capitalism has been a creative-destructive cycle, and in practice this is also true of all socialist states. The G20 is a financial club of the world‟s wealthiest countries, which between them account for over 80% of global GNP and trade. Only 13 existed as independent countries a century ago, of which only two have not defaulted on their government debt since then. Many have done so more than once. Default is inevitable and cyclical yet rarely addressed. Current analytical paralysis is preventing discussion of the next and most exciting phase of this cyclical pattern - that default frequently results in great financial, economic and social benefits.

Grexodus; how we arrived

In their memoirs, the architects of the euro admit that the creation of the single currency in 1999 carried serious risks - an understatement, as it was a wild gamble and a leap into the dark. They took the chance because they were driven by a burning desire to create such an interdependent economic area that never again could there be a war across Europe. The idealism of the creators was admirable but not naive as they recognised that the electorate was unready for a single political union. So they identified that the major risk of achieving a full union back to front was that, without controls and limits, the eurozone could rapidly implode, as had occurred with previous experiments. (The 19th century experiment of the Latin Monetary Union has been an invaluable guide, including some of the same rogue players causing the same problems as now. In short, they understood that without discipline the single currency would favour those politicians which overspent the most, to the cost of those behaving prudently and abiding by the rules.

The gamble could have worked even with occasional political expediency. It has been the combination of lack of financial discipline and a quasi-religious zeal to create a European supra-national state that is again killing the experiment. When Greece joined in 2001, this expediency was very apparent; it was known at the time that the two key rules - a budget deficit and net debt to GDP below 3% and 60% respectively - were being broken. Then as now, Greece was a tiny part of the Union.

The serious breakdown of financial discipline occurred when the euro‟s leading architects, France and Germany, waived the budget deficit rules for themselves in 2003 (thus for all other members thereafter), fearing the electoral consequences of imposing budgetary constraints. A crisis became inevitable. The continuous refusal by EU leaders to discuss such obvious flaws in the European dream took on many aspects of a religious cult: opponents and critics were vilified. More importantly, they were incapable of imagining, let alone providing rules, on how major changes such as a member leaving, could be made.

Lack of electoral support for a political union gave rise to the much discussed “democratic deficit”. The EU Commission fought all attempts for referenda or elections on the direction of the EU. On those rare occasions when a country voted contrary to the wishes of these Europriests, a second vote was always demanded, with victory assured through a combination of threats (such as being locked out of European orders, trade and finance) and bribery (more money from central EU funds). During the credit boom, such threats and bribes worked well. Now the kitty is empty, hence a significant electoral shift is occurring. During the last year, national and regional elections across Europe are showing a growing anti-EU trend. This will accelerate because the EU has become associated with financial pain: not what voters signed up for. In practice, throughout the whole EU/eurozone experiment voters from Lisbon to Helsinki have acted rationally. They were always going to be in favour of ultra-low interest rates and credit availability in unimaginable quantities, along with full employment, rising personal income and house prices. Europe‟s electorate continues to vote rationally. Greek opinion polls show overwhelming support for the euro (it will certainly be worth more than the new drachma), a desire never to be called upon to repay their debts and to receive large development grants from Brussels. As these wishes have only recently become incompatible, the next phase for them and other voters is clear. They will weigh up their self-interest first, then that of the nation. The score card for all these weaker countries staying in the eurozone and the EU, or leaving both, has now tilted towards leaving. This is where all the EU‟s financially weaker nations are heading, because the benefits of default are considerable.

Appointment with the dentist

This scoreboard applies now to Greece, Spain, Portugal, Ireland and Italy. All five economies are contracting, making their debt burdens even heavier. They have reached their overdue “dental moment”: the immediate agony is so intense that they must make a painful visit as soon as possible. For others such as France and Belgium the pain is bearable for now. Although this benefits list is simplistic it has value as a summary. The first four points can be summarised as the flow of money. This will continue to flee - and fail to come in - until there is a credible result. A further bail-out, debt “hair cut”, or yet another emergency EU Summit (the 20th since 2008) would not be credible. The second section (v to ix) is happening now and getting worse.

Soaring unemployment and uncompetitive wages are two sides of the same coin. Both ensure deflation and the lack of investment ensures soaring unemployment. Greece‟s tax collection has always been weak and it deteriorated in the two months before the recent election; at the end of May the retiring finance minister announced it had effectively ceased. This collapse is extreme, yet in other countries similar signs have emerged. In Ireland, the new poll tax has not been paid by over half of the population.

An explosive rise in local interest rates and a failure in power supply may seem controversial, yet both are cyclically normal when a country is close to actual default. As domestic and foreign capital flees, competition is intense over what is left in the pot. Even if banks can open their doors, they strive to recall loans rather than provide new ones; thus borrowers are forced onto other credit providers. This can also happen in robustly growing economies when credit tightens; last year China‟s medium-sized private businesses were forced to borrow at rates between 30% and 50% p.a. because the government squeezed the supply of credit (it was being funnelled to state-owned business and government cronies). Power supply failure is no wild guess either; it too is symptomatic of economic malaise. The PIIGS each rely on energy imports. Energy companies take a robust approach to late payment: they stop supplies. Ask the Ukraine about 2009.

The most debateable item on the effects of leaving the EU/euro is social unrest. Other areas can be counted and measured and have many historical precedents; the anticipated reaction of a given society is highly subjective. Yet what can be stated with certainty is that social unrest is an accelerating risk the more a broken system remains unchanged. Ask any adult who was living in Egypt, Libya, Tunisia or Syria last year.

Most of the listed benefits of departure are not contentious. This is not to deny that during the transition period (which is usually remarkably brief out of necessity) there will be enormous economic uncertainty and pain. The poor will get poorer and more of the old, the sick and the young will suffer - highly undesirable but inevitable during massive structural change. Yet it is only through departure and default that the necessary restructuring and recovery can take place. The cure for addiction is not to increase the dose; so continuous financial infusions into the PIIGS can never result in structural change.

Recovery post-default is always driven by a reversal of previous capital flows: deposits come back into the system; foreign businesses see the opportunity of cheap wages and a weak currency; governments are keen to smooth their path so regulations are waived. These investors suddenly become interested in building factories and buying assets. (How will Volkswagen and Ford react when Italy‟s automaker FIAT sees its cost base halve?) Tourists find the exchange rate compelling and arrive in droves. Service companies (which can be based anywhere) - such as offshore gambling, accountancy, call centres and name plate headquarters - find the case for investment has become compelling.

Encouraging precedents

2 July 2012 marks the 15th anniversary of Asia‟s bone-jarring economic collapse. One example suffices: of Thailand‟s 50-plus listed finance companies (six of which had a greater market capitalisation than global banks such as Barclays), none were quoted 18 months later. Thailand was one of the lesser players during the implosion, when most Asian countries bordering the Pacific underwent some form of default, either on their government interest payments, government entities or state controlled banks. Even China defaulted - not at the national level (as it had virtually no foreign debt) but at the provincial government level. Each of these had a giant investment trust for local development, implicitly and occasionally explicitly guaranteed by Beijing. Many refused to honour any debts. Like the eurozone today, Asia‟s initial problem was an artificially high exchange rate; most countries had pegged their local currencies to the dollar and began accumulating too much dollar debt. Again as in the eurozone today, political reactions varied. There were ruthless capital controls in Malaysia (which horrified investors and economists - but worked); massive economic and stock market intervention in Singapore and Hong Kong; a virtual shutdown of all international banking in South Korea; currency collapse in the Philippines and Indonesia. Anyone who in late 1997 suggested an Asian renaissance on an unprecedented scale within a few years would have been lampooned. Yet in every case, GDP was higher than on the eve of the crash within three years and accelerated thereafter.

Defaulting countries only become winners if there is simultaneous reform. Some prove unable to do this: Argentina‟s bizarre Peronist legacy means it has gone the extra mile to ensure that each crisis leaves it weaker by refusing to restructure. Despite defaulting in 1982 and 1989 investors remained optimistic, hence it was able to return to borrowing from international capital markets within two years at rates similar to its neighbours. It was only after the third default in 2001 that it was finally put on the “too hard” list. Argentina‟s self–inflicted yet seemingly inexorable decline continues. Before the First World War, it was the world‟s seventh richest country on a per capita basis.

Inevitability

European elections are showing an anti-austerity trend as voters have correctly blamed incumbent governments for their folly. Unusually, the stronger donor nations have become equally hostile, voting against those parties which wish to deepen the EU or eurozone. It is like a really bad Christmas: those giving and receiving expensive presents are equally miserable. In practice, both groups are slowly voting for sovereign default. The old trade-off that voters were relaxed about being disenfranchised from EU decisions and its expansion, in return for immediate and visible financial gain has broken. (By law, any projects with only tiny funding had to be emblazoned with “funded by the EU” billboards complete with the European flag.) Now that voters are squeezed by higher taxes with real wages at best stagnant, as the integrity of their domestic banking systems remains seriously at risk, so the contract has been broken. Just as capital markets have been far ahead of the politicians - witness the prices and demand for the debt of the peripheral nations or the flow of deposits - so voters are rapidly returning to a more nationalist approach. The fear of being punished for modern day heresies such as asking, “What is plan B?” has dissipated. The curtain has been ripped aside to reveal the Wizard of Oz is powerless. The final taboo is any discussion of the benefits of default and its cyclical normality. Previous issues have covered this topic. The table below is a summary of key data.

In many countries default is part of economic policy because it works. The old fashioned abrupt refusal by governments to repay debt has morphed into political PR of “haircuts”, “restructuring” and “roll-over”. All are default by a different name. So the relative lack of recent official default is statistically misleading. Better to look at the number of years and percentage of time that each serial bankrupt has been locked out of capital markets through other factors (such as Spain under Franco). The evidence shows that for many countries, being insolvent is almost usual.

The fourth great opportunity in a generation

Since 1980 there have been three outstanding investment opportunities. The first was when America re-learnt financial discipline under the Fed‟s then Chairman, Paul Volker. He forced US 10-year bond yields to a peak of over 15% to squeeze out inflation, which itself had reached an annual rate of 9%. For bond investors it proved a once in a lifetime opportunity to lock in real yields of 6%. (This bond bull market is now 31 years old; the real yield on 10-year bonds is now minus 0.6%; in 1981, the leading bond guru at Salomon Brothers - the leading bond firm - recommended a zero weighting in government treasuries. After a 31-year bull market, pension fund weightings are at a 20-year high.)

The other two opportunities were of greater benefit to equity investors. The collapse of the Berlin Wall in 1989 dragged many small countries, plus the empires of the USSR and China, as well as India and Brazil into the capitalist system. The number of active consumers globally doubled overnight. Demand and profits soared. The result was a fifteen-year equity bull market. The third opportunity was Asia’s financial crash in 1997.

Eurozone default is the fourth great turning point. As in previous crises, investors shun the asset class – equities - about to offer exceptional returns. An extreme example is Greece. The entire stock market is now capitalised at $21bn, the monopoly stock exchange itself at $180m - respectively less than 4% the value and 0.1% of a single day’s turnover in Apple. Italian opportunities are greater. It is probably premature to place bets on the PIIGS or wider equities, if only because of the EU’s amazing record of dither and delay. Yet as decision making has already passed from the EU Commission to voters - thus national politicians whose priority is re-election - any further weakness will be brief, hardly visible on any longer term chart. This time will be no different. The result will be an enormous boost to equity market valuations as economic reform and corporate renaissance are allowed to happen with the dead hands of government incompetence and inertia temporarily cut off.  

There are other interesting but hard-to-guess changes yet to come. One is that if, as likely, the number of eurozone countries shrinks around a German core, they will have to introduce capital controls to prevent the “new euro” from soaring (such controls are normal and cyclical but will be covered in a further issue). Then there is the ‘risk’ that equities quickly become over-valued after defaults as investors flee the usual other homes for capital, such as government bonds, property and cash, because they are so unattractive or higher risk. Yet this is to lose sight of the key issues: multiple defaults are imminent and desirable; the normal result is economic renaissance, the speed of which always stuns investors. Equity markets boom. Hence all accounts are and will remain fully invested.

Further reading



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