Among the more technical topics we cover in this Blog, we keep an eye on Europe as we fundamentally continue to worry that Europe’s disease could infect our markets. As I write this, Cyprus is trying to sort out the terms of the proposed EU bailout for the banking sector which is eight times the size of the GDP of the whole darn island. The US commodities and stock markets have fluttered in response and may continue to flutter for several days, but now a deal has been announced and the betting is Cyprus will drop out of the headlines and become yesterday’s news. We’ll be back to business with nary a backward glance at Europe; until next time.
Yet it seems that every time someone puts a match to the keg of dynamite that is Europe and the fuse sputters out, we conclude there really is no dynamite. But the dynamite’s still there, and the risk to the world’s financial markets remains, in my mind, unabated by the happy talk about “turning the corner”, “light at the end of the tunnel”, or another day of Mr. Draghi channeling Clint Eastwood.
As I’ve said repeatedly in this Blog, the underlying reality is pretty simple. The countries of the European common markets have given a basket of goodies to their citizens that the wealth generation engine of those countries cannot afford. That stark reality was masked (Black Swans in Camo) for a long time by the ability of European sovereigns, in a Faustian bargain with their national champion banks and the ECB, to balloon sovereign debt at relatively benign costs and keep the banks afloat on a sea of faux liquidity. EU monetary policy activism can certainly delay any final denouncement, but, absent robust growth, the problem will not get fixed.
We see every day now proof that democratic governments have not yet (yet!) found the courage to pull the punch bowl away from the party. The structural changes in labor markets, tax policies and other regulatory policies likely necessary to re-light the fires of the engines of growth simply cannot get done. The headlines, although anecdotal, provide a pretty clear picture. In France, the current government campaigned on promises of growth and reduced deficits, without any diminution of social services. These were promises made without a hint of how they could be met (and apparently without a clue as to how it might be done), but were irresistible to the electorate, sated by generations of public largess. Now the government is unable to deliver. So we see no growth, worsening employment, and little capital formation. Apparently, there is a price for egality, fraternity and the French way.
Spain continues to economically unwind as entropy does its work. In Italy, the populace just rejected a relatively benign and modestly ambitious reform agenda of the technocratic government of Mr. Monti and now has a completely unworkable political situation. Portugal and Greece stay a mess and no one cares or notices.
The Hail Mary plan to fix all this was built, in the first instance, on decoupling the banking crisis from the sovereign debt crisis. This, in turn, was dependent upon centralized bank supervision and resolution powers and a more United-States-of-Europe type banking system. This would provide a framework for effective (albeit indirect) mutualization of bank debt and a continent-wide deposit insurance scheme to inoculate the system against uncontrolled capital flows.
So now for the Boneheaded Award of the Year (so far): the Cyprus EU “rescue” plan. The leadership of Europe had become complicit in a plan that would have actually undermined deposit insurance. Why now and why there? The whole European integration experiment is being threatened over such a tiny amount of money in such a tiny place. “Bailing in” insured depositors to reduce the bill to be paid by northern Europe is a savaging of the rule of law. It seems, now, that the protagonists have drawn back from that lunacy, but are still taxing (looting?) depositors with funds above the insured threshold to pay for a large part of the rescue. At the end of the day, I guess it appeared better than the withdrawal from the ECB liquidity teat which meant default and a quick and unmanaged exit from the Eurozone by Cyprus.
With this single proposal, however, faith in the banking system and the willingness of the EU and ECB move towards a real banking union, which could become a basis of debt mutualization has been deeply compromised. The damage is done. Who now will trust the ECB to fix a bad bank without dinging bondholders and depositors? Every country and every bank for itself? Bank-run anyone?
We have lost ground in this little contretemps. The threat of social unrest defeats meaningful reform and the lack of meaningful reform may cause more social unrest. Now the plan of using banking integration to buy more time for the system to heal itself has taken a huge hit. Not to get too dramatic here, we’ve seen this movie before; roll the credits for 20th century Europe. Something could give.
We’ll stare at the headlines about Cyprus for a day or two and probably move on until the next crisis. But Europe keeps getting closer to having played out its rope-a-dope policy of waiting for bad things to go away and better things to come. The next crisis, or the next, or the next after that, might be the Archduke Ferdinand moment. The center will not hold and the system will unwind with very real negative consequences for Europe. In the lee of that event, economic activity all over the world is already somewhat suppressed.
We have repeatedly seen a European crisis (really, just one long multi-year metastasizing crisis) causing a periodic startle effect in the US markets that rapidly dissipates. Fundamentals continue to look better and better here in the US. I remember the received wisdom in 2007-2008 that the subprime lending problem would not infect other parts of the capital stack. Well, that turned out to be breathtakingly wrong. On the other hand, we’ve all heard the Chicken Little claims that markets are so integrated that the flapping butterfly wings of a Cyprus banking crisis across the pond will inevitably result in doom here at home. I frankly don’t know how robust the transmission mechanism is between crisis in Europe and economic growth in the US and it has not seemed to be terribly powerful to date, but it’s a serious question.
From where we sit, as one of the largest commercial real estate finance practices in the world, the markets seem pretty robust and our strategic view remains the US economy and the commercial real estate finance sector will continue to grow and prosper. On the other hand, it’s certainly worth taking a moment to think defensive thoughts once in a while.
By: Rick Jones