Saving the Euro (Merk)

by Axel Merk, Merk Funds

The man­age­ment of the Euro­zone debt cri­sis is dys­func­tional. In our assess­ment, to save the Euro, pol­icy mak­ers must focus on com­pet­i­tive­ness, com­mon sense and com­mu­ni­ca­tion. If pol­icy mak­ers strived to achieve just one of these prin­ci­ples, the Euro might out­shine the U.S. dollar.

Com­mu­ni­ca­tion

Let’s start with the sim­plest of them all: com­mu­ni­ca­tion. In a cri­sis, great lead­ers have a no-nonsense approach to com­mu­ni­ca­tion: pro­vid­ing unem­bell­ished facts, a vision, a path on how to get there, as well as progress reports. Just as in any cri­sis, such a leader typ­i­cally only has lim­ited influ­ence on the events play­ing out, but serves as a cat­a­lyst to rally the troops, pro­vide opti­mism, avoid pan­ics, explain sac­ri­fices that must be taken, and show peo­ple the light at the end of the tun­nel. The Euro­zone needs a com­mu­ni­ca­tor. It can even be more than one.

The one uni­fy­ing face of the Euro­zone is Mario Draghi, head of the Euro­pean Cen­tral Bank (ECB). Bet­ter than his pre­de­ces­sor, Draghi is able to artic­u­late the issues and has been lec­tur­ing polit­i­cal lead­ers on their job when it comes to, among other things, fis­cal sus­tain­abil­ity and struc­tural reform. Draghi has made it clear that while liq­uid­ity is abun­dant in the Euro­zone, it is rather “frag­mented”; as such mon­e­tary pol­icy is not the bot­tle­neck, instead, gov­ern­ments and reg­u­la­tors must live up to their duties. How­ever, Draghi is the first to point out that he can­not be the spokesper­son for fis­cal and reg­u­la­tory matters.

Start­ing at the top, the exec­u­tive branch of the Euro­pean Union is the Euro­pean Com­mis­sion, headed by José Manuel Bar­roso. Inter­ested in the vision Europe so des­per­ately needs? Barroso’s vision should give the answers; unfor­tu­nately, it comes across like a school essay, unlikely to go down in his­tory as the vision that saved the Euro­pean project. Google is proof that his office must do bet­ter in com­mu­ni­cat­ing with the pub­lic: the Commission’s web­site ranks third in results when explic­itly search­ing for it.

Olli Rehn, EU com­mis­sioner on mon­e­tary affairs, is the pub­lic face for the polit­i­cal side of the euro. While Rehn has achieved much given the lim­ited author­ity he has been given, we urge him to take a big­ger pub­lic pro­file. In announc­ing the Span­ish bank bailout, his office released a state­ment say­ing “that the Com­mis­sion is ready to pro­ceed in close liai­son with the ECB, EBA and the IMF, and to pro­pose appro­pri­ate con­di­tion­al­ity for the finan­cial sec­tor.” The state­ment goes on to read “The Com­mis­sion is ready to pro­ceed swiftly with the nec­es­sary assess­ment…” – an action plan would have been preferred.

The EBA ref­er­enced above is the Euro­pean Bank­ing Author­ity, estab­lished only in 2011. The head of the EBA is Andrea Enria. Who? If the Euro­zone wants to move towards a “bank­ing union”, Enria needs to work harder in becom­ing a house­hold name. As of this writ­ing, the lat­est head­line on the EBA’s web­site appears ill suited for pub­lic con­sump­tion: “Con­sul­ta­tion paper on draft imple­ment­ing tech­ni­cal stan­dards on super­vi­sory report­ing require­ments for liq­uid­ity cov­er­age and sta­ble fund­ing”. Amongst impor­tant top­ics that have not been addressed in the Span­ish bank­ing bailout is what author­ity the Euro­pean Bank­ing Author­ity (EBA) will have in restruc­tur­ing Span­ish banks. Crony­ism has left its regional lenders, the cajas, uncom­pet­i­tive. Finland’s Prime Min­is­ter Katainen lamented after the announce­ment of the Span­ish bank res­cue, “there must be a pos­si­bil­ity to restruc­ture the bank­ing sec­tor because it doesn't make sense to recap­i­tal­ize banks which are not capa­ble of run­ning” – the con­cern is fair and should have been pre-emptively addressed by the EBA. Instead, in typ­i­cal Euro­zone fash­ion, the med­dling is erod­ing trust. For good­ness sake, this is sup­posed to be a €100 bil­lion bank bailout, not a text­book approach on how to squan­der yet another oppor­tu­nity to tame the debt crisis.

Instead, in explain­ing the Span­ish bank­ing bailout, con­ser­v­a­tive Span­ish Prime Min­is­ter Rajoy bragged to his domes­tic audi­ence about how Spain avoided a bailout (really?). Some polls sug­gest 80% of Spaniards have “lit­tle or no” con­fi­dence in him – that’s half a year after his party won an absolute major­ity (if it’s any con­so­la­tion, the pub­lic trusts his Social­ist oppo­nent even less). In our assess­ment, based on the attrib­utes out­lined of what the com­mu­ni­ca­tion skills of a great leader may be, Rajoy flunks on all accounts. Rajoy appears more inter­ested in play­ing games of chicken with Eur­zone lead­ers than in real reform. But we are get­ting ahead of ourselves.

Com­pet­i­tive­ness

Com­mu­ni­ca­tion can only do so much. No bank bailout for Spain will get its econ­omy back on its feet if Spain is not an attrac­tive place to invest in. No bailout will cure Greece, unless cap­i­tal wants to come to Greece. Dif­fer­ently said, aus­ter­ity is the easy part; struc­tural reform is the tough job. The key “encour­age­ment” to engage in struc­tural reform has come from the bond mar­ket: the higher the cost of bor­row­ing for gov­ern­ments, the greater the incen­tive to get one’s house in order. Unfor­tu­nately, a side effect of the bailouts is that such incen­tive may be lost. Span­ish Prime Min­is­ter Rajoy is proof of that: when­ever the pres­sure of the bond mar­ket increases, reforms are promised; the moment the pres­sure abates, these promises are watered down.

While Rajoy encom­passes just about all that’s wrong with the Euro­zone process, it’s the (lack of) process rather than the per­son that is so detri­men­tal. In Spain’s exam­ple, painful aus­ter­ity mea­sures have been imple­mented. Now, Rajoy argues, it’s time for Euro­pean lead­ers to step up to the plate and do their part. But last time we checked, deficits con­tin­ued to pile up. Rajoy has argued that mea­sures that are too dra­con­ian now are unwise. Unfor­tu­nately, it takes years to build up con­fi­dence, but it can be destroyed in rel­a­tively short order; once destroyed, an enor­mous effort must be under­taken if con­fi­dence is to be regained. Half-baked solu­tions won’t appease the mar­ket. To reduce a youth unem­ploy­ment rate of over 50%, make it eas­ier for com­pa­nies to be formed and con­duct their busi­ness, eas­ier to hire and fire peo­ple. Pump­ing money into a non-competitive bank­ing sys­tem won’t lead to a sus­tain­able recovery.

The “fis­cal com­pact” pol­icy mak­ers are call­ing for is hap­pen­ing by default, as an increas­ing num­ber of coun­tries give up sov­er­eign con­trol over their bud­get­ing in return for fund­ing from the IMF and Euro­zone. Sim­i­larly, the path towards a “bank­ing union” appears to be shap­ing up through bank bailouts, as coun­tries ask­ing for help will have to yield con­trol over their bank­ing system.

And while we have been bash­ing Spain, Ger­many is about to destroy the com­pet­i­tive­ness of its bank­ing sys­tem. In order to win the required 2/3rds major­ity in par­lia­ment to pass the “fis­cal com­pact”, the Ger­man gov­ern­ment needs approval from the oppo­si­tion. To get such approval, the Merkel gov­ern­ment is pro­ceed­ing with the intro­duc­tion of a finan­cial trans­ac­tion tax. Lon­don, New York and Sin­ga­pore ought to write thank you let­ters. It might be more pru­dent to let periph­eral banks fail than to poten­tially jeop­ar­dize the long-term com­pet­i­tive­ness of the Euro­zone bank­ing sector.

Com­mon sense

Unfor­tu­nately, with more cen­tral­ized man­age­ment through bailout regimes, the focus shifts from improv­ing the local econ­omy towards man­ag­ing the bailout régime, try­ing to max­i­mize the money that can be extracted from the res­cue funds. Instead, com­mon sense solu­tions should be a top pri­or­ity. Since the Span­ish bank­ing bailout is the most recent exam­ple, let’s pon­der a few questions:

Why would you keep your money in a Span­ish bank? In the U.S., some peo­ple put their money into com­mu­nity or other local banks, but many put their deposits with large, national banks. Sim­i­larly, why would you put your money into one of the Span­ish cajas, even if well cap­i­tal­ized, when you can open up an account with Deutsche Bank? Could it be that the Span­ish bank­ing sec­tor is too large? Could it be that, rather than prop­ping up failed insti­tu­tions, the gov­ern­ment should focus on attract­ing cap­i­tal from any insti­tu­tion that wants to come to Spain? Could it be that the focus should be on mak­ing Spain an attrac­tive place to invest in?

Why do we have national bank reg­u­la­tors rather than a pan-European reg­u­la­tor? Well, in 2011, the Euro­pean Bank­ing Author­ity (EBA) was cre­ated. Yet, it’s the national bank reg­u­la­tors that dic­tate how domes­tic banks are run. And guess what, national bank reg­u­la­tors declare domes­tic debt to be risk free, and as such, banks would typ­i­cally not put cap­i­tal aside against their own national debt. Banks are in the busi­ness of man­ag­ing risk, but if they are told to clas­sify some­thing as risk-free that is clearly risky, they may be wise not to touch their own sov­er­eign debt with a broom­stick. Ger­many, the poster child in this cri­sis, is one of the coun­tries that has his­tor­i­cally been reluc­tant to yield power to Brus­sels (although they are por­trayed as more prag­matic these days). We would shed no tears to see the Ger­man bank reg­u­la­tor BAFIN yield author­ity to the EBA. Remem­ber when banks pub­lished their sov­er­eign debt hold­ings last year at instruc­tions of the EBA? Well, BAFIN wanted to give Ger­man banks a free pass. For­tu­nately, mar­ket forces pre­vailed (by sell­ing Ger­man bank stocks and debt) and encour­aged the vol­un­tary pub­li­ca­tion of the data.

And why does the ECB not take a lead in cre­at­ing a ‘bank­ing union’ by con­vert­ing national cen­tral banks to divi­sions of the ECB? Cur­rently, when money flows from Spain to Ger­many, the Bank of Spain incurs a lia­bil­ity at the ECB; in return, the Bun­des­bank has a claim against the ECB. In a true cur­rency union, such flows should not mat­ter. Instead, a for­merly cryp­tic mea­sure, TARGET2, that mea­sures such flows, is closely fol­lowed as an indi­ca­tor of cap­i­tal flight from the periph­ery. To elim­i­nate the con­cern that a country’s exit from the Euro­zone could poke a major hole in the ECB’s bal­ance sheet, the ECB should merge the national cen­tral banks, turn­ing them into ECB divisions.

Empower the peo­ple, not the bureau­crats. Pol­icy mak­ers must find a way for local gov­ern­ments to own their own prob­lems. When things fail, local gov­ern­ments must be held account­able. It can­not be that the Dutch, Finns and Ger­mans are blamed for the Greeks fail­ing to meet their goals. Some claim this may only be achieved when coun­tries have inde­pen­dent cur­ren­cies. How­ever, there might be a bet­ter way: ECB Pres­i­dent Draghi has urged pol­icy mak­ers to clearly define roles, dead­lines and con­di­tions to be sat­is­fied. Crises will hap­pen peri­od­i­cally, but they are far less stress­ful if sound insti­tu­tional processes are in place. The ire when things go wrong can then be directed at the party respon­si­ble. This is not rocket sci­ence, but sounds like com­mon sense to us.

In our assess­ment, the euro has been mostly weak because of the utterly dys­func­tional process. The good news may be that, in our assess­ment, this isn’t a Euro­pean cri­sis. The bad news is that, well, this is a global cri­sis. As such, should the process improve, the cri­sis may tar­get other regions in the world. The U.K., the U.S., and Japan are some of the can­di­dates. Unlike the Euro­zone, the U.S. has a cur­rent account deficit; as such, the U.S. dol­lar may be far more vul­ner­a­ble than the euro has been should the bond mar­ket ever be less for­giv­ing about fis­cal largess in the U.S. As we have argued for some time, there may not be such a thing as a safe asset and investors may want to take a diver­si­fied approach to some­thing as mun­dane as cash.

As I am wrap­ping up this analy­sis, EU Com­mis­sioner Bar­roso is start­ing a more pub­lic cam­paign for a bank­ing union, sug­gest­ing that the biggest banks across the EU sub­mit them­selves to a sin­gle cross-border super­vi­sor. The Bun­des­bank is already push­ing back, argu­ing this might equate to a back door Eurobonds.

Please make sure to sign up to our newslet­ter to be informed as we dis­cuss global dynam­ics and their impact on cur­ren­cies. Please also reg­is­ter for our upcom­ing Webi­nar on June 13 where we will dis­cuss the invest­ment strat­egy and objec­tives of the Merk Absolute Return Cur­rency Fund. We man­age the Merk Funds, includ­ing the Merk Hard Cur­rency Fund. To learn more about the Funds, please visit www.merkfunds.com.

Axel Merk

Man­ager of the Merk Hard Cur­rency Fund, Asian Cur­rency Fund, Absolute Return Cur­rency Fund, and Cur­rency Enhanced U.S. Equity Fund, www.merkfunds.com

Axel Merk, Pres­i­dent & CIO of Merk Invest­ments, LLC, is an expert on hard money, macro trends and inter­na­tional invest­ing. He is con­sid­ered an author­ity on currencies.