A View from the Trenches, February 10th, 2010: "An institutional perspective on the Euro"
Please, click here to read this article in pdf format: february-10-2010
We’re back and still concerned about the situation the capital
markets face and will continue to face. Essentially, (we differ with
the mainstream view and) we stand by our interpretation that Europe does not face a short-term liquidity crisis, but an institutional crisis.
Institutional economics is one of those underappreciated and
misunderstood branches of Economics (in our view, if economists had
properly read Von Mises’ “Human Action”, Institutional Economics or
Behavioural Economics would have never taken off as disciplines.
Perhaps the best known economist within the Institutional tradition is
James Buchanan (1986 Nobel Memorial Prize), but we also enjoyed very
much and recommend reading the works of Peruvian economist Hernando De
Soto).
The institutional economist asks the following question: “If
the European Union is actually not a Union, but a Confederation, why
should Euros be held as the world’s alternative reserve currency,
instead of Canadian Dollars or Australian Dollars or Swiss Francs?” We
think this is a valid question and a question markets are asking as we
write. But first, let’s briefly describe what a Confederation and a Union are:
Confederations are alliances of sovereign states. “…In a Confederation,
the links among members are weaker. The legal instrument of the
alliance is a “treaty”. The purpose of a Confederation is economic
integration and military assistance among members. Member states remain
sovereign and as such, keep the powers of self-determination.
Confederated states reserve the right to nullify, reject legislation
and eventually, of secession. They may issue currency, keep customs and
sustain armed forces. They lack a strong common government, although
they may unify their foreign policy.
In a Union, the links among member states are
more vigorous. In a Union, one finds a definitive purpose to integrate
the states. There is a sovereign federal government, while the states
are autonomous. The states can govern themselves, have their own
legislation, but these acts are subordinated to the Union’s
constitution and federal laws. Secession is not allowed, although
member states conserve those rights that they did not delegate to the
federal government, when the Union was established….” (our translation
from “Curso de Derecho Político”, H. Sanguinetti, 4th Edition, 2000)
As investors, what should we interpret as a catalyst, as a
defining moment? Here’s our view: If the IMF has to intervene, the
European Union will definitely be a Confederation. This is
unfortunately the path of least resistance. This is the easiest and
less painful path. If the IMF is engaged, the Euro will no longer be
considered an alternative global reserve currency and the bid that
there was under such belief will no longer be there. We shall be
sellers of Euros under this scenario. This is the worst-case scenario,
for if the EU citizens lose purchasing power, the global recovery will
become a long-term dream. Note that we don’t care about Debt/GDP ratios
or other metrics. The relevant issue here is that on the margin, the
Euro would no longer offer more safety than other strong, healthy
currencies. In fact, its complex institutional framework would be a
burden, compared to other ones, simpler to understand.
In the world of corporate credit, when lenders are not satisfied with
the credit quality of borrowing subsidiaries, they may demand
cross-guarantees, in addition to an irrevocable guarantee of the
parent. Unfortunately, this cannot happen with sovereign debt. The more
difficult and painful path for the European Union is to stand up to the
challenge and lay the ground for a stronger integration, under a
central government that can provide legally and operationally a
guarantee for not just the debt of Greece, but of any other state under
stress (i.e. Portugal, Spain, Ireland).
Such integration demands political will and time. Unfortunately, the
world lacks both. Therefore, we were very suspicious, when at 12:19pm
yesterday, Bloomberg announced that Germany was considering assisting
Greece. In fact, we smelled something wrong earlier, when after 10am,
the Canadian dollar broke its correlation with oil (chart above,
source: Bloomberg).
At 11am, it was clear that the source was the cross with the Euro.
Somebody knew something that the rest of us ignored (chart below,
Eur/USD, source: Bloomberg). And then, the rumor was officially out at
12:19pm, that a member of the German’s Christian Democratic Union had
said Germany was considering assisting Greece. The Euro had gained 1%
and profits were immediately taken!
We are of the view that the market sold into this strength, for if
it the rumor had had real merit, the bounce should have been way
stronger. However, we are also concerned about the existing
misinformation. As we write (11pm ET), the “Frankfurter Allgemeine” (at
11:02pm ET) reports Mr. Joaquín Almunia (ex-economy commissioner, since
Feb 10th, according to Bloomberg) to have only expressed that the
European Union should
promise protection to Greece. However, Madrid’s “El País” reports that
the European Union and Germany are preparing a package for Greece. Le
Monde and Financial Times back the latter interpretation.
All we are certain of is that a European plan should put the IMF
alternative farther rather than closer, and that’s a good thing.
However, a plan for Greece is hardly going to solve the situation, for
it is the European Union that is in crisis, not just Greece. And the
upcoming strike of public employees in Greece is not going to make life
simpler.
Martin Sibileau
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