The European Morass (Excerpted from Tiburon Investor Letter for November, 2011)
 
Many market participants are pinning hopes on EU policy makers influencing the steadying of markets with the creation of a fiscal union that will allow the ECB to become the lender of last resort. But given the disappointing history of policy makers worldwide since 2008, we want to see both words and actions, before suggesting there’s any stability there. Despite what markets might do in the next two weeks, the impact is not likely to be knowable near term. Policy makers are prone to announce that the IMF will lend to Italy, using IMF funds, the ECB, EFSF, and possibly others. The total amount could be as big as €500bn. A big number could impact markets near term, until investors start asking how this solves the structural problem in the EMU, which is that there is no actual present fiscal solidarity, nor fiscal discipline, and no lender of last resort to sovereigns. While there is a “fiscal compact,” as Mario Draghi has dubbed it, market participants want to know what this means concretely before buying bonds (more on this in a moment). We do not think the Summit will promise a Eurobond or QE (near term). 

All diplomacy is a continuation of war by other means.  -  Zhou En Lai[1]

Germany has taken the leadership role and seeks to influence and has the power to impose some fiscal discipline across Europe by virtue of its economic might. This is less a fiscal union and more an austerity club - a way of imposing painful budget cuts, tax hikes and other measures onto euro-zone countries through stiffer sanctions and regulations, with very little offered in return.

Austerity without quantitative easing is unlikely to work. Budget deficits can facilitate the deleveraging process so that it does not produce massive economic contraction. The historic episodes of deleveraging fit into one of four archetypes: 1) austerity or “belt-tightening,” in which credit growth lags behind GDP growth for many years; 2) massive defaults; 3) high inflation; or 4) growing out of debt through very rapid real GDP growth as a function of war, a “peace dividend” following war, or a commodity (often oil) boom. Europe, following the austerity path, if history is any indication, would experience six to seven years of deleveraging to reduce debt to GDP by 25%.  GDP typically contracts for the first two to three years before turning.

Ripping off the Band-Aid Slowly

27 sovereigns with differing economic engines, cultural characteristics and demographics must agree to a fiscal compact. Okay, let’s assume this can occur. Germany acts as final arbiter on the fiscal probity of all the members of this European Austerity Club with all 27 adhering to EU determined budgets and tax obligations. Sure, why not? So now countries with Debt/GDP of say 80-120% must comply with such budgetary and tax burdens and grow their economies sufficient to make good on its obligations?  Economists Carmen Reinhart and Kenneth Rogoff have argued that high (90%) Debt to GDP levels are unsustainable and fiscal austerity coupled with deleveraging causes lengthy deteriorating outcomes for Sovereigns facing such circumstances.[1] Now you can quibble with some of their thesis (like not distinguishing between the differing economic power of Sovereigns with like Debt to GDP ratios), but the history and relationships are undeniable. I am not an economist but from the work I’ve done recently I must admit to falling into the Keynesian camp is in a slump, the private sector is either unwilling or unable to spend, resulting in a demand shortfall. If that shortfall is not plugged, employment and output fall. The way to plug the shortfall is for the public sector to step in with policies that increase demand such as increased spending, tax cuts, and transfers.

 
A large-scale asset purchase program of quantitative easing, buying euro area government bonds in the secondary market, would be justifiable under the treaty if it was undertaken for monetary policy purposes. That may mean the ECB needs to take rates down to a “zero-bound.” It would also mean that the ECB would need to buy either a representative basket of euro area government bonds or, perhaps, EFSF bonds. For such a program to be similar in scale to that seen in the US or UK would imply around €1trillion of asset purchases. Unfortunately, QE does not solve the structural issues in Europe. It is merely a tool to buy time and another way to transfer sovereign debt to the official sector. In the extreme, if the ECB is forced to extend QE, but fiscal reforms are not successfully implemented, we could end up in a situation where certain countries are still forced to restructure debt. In such a scenario, the perverse outcome is that larger haircuts may have to be imposed on private bond holders, as the official sector (ECB) is unlikely to participate in a restructuring. Large scale QE would also bring the question of moral hazard back to the fore. One could argue that such bold ECB action reduces the need for political and structural reform. However, without massive QE, austerity budgets will severely hamper and extend the pain in Europe.

A Buyer of Last Resort?

If, as and when the ECB buys a massive amount of Sovereign bonds as part of a QE initiative, it subordinates private holders of these bonds – making them structurally junior. Rather than take a haircut on bonds as part of a restructuring, such private bondholders can choose to sell into markets, I suppose, at least temporarily buoyed by QE buying, or hold and call bonds “current” for accounting purposes, remaining at risk on a mark-to-market basis, or ultimately, for any future restructuring that compels a haircut and then as a junior stakeholder to the ECB. Given that classic government bondholders are looking at these securities as “risk-free,” it would seem that the constituent buyer base of future EU issued or any European Sovereign’s debt is not the classic government bond buyer. Put another way, these are not sanguine times, and given the myriad outcomes for EU issued or Sovereign debt, what yield is called for to take up the full complement of bonds issued? It’s not clear that even with rates at zero and massive ECB bond buying, that Sovereign borrowing rates reduce meaningfully given the future risks.

 
So as part of a fiscal compact, might the public/banks be compelled to buy bonds? It’s surely possible. In the ultimate can kicking, Europe might increase its own holdings of Sovereign exposure to a magnitude of say, Japan. The analogy doesn’t end there as Europe ages, European economic engines can sputter, in part, a function of an aging populous. Then what?

Peter M. Lupoff          Tiburon Capital Management, LLC       December 13, 2011

[1] “Growth in a Time of Debt”, Carmen Reinhart, Kenneth Rogoff, NBER Working Paper No. 15639, January, 2010.