Home > Getting Global, View From Up Top > Europe Throws a Hail Mary Pass

Europe Throws a Hail Mary Pass

By: John Mauldin

In a 1975
playoff game, the Dallas Cowboys were nearly out of time and facing
elimination from the playoffs, down 14-10 against a very good Minnesota
Vikings team. The Cowboys future Hall of Fame quarterback Roger
Staubach had no very good options. He later said he dropped back to
pass, closed his eyes and, as a good Catholic, said a Hail Mary and
threw the ball as far as he could. Wide receiver Drew Pearson had to
come back for the ball and, in a very controversial play, managed to
catch the ball on his hip and stumble into the end zone. Angry Vikings
fans threw trash onto the field, and one threw a whiskey bottle that
knocked a referee out. After that play, all last-minute desperation
passes became known as Hail Mary passes. (That was a very thrilling
game to watch!)

And that is what Europe did last weekend. They threw a Hail Mary
pass in an attempt to avoid the loss of the eurozone. Jean-Claude
Trichet blinked. Merkel capitulated. Today we consider what the
consequences of this new European-styled TARP will be for Europe and
the world. We do live in interesting times.

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Europe Throws a Hail Mary Pass

On Thursday of last week Jean-Claude Trichet, president of the
European Central Bank, said three times "Non! Non! Non!" when asked in
a press conference if the ECB would consider buying Greek bonds. His
exclamation was accompanied by a forceful lecture on the need for
eurozone countries to get their fiscal houses in order, some of which I
quoted in last week's letter. Trichet was remonstrating about the need
for the ECB to remain independent, and was rather definite about it.

Then on Sunday he said, in effect, "Mais oui! Bring me your Greek bonds and we will buy them." What happened in just three days?

Basically, the leaders of Europe marched to the edge of the abyss,
looked over, decided it was a long way down, and did an about-face. It
was no small move, as they shoved almost $1 trillion onto the table in
an "all-in" bet.

Bailing out Greece is very unpopular in Germany. So why did
Chancellor Merkel agree to do so? This is the story that has come out
in the last few days.

"French President Nicolas Sarkozy threatened to pull out of the euro
unless German Chancellor Angela Merkel agreed to back the European
Union bailout plan at a summit last week in Brussels, El Pais newspaper

"According to El Pais, which didn't say how it obtained the
information, Spanish Prime Minister Jose Luis Rodriguez Zapatero said
(in a private meeting of his Socialist politicians) that Sarkozy
demanded 'the commitment of everyone, that everyone should help Greece,
everyone according to their means, or France would reconsider the
situation of the euro.'

"Sarkozy banged his fist on the table and threatened to quit the
euro, which forced Merkel to cave in, Zapatero told the Spanish
politicians, according to the El Pais account.

" 'If at this point, given how it's falling, Europe isn't capable of
making a united response, then there is no point to the euro,' the
newspaper quoted the French President as saying.

"It wouldn't be the first time Sarkozy linked the fate of the euro
to a willingness to support Greece. On March 7, before meeting Greek
Prime Minister George Papandreou in Paris, Sarkozy said: 'If we created
the euro, we cannot let a country in the eurozone fall. Otherwise there
was no point in creating the euro. We must support Greece because they
are making an effort." (Bloomberg)

I find this interesting when I compare it to the analysis from my friends at Stratfor:

"Germany now senses the opportunity to reform the eurozone so that
similar crises do not happen again. For starters, this will likely mean
entrenching the European Central Bank's ability to intervene in
government debt as a long-term solution to Europe's mounting fiscal
problems. It will also mean establishing German-designed European
institutions capable of monitoring national budgets and punishing
profligate spenders in the future. Whether these institutions will work
in the long term – or fail as attempts to enforce Europe's rules on
deficit levels and government debt have in the past – remains to be
seen. But from Germany's perspective, they must."

Well, at least France and Germany are not looking at each other over
the Maginot Line. But it is the age old-struggle: who will lead?

There are so many implications of this latest action, it is hard to know where to begin.

"What is the plan? First, European governments have committed €500bn
(€440bn in loan guarantees to eurozone members in difficulties, and a
€60bn increase in a balance of payments facility). Second, the
International Monetary Fund will, it appears, put up an additional
€250bn ($320bn, £215bn). Third, the European Central Bank has, to the
chagrin of Axel Weber, president of the Bundesbank, decided to purchase
the bonds of members under attack. Finally, the US Federal Reserve has
reopened swap lines, to provide foreign banks with access to dollar
funding. This is a panic-driven response to market panic. It reminds us
of the autumn of 2008." (Martin Wolf, Financial Times)

Above all, this is a move to buy time. There is enough in this fund
to purchase all the expected debt of Greece, Portugal, and Spain for
three years. The money could actually last a lot longer, as Spain might
not need to tap the fund for some time.

There were clearly some other quid pro quos that came out of this
weekend. Both Spain and Portugal announced new austerity moves, which
will help them get back below the 3% deficit limit mandated by the
Maastricht Treaty within (they hope) a few years. It was the usual
combination of tax increases, some budget cuts, and across-the-board
pay cuts for government workers. These are very left-wing socialist
governments, and their announcements were not popular with their
followers or the unions. But they are enacting these cuts before a
durable recovery has come about. They are committing themselves to a
very rough road.

But it is not just the PIIGS countries that are out of compliance in Europe. Look at the following chart from Der Spiegel. Note that France has a budget deficit of over 8%. There are going to have to be austerity measures enacted all over Europe.


Notice that Ireland has the largest deficit, at 14.7%. This is in
spite of (or more aptly because of) the enactment of severe austerity
measures, far beyond what Greece, Portugal, and Spain have
contemplated. And what has that gotten them? An economy that has shrunk
by almost 17% in the last two years, 14% unemployment, and a country in
the grip of outright deflation. Property prices have fallen by 34% and
are still falling. Their banks are in shambles.

And their debt-to-GDP is rising, because even as they borrow their
GDP is falling. It is hard to cut that ratio when GDP is falling. If
GDP falls 20%, then the debt-to-GDP ratio rises by 25%. And that means
your interest-rate costs are an ever bigger chunk of your tax revenues.

Let's be clear. These austerity measures are not growth plans. They
are not designed to help countries grow their way out of the problem.
There is no reason to think that if Greece enacts the measures that
have been proposed, that what happened to Ireland will not happen to
them. It almost certainly will. Credible estimates I have seen suggest
that the Club Med countries will see their GDP drop at least 4% this

It is not just the PIIGS. All of Europe will be making cuts. And in
the short term that is going to be a drag on growth and a headwind for
the euro.

It's More Than Just Government Debt

A recent study by Portuguese economist
Ricardo Cabral
shows that the PIIGS have even deeper problems. With the exception of
Italy, they have a large percentage of their debt owned by foreigners.

"Greece, for example, has approximately 79% of government gross debt
held by non-residents and has a net international investment position
of -82.2% of GDP. Interest payments on public debt represented nearly
40% of Greece's already large 2009 budget deficit – and this is set to

These interest payments leave the country, making their already bad
trade imbalances even worse. And the taxes that might be paid on the
interest go to other countries, too.

Cabral looks at the average external debt during 16 debt crises over
the past 30 years. On average, Greece, Spain, and Portugal are now 30%
worse off than these other countries when they went into crisis and
restructured debt.

Cabral notes (as I have done in past letters) that there are no good
choices. Continuing to increase debt owed to foreign creditors just
digs a deeper hole that they must dig out of. His conclusion is that
some sort of debt restructuring will ultimately be required.

Martin Wolf writes this week of the problems facing the eurozone:

"… the story of the eurozone economy has, in consequence, been one
of divergence, not convergence. The rough external balance masked the
emergence of countries with huge current account surpluses and
corresponding exports of capital, notably Germany, and of others with
the opposite condition, notably Spain. In countries with weak domestic
demand and low inflation, real interest rates were high; in countries
with strong demand and higher inflation, the reverse was true. The
result is not just huge fiscal deficits, now that private-sector
spending has collapsed, but a need to regain lost competitiveness. But,
inside the eurozone, this is possible only with falling wages, higher
productivity growth than in Germany (and so soaring unemployment), or

Take a look at the charts below from his Financial Times
column. The PIIGS have much higher labor costs per unit of production
than Germany, as much as 50% higher! Germany runs large trade surpluses
while the Club Med countries have large trade deficits.

A country may want to reduce its government debt, its businesses and
individuals may want to reduce their debt, and they might like to run a
trade deficit. However, the rules of accounting are such that you can
only do two of the three.

The reality is that the coming austerity measures are going to
reduce the ability of the PIIGS to buy products from outside their
countries. Germany's surplus will thereby suffer.


Let's look at yet another set of graphs from Der Spiegel to
get a handle on the problem facing these countries. Their unemployment
is already high and is going to get worse. They are not enacting
pro-growth policies. Spain, for instance, has a rule that a company
must pay a one-month severance fee for each year an employee has
worked. Thus, if you have worked for ten years, you get a ten-month
severance allowance if you are laid off. What that does is discourage
new employment, and it means that newer workers are laid off first.
That is one of the reason Spain has such a high unemployment rate among
young people.


The Grand Misallocation

What this Euro-TARP does is take money from mostly good credit and
give it to weak credit. It will crowd out private savings that go into
private enterprise (which is where jobs come from) and put it to
unproductive uses in the government debt of weak countries.

There are only two ways to grow an economy: you can grow your
population or you can increase productivity. That's it. The Club Med
countries are not growing their populations appreciably, as their birth
rates are low. And you increase productivity by investing private
capital into businesses, the way the Germans have done, which is why
their labor unit costs are so low compared to their competition.

Euro-TARP almost mandates that capital be misallocated into non-productivity-enhancing government programs and debt.

Europe is run by Keynesians (as is the US). They see everything as a
liquidity problem. And sometimes it is. But the PIIGS have a debt
problem. And you don't cure a debt problem with more debt unless you
have a clear path to grow your way out of the debt. But as I have
demonstrated, there is no clear path to growth with the current
policies. They will produce deflationary recessions, lower government
tax receipts from reduced GDP, and higher unemployment.

At the end of the day, Greece will just have more debt. Perhaps
Spain and Portugal can work through their problems, but that will be
very difficult and will involve considerable economic pain. Italy can
succeed if it decides to.

This new program simply buys time to try and figure things out. It
is Germany saying, "Ok, I give you 3-4 years. But don't come back
asking for more."

All this does is bridge to the middle of the decade, when the truly
massive health and pension promises made all over Europe must be dealt
with. The US has the option of raising taxes, reducing benefits, and
means testing, should we so choose to do so to meet the demands of
entitlement problems. Europe already has tax rates that are high and
growth-inhibiting. The entitlement problems in many countries are more
onerous, and their working populations are not growing.

This is just the beginning of their woes. They have a long way to go
and a short time to get there. Can it be done? Yes, of course. But it
is going to require a great deal of change. I hope they pull it off, I
really do. I have been to most of Europe and love every bit I have
seen. The world is better off with a united Europe.

That being said, I have my doubts that the European Union in its current form will exist in 5-7 years. I hope I am wrong.

One implication. The euro is on its way to parity with the dollar.
So is the pound. That is going to help their exports vis-à-vis the US.
Watch the yen fall rather sharply over the next few years. Senators
Schumer and Graham gripe about China. What are they going to say about
Europe, Britain, and Japan, all of which are on course to premeditated
devaluation? This is going to be just one more challenge for businesses
in countries with the world's stronger currencies.

Another side bet? The ECB says it will sterilize those government
bonds it buys (meaning, it will make sure it does not add to the money
supply). My bet is that when deflation starts to run throughout Europe,
the ECB will decide that maybe not so much sterilization is required
after all.

New York, LA, and Italy

As I noted above, I have cleared my schedule to be at the Agora
Financial Conference in Vancouver, July 19-23. They have a truly great
line-up of speakers. I suggest you go to http://agorafinancial.com/vancouver2010/ and look at the program and then go ahead and register.

This week, I had to lay over in Montreal due to bad weather in
Chicago, which meant I had to get up at 2:45 am to make a flight to get
me back to Dallas in time for a speech. Ugh. I am fairly used to
travel, but I make a point not to push it. My body just needs my 8
hours' sleep, and sadly I can't sleep on planes, unlike Dennis Gartman,
who can sleep anywhere. It really kicked my butt.

On Monday I fly to New York for a day, then two nights in Stamford,
Connecticut, speaking to Pitney Bowes execs. I am looking forward to
Monday night, when I get to have dinner with Art Cashin, Greg Weldon,
and Cliff Draughn (coming up from Savannah) – we'll hash over the
problems of the world.

Then it's a quick trip to LA the following week, to meet with a team
of people who are helping us redesign our websites and services to you,
gentle reader. We are in for a major upgrade and I think you are really
going to like it.

And then home, where I will stay until June 3, when the whole family
(seven kids and spouses, grand-babies) takes a two-week vacation to
Italy. I am going to stay over and speak at the Global Interdependence
Center Conference in Paris, June 17th and 18th, with my good friend
(and euro-bull) David Kotok and other luminaries. There will be a lot
of central banker types, and if you want to get a feel for what's
happening in Europe you should come. Information is at www.interdependence.org.

We have been planning (or Tiffani has) for the Italy trip. I really
can't wait, as it's going to be a ton of fun. Thanks for all the
suggestions as to where to go and what to see and where to eat! It has
been over 25 years since I was in Italy, and that was just a few days
in Rome and Venice. This time it's two full weeks, with a week in Rome
and Venice and then a week in Tuscany, then to Paris, and then back to
Tuscany and Milan. And since we decided to go, the euro has fallen 25%.
That helps a lot! I used miles to take everyone, but hotels are a real
expense. Every little bit helps.

It is once again late and time to hit the send button. Enjoy your week.

Your still recovering from an early morning analyst,

John Mauldin

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