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Tuesday, March 22, 2016

John Mauldin : "Open Letter to the Next President "

Open Letter to the Next President, Part 2 | Thoughts from the Frontline Investment Newsletter | Mauldin Economics


European Unity Crumbling
Europe is in economic and political crisis. The last European financial crisis exposed a façade of unity that was never sustainable. The façade will almost certainly collapse before you finish your first term in office. The Eurozone’s breakup has the potential to be the biggest economic crisis you will face. How you handle it will make or break the entire global economy. The problem is that there is nothing you can do to prevent the coming crisis. All you can do is help steer Europe on a course that will result in the least damage to the US economy in particular and the global economy in general.
The European Union was a noble dream, but as happens with most dreams, reality eventually sets in. It is simply not possible to maintain economic unity and a single monetary policy among a collection of states each of which sets its own fiscal policies. The EU subset that shares the euro currency already sees this. The rest of the members will follow soon enough.
Europe’s sovereign debt crisis was the first sign that something was structurally wrong. Germany spent years loaning euros to poorer Eurozone countries so they could buy German-made goods. Other exporting nations within the EU did the same. The resulting trade imbalance had to show itself somewhere. It did, in the government debts of countries like Greece, Italy, Spain, Portugal, and Ireland.
To this point, the attempted solution for outsized debt has been to impose “austerity” measures on those countries while they supposedly restore fiscal discipline. The European Central Bank has bought struggling nations time by depressing interest rates to artificially low levels, but that policy carries its own unintended consequences. The results have been mixed at best. Spain and Ireland are recovering somewhat; Greece, Portugal, and Italy are not.
Italy will probably be your main headache. Its banking system is already breaking down as nonperforming loans proliferate. Nonperforming loans make up almost 20% of Italian banking system assets. Not surprisingly, as you go from north to south in Italy, the percentage of bad loans increases. Some southern banks hold nearly 40% nonperforming loans. (By contrast, you should be thankful that nonperforming loans of US banks are down to a somewhat manageable 1%. During the worst of our banking crisis, US nonperforming loans never rose above 3½%. Italy’s level is almost six times greater, and there is not an economic crisis yet.)
A collapse of the Italian banking system is a systemic risk for all of Europe, which means that it is also a systemic risk for the global economy. Italy is the eighth-largest economy in the world, only slightly smaller than India. But, whereas the world could probably tolerate a major setback in India, Italy is extremely critical because of its economic impact on Europe and thus on the global economy.
Italian government debt is already 132% of GDP and rising. The Italian economy is roughly the same size it was in 2000. Economists have been projecting growth for Italy for nearly all the intervening time, but that elusive growth just keeping slipping farther into the hypothetical future. Italian nonperforming loans represent just under 20% of GDP, yet Italian banks are literally too big to save. Further, another 10% of GDP and more would likely go up in smoke in a banking crisis, in the form of Italian bank bonds that have been sold to the general public as safe-yield vehicles.
There are negotiations underway to create a “bad bank” in Italy and somehow sell its paper to the public. That bad-bank debt would of course come with government guarantees, but these would cover only a portion of the nonperforming loans. There is still no agreement for a total solution. Germany is especially wary of committing to cover bad-bank loans of another country, because to do so would set a precedent that could be staggeringly expensive.
Italy is not the only European country with problematic nonperforming bank loans; it is just the biggest such country with the largest pile of debts. There is a laundry list of countries in Europe whose economic problems may not be as big as Italy’s but whose woes are certainly significant and will become much worse if another financial crisis hits Europe. Crises have a way of cascading beyond national boundaries.
Compared to Italy, Greece will seem quite manageable. Obama was able to watch from afar as Merkel and the EU dealt with Athens. You will not have that luxury when Italy craters. It is much bigger than Greece and far more important to the world economy.
Greece remains important for another reason, though. It is the main gate through which fleeing Syrians, Iraqis, and others try to enter Europe. The wealthier states need Greece’s cooperation to keep the flow of refugees manageable.
I know some of you presidential candidates are not fans of the New York Times, but let’s look at a recent Times report concerning Greece and the refugee crisis anyway. A feature story last week explained how Greece is the eye of two different storms:
Greece is now ground zero for the two greatest challenges to afflict Europe in recent years: the debt crisis and Germany’s insistence on austerity as the only cure, and the backlash against the wave of human migration from war-torn and impoverished countries….
Greek officials warn that refugees might be stranded in the country for two years. So many are stranded at the port of Piraeus, near Athens, that the passenger terminals – usually where vacationers wait for ferries to the islands – are crammed with sleeping Syrians and others. On Saturday morning, a group of bewildered Korean tourists wandered into a terminal transformed into a Little Syria.
The migrant crisis is already a humanitarian disaster, and the situation is getting worse. The European Union is all but paralyzed, as I wrote last September in “Merkel Opens the Gates.” In that letter I quoted a column from The Economist that nicely illustrates the problem:
Policymakers are fizzing with ideas, from the use of development aid to bring recalcitrant transit countries into line to the strengthening of a Europe-wide border guard. Once the principle of shared responsibility for migrants is established, says another official, the numbers of relocated migrants can be scaled up, and new programmes established, without too much wrangling.
I responded with this:
What arrogance. Brussels will bring those “recalcitrant transit countries” back in line. The “wrangling” will be over once they establish the “principle of shared responsibility.”
“Shared responsibility” is exactly the principle the EU never manages to establish, regarding immigrants or anything else. Yet nameless officials still tell everyone not to expect “too much wrangling.”
Nothing is ever done in Europe without a great deal of wrangling.
That was more than six months ago. Is Europe any closer to a solution now? Hardly. If anything, the crisis is intensifying. The Paris terror attacks in November resulted in the reimposition of border controls through most of the previously open “Schengen” area. The attacks also convinced many Europeans that migrating Muslims are a security threat. An initial welcome turned into fear. One of the key leaders in Europe, Angelina Merkel of Germany, finds herself under intense political pressure because of an anti-immigrant backlash from voters.
Desperate for any solution, the EU is now seriously entertaining a deal to accept Turkey as a member in exchange for Turkey’s holding most of the migrants within its borders. That nascent deal is already running into the EU’s dysfunctional structure that demands unanimous approval by member nations for everything.
Stop right here. Those who originally designed the EU had visions of a “United States of Europe.” Yet the USA they wish to copy does not require every state to agree on everything. Can you imagine if we had to do so? Would Texas and Vermont ever find common ground? Florida and Montana? Hawaii and Mississippi? Of course not. The idea is absurd. Our government would have collapsed long ago if unanimity were the requirement.
We can amend our Constitution if 75% of the states agree. An amendment to the Maastricht Treaty, which is the organizing document for the EU, requires agreement by all 23 members.
The US has survived because we have a system of majority rule with minority rights. We require supermajorities for certain big decisions such as Constitutional amendments. We do not demand that every state agree to every major decision, because it would never happen. Paralysis would be the result – as Europe is now proving.
Giving Turkey a path to EU membership is problematic to Cyprus, which is a tiny island but an equally powerful EU member state, with technically the same vote and potential veto that Germany and France have. Cyprus can veto the refugee deal that the rest of Europe so desperately needs to make with Turkey.
The solution to this point has been for the large and economically powerful EU/Eurozone members to simply force their will on the smaller states, resolving short-term challenges at the cost of long-term unity. This week they did it to Cyprus. The Wall Street Journalreported on Friday that the “EU Agrees on Deal to Send Migrants Back to Turkey.” Notice this part of the deal:
Turkey’s EU membership bid will also be accelerated, while steering clear of a conflict with Cyprus that has held up negotiations. Cyprus has an EU-backed veto on starting accession negotiations over a number of new policy areas, because Turkey doesn’t recognize its passports or allow ships and airplanes from Cyprus into its ports and airports.
Under the agreement, the EU commits by the end of June to start negotiations on aligning Turkey’s legislation on financial and budgetary affairs to EU law – a policy area, or chapter, that wasn't blocked by Cyprus.
Cyprus has legitimate concerns here. The EU solution is to simply ignore those concerns and plow ahead on other fronts. That approach will probably work, too, but each such episode pulls a few more bricks out of the EU superstructure. Bullying your smaller members is not consistent with the idea of an “ever-closer” union.
Let me put this more bluntly: there is a substantial probability that Europe will have a financial crisis that will create significant economic chaos, and if it is combined with an immigration crisis, the results are unknowable but unpleasant to contemplate.
Another looming danger is that the United Kingdom will hold a referendum this summer that may well lead it out of the EU. A member leaving the EU would set a dangerous precedent. For years following, there would be major consequences for world trade and currency flows.
There are two possible outcomes to a European financial crisis stemming from massive sovereign debts and unbalanced budgets. The first is that an entirely new economic structure might evolve in the European Union. If the EU is to stay together, it is going to have to resolve the sovereign debt issues. Because the European elites really do want to see a united Europe when push comes to shove, they are likely to take on the debt of every Eurozone nation according to some odd formula that only a European bureaucrat could love, mutualize that debt, and stick it on the balance sheet of the European Central Bank. They would then require each country to balance its own budget, much as the various states of the United States must do. It would be a difficult thing to do, but it could be done.
However, mutualization would very likely make the euro weaker, possibly much weaker. And of course, Germany would have to go along with the mutualization of debt. Why would they do this? Because 40% of their GDP derives from exports, half of which are sold to their fellow European Union members.
The second possible outcome is that there will be no agreement on how to deal with the debt, and the European Union currency region will sunder and its various countries go back to managing their own currencies. Those new currencies would likely be much weaker against the reinstituted German mark, thus pummeling German exports. As a side effect, a significant portion of the European Union’s former member states would then find their currencies 30 to 40% lower against the dollar (and some small countries might see a much more significant drop). While that scenario would be good for American tourists (think cheap Italian and Greek holidays), it would not be good for American exporters of all types, including and especially agriculture.
We will talk next week of what you as president might do to strengthen the exporting capability of US corporations – and there is much that could be done on a bipartisan basis – but continuing deterioration of the European situation could lead to an immensely difficult environment for US exporters and would likely trigger a deep recession in the US.
Alternatively, the ECB could continue to monetize Eurozone debt and step it up a notch or two in the wake of an Italian crisis, which is likely to weaken the euro. Such a program might kick the European crisis can down the road a few years, but that debt is going to have to be rationalized sometime. The latest ECB move to create a multitrillion-euro “loan book” – essentially paying European banks 40 basis points to borrow money and then turn around and lend it at very low rates, and presumably even buying negative-rate sovereign debt – could potentially kick the can far enough down the road to bounce it into your second term. It is unclear what the consequences of such a radical ECB action will be, but the experience so far suggests that the strategy might not result in the growth that we would like to see in Europe. How long a low-growth or no-growth continent could maintain political stability without a backlash from voters – especially given the immigrant crisis – is a question that looms like a spectre over the whole EU project .
Regardless how the economic crisis turns out, the migrant crisis will remain. The refugees will not stop coming as long as jihadists threaten their homes. The deal with Turkey is unlikely to solve the problem. Refugees will keep crossing the sea; and with 23 countries having to approve Turkish membership in the EU, it is truly up in the air as to whether such a deal on immigration will actually come about. There is much more potential for instability in a region that is the equivalent of the US in economic importance.
I could say much more about Europe, but I will leave it there.

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