Got a Problem? Easy, Blame Free Trade
It is not an understatement to say that Europe is an economic mess. It might be surprising, however, to mention that one of the most dysfunctional national pieces inside the patchwork currency noose of the euro is France. In the past twelve months, the French government has been "forced" to rescue Dexia, a major Belgian/French financier of municipalities, and Caisse C'ale du Credit Immobilier de France, a systemically important housing finance concern. Total French government involvement in those two non-traditional banks is a bit more than €50 billion.
The off-balance sheet arrangements of the French national government are going to grow again after news this week that Banque PSA Finance is being offered €7 billion in state guarantees on PSA's debt. This non-bank bank is the financing subsidiary of Europe's #2 carmaker, PSA Peugeot Citroen SA. Off-balance sheet treatment is considered appropriate here because the national government's involvement is limited to guaranteeing debt, thus not a direct bailout.
The complication, and what might arouse EU regulators, is that the French government is not simply handing over its "good" credit profile. In return for this non-bailout bailout, the government expects greater corporate leadership involvement and placement for government officials and, of course, union leaders. Money that isn't money does not come cheap for struggling companies.
Objecting to this non-bailout of the non-bank is Peugeot's larger competitor, Europe's #1, Volkswagen AG. According to Reuters, one of Volkswagen's largest shareholders, the German state of Lower Saxony, has registered public objection to the proposed arrangement as a potential violation of EU competition rules. Peugeot's options are fairly limited as it has seen business fall off a cliff in both the periphery and core of Europe, but it has also sought out strategic partnerships with such illustrious carmakers as General Motors and one of its largest shareholders, the US federal government.
The problem with Banque PSA is not losses on loans to car buyers, the non-bank has remained consistently profitable, but its financing condition as it relates to its parent Peugeot. The decline in the fortunes of Peugeot has brought with it debt downgrades that directly impact PSA. Both Moody's and Fitch require no more than a two notch difference between the parent and the financing subsidiary. Therefore, at best, PSA is stuck with Peugeot's debt as an anchor in its liquidity profile. If Peugeot is downgraded again, as Moody's has indicated, PSA will find itself one notch into speculative grade, otherwise known as junk.
Banque PSA is not without financing options itself, however, though a downgrade into junk would threaten its intermediate-term viability. As an eligible participant in the European bank network funding scheme, it has direct access to the ECB. That central bank liquidity access comes at a relatively steep price - PSA would be required to front a 16% haircut on any eligible collateral, at least as the collateral rules are currently construed (when the going gets tough, count on the ECB to loosen those rules, again). That leaves securitizing auto loans as probably the best financing option for PSA, but that will require a financing bridge to get there; thus the non-bailout off-balance sheet debt guarantee.
The official sector looms over everything here and none of it is enough.
The primary problem is not that PSA is stuck passing along higher financing costs to auto borrowers, though that is being used as the principal excuse for this accounting exercise, it is that Peugeot is simply unable to sell enough cars. As long as PSA is tied to its carmaker parent, their fortunes will remain intertwined. Registrations across both the Peugeot and Citroen brands were down almost 11% in 2011. Third quarter 2012 sales are down another 3.9%, and Peugeot's stock is down 45% year-to-date.
The ECB's answer, indeed the answer of mainstream economics, is to buy Spanish bonds on the open market? In all seriousness, this case perhaps demonstrates just how far afield monetary economics has strayed from what ails the global economy. In this one instance, the preferred monetary tool of increasing credit availability and reducing its related cost actually seems the most appropriate. The fortunes and ability of PSA to provide loans to perspective car buyers directly benefits the real economy through the related financing of car sales at Peugeot. There is no more efficient and direct link between the financial world and the real economy as there is here with PSA and Peugeot.
Yet, there is really little doubt that all of these financial re-arrangements will fall far short of rescuing Peugeot from the abyss of the European car market. The lack of competitive financing may be a marginal nuisance to the carmaker as it tries to compete for business, but that is not what ails the firm. The issue is not even profitability for Peugeot; it is a revenue issue, as in a lack of overall car buyers. The travails of the French automaker are not unique, they are representative of manufacturing and global trade levels in the second half of 2012.
Just yesterday, despite headline pronouncements of a large rebound (due mostly to Boeing), durable goods orders in the United States were less than impressive. That statement is not only valid when viewing the trend that has developed since the early part of the second quarter but also when viewed against year-ago levels. Total durable goods shipments, ex-aircraft, were up only 0.3% over September 2011. New orders were actually down 4.63%. Worse yet, capital goods shipments and new orders were down by 2.1% and 9.99% over September 2011, respectively - a 10% plunge in capital goods orders is not consistent with a healthy market for business investment in productive capacity. Capex, as it is called, is the process of turning successful business into growing and expanding employment, closing the circulation loop of marginal money in the beneficial creation of productive wealth in any economic system.
As bad as those numbers were in the United States, exports for the export-oriented economy of Japan were perhaps an order of magnitude worse. Year-over-year, total export shipments fell by 10.3%! Included in that overall figure was a 0.9% increase in exports to the United States (which is not anywhere close to a robust figure for a yearly rate of change), a 14.1% drop in shipments to China, and an absolutely astounding 21.1% collapse in exports to the European Union.
In response, Bank of Japan Governor Masaaki Shirakawa indicated his desire to conduct "seamless" monetary easing. Given that a significant proportion of the decline in exports, particularly to Europe, has a currency component (the yen has strengthened about 14% against the euro since April 2011), I'm not sure that "seamless" and monetary interventions belong in the same thought, let alone policy goal.
This is the age of global free trade.
In the years since the adoption of NAFTA on January 1, 1994, the benefits of global free trade were supposed to have been easily apparent to all parties involved. Ross Perot famously and comically warned in the 1992 presidential debates that there would be a "giant sucking sound" as US jobs relocated to Mexico. He was only partially prescient. It took 17 years, but, beginning in 2009, Mexico now produces more cars than Canada.
Ford Motor, acting on the same lack of demand as Peugeot, has announced deep production cuts in Europe. The company has already slated the eventual closing of a plant in Genk, Belgium, and more immediate closures of plants in Southampton and Dagenham, UK. Ford expects to reduce supply in Europe by 18% as a result of these moves.
At Ford's Hermossillo plant in Mexico (opened in 1986), however, the company announced in April its intentions for a $1.3 billion upgrade. It is expected that this capital expenditure will increase the number of workers from 2,700 to 3,700 as it focuses on increasing production of the Ford Fusion and the Lincoln MKZ.
The proximity to the United States is not the only selling point for Mexico. An increasing appetite and ability to purchase more expensive automobiles is coming from countries like Brazil. But far and away the biggest draw is the estimated $5 to $6 an hour labor costs - the very sucking sound clumsily elucidated by Mr. Perot two decades ago.
In the race to "seamlessly" devalue currencies against each other, as even Fed Chair Ben Bernanke implicitly asserted a few weeks back, the central banks of the developed world are missing both their real targets and the central problem. Mexico cares little if the euro devalues against the yen or dollar. Neither does Vietnam, Indonesia, Taiwan or even China. Japanese, American, Canadian and especially French workers cannot compete against $5/hour.
In every respect, they were never supposed to. Global trade was supposed to be a rising tide that lifted all boats all over the world, not a zero sum game of competing for manufacturing scraps. The wealth and relative affluence of the "developed" world was supposed to filter its way into the emerging economies of Asia and Latin America (though Africa is never mentioned) through the beneficial arrangements of free trade. Instead, labor forces in each of the developed economies found themselves in direct competition with incomparable pay scales of those emerging nations.
The laws of comparative advantage, first proposed by David Ricardo in the early 19th century, should have applied in these instances. But trade actually means TRADE, as in the mutual exchange of goods or even services - it takes two sides to trade. In trading and adopting free trade with these low pay scale nations, what goods can we sell back to them that they can actually afford? The prime economic problem with China is not so much that they peg their currency to the dollar, thus giving them a labor cost advantage, it is that we have no equivalently priced and sized market to return the trade advantages.
Instead, the financial flow of money in these "free trade" arrangements inevitably ends up in the official sector at various central banks. "Capital" (an inappropriate term for this flow process) that accumulates as official reserves at foreign central banks is essentially dead capital. In the trade arrangements that Ricardo foresaw, capital amounted to the efficient arrangement of production factors, independent of national boundaries, that allowed an economic system to be more productive across the whole. A more productive system is one that advances the cause of human civilization and the overall standard of living.
The intrusion of central bank reserves and the political impulses of constant government interventions surreptitiously erodes that productivity factor. In the two decades since NAFTA, foreign reserve accumulations have been returned to the United States not as reciprocated trade, but as financial economy purchases of financial instruments, particularly US government and agency bond instruments. The same has largely been true of Europe, but especially in the constraining age of the euro. Comparative production advantages locked into Germany's abandonment of the D-mark were returned as current account surpluses. That current account imbalance has only become exponentially worse since 2009.
What the post-2008 world laid bare was the hollowness of the free global trade promises. As low cost countries increasingly "won" the labor competition for jobs and production facilities (true wealth), global central banks supplemented lost wages with "stimulative" monetary policies that significantly undercut the true price of financial risk. As wage income in the US stagnated, the US economy moved forward under the cover of debt-fueled consumer spending and asset bubbles. In that respect, the US was not all that much different than Greece or Spain.
This is not what Ricardo had in mind.
A natural price of financial risk would not have led to such a sustained imbalance. Had interest rates been allowed to normalize to the unilateral trade environment and the domestic suppression of wages, foreign "capital" flows would have been oriented toward high-return productive investments. The artificial suppression of risk spreads, in addition to the regulatory favor given to sovereign debt, de-emphasized the real economy returns that should have led to close the virtuous trade circle. Given a low spread between a "risk-free" US agency bond and a much more risky potential investment in corporate debt that might be used for capex-type expansion of productive facilities or developing new technology, there is little wonder foreign "capital" reserves favored the official debt sector (the political class was only too happy to oblige this favoritism).
The net result of bastardized free trade is what we face today - jobs that were increasingly oriented to the financial economy and government. Employment follows the marginal flow of "capital", even when that capital ends up as the opposite of what capital is supposed to be. In the US, "free trade" became one of the direct pipelines into the growth and abuse of the mortgage market. Free trade in this context has been synonymous with the domination of finance over these various economies.
The failure of finance after 2008, then, exposed the lack of wage income necessary to keep the whole closed system afloat. Without the financial flow supplementation, systemic wage levels are unequal to the economic challenge. What was promised as an age of free trade prosperity morphed into illusory wealth on a scale never imagined. Finally freed from that illusion, we now have to hope that markets will eventually be allowed to clear imbalances enough to restore an actual growth trajectory based on jobs and wages allocated by market needs, not artificial "capital" favoritism among central bankers. But as the saga of governments and their cumulative automaker fetish demonstrates, systemically important industries are much the same as banks, and therefore untouchable by the hands of market discipline.
Modern free trade rolls on anyway without the promised benefits. As I said, it is now a zero sum game that pits domestic labor forces against each other in direct competition rather than shared, growing efficiency. That is really too bad since trade will end up with a nasty reputation unfitting its true design. Global trade, done freely without political and central bank collusion into the financial sphere, would actually offer one clear, but certainly not seamless, pathway out of this messy malaise.
