French President Sarkozy allegedly told German Chancellor Merkel that France would leave the Euro if her government didn’t agree to the EU contingency bailout plan. According to a Spanish newspaper, Sarkozy threw a fit worthy of a two year old, slamming his fist on the table, demanding EU solidarity and saying that no European country could be allowed to default. One wonders what would have happened if Frau Merkel had merely responded with a shrug and a jaunty c’est la vie! Would Sarkozy really have just walked away from the Euro - and Germany - when it is the only thing standing between France and its own Greek style day of reckoning? The terrible truth is that the French economy is basically Greece on steroids and they need the Euro a hell of a lot more than the Germans ever have. French debt to GDP isn’t as high as Greece yet but it is well on the way and by the way 58% of it is held by foreigners with 20% coming due this year. One can’t help but wonder if Sarkozy’s tantrum wasn’t more about his own country than the Club Med nations.
I would also note that while Sarkozy seems to have been successful intimidating Frau Merkel, the ”speculators” he wanted to punish are made of sterner stuff and haven’t succumbed to his harsh rhetoric. The Euro bounced briefly on Monday but all that did was give the dreaded speculators a better entry point on the short side. There seems to be considerable skepticism about the alleged independence of the ECB which did a U turn so quickly concerning the purchase of Greek debt that you could almost see the lash marks on Trichet’s backside.
In fact, investors and survivalists everywhere seem to be abandoning paper currencies at an alarming rate. There has been a lot of attention recently on the Euro and its fall against the dollar, but the dollar isn’t exactly roaring either when compared with gold. Stock market investors seem to be reacting to the recent dollar “strength” as if it is the same type of strength evident in the middle of the financial crisis but there are significant differences. Back then the dollar was rising against everything, gold included. Also back then, the TIPS market showed an actual expectation of outright CPI deflation. This time, the dollar is rising against the Euro but gold is setting new nominal records and CPI inflation expectations according to the TIPS market haven’t changed appreciably. So, if you are worried that the “rising” dollar is an indication that conditions are deteriorating as they did in the Fall of 2008, stop worrying about that and worry instead about the fact that a lot of people seem to prefer gold money to any of the Monopoly like paper versions, US greenbacks included.
The EU bailout announced last weekend will not fix what ails Europe but it could buy them some time if they start to address their long term structural problems. Based on the Greek riots that erupted after the government enacted the bailout required austerity measures, I would suggest that the other governments of Europe take this opportunity to devise pro growth ways to address their budget issues while they still have the chance. The good news is that European taxes are so high and the regulatory structure so complex that there are myriad ways to attack both the budget deficits and the lack of growth. If nothing else is learned from Greece let it be that putting off reform is the moral equivalent of inciting a riot. The blood of the three bank employees who died in the Greek rioting stains not the hands of the protestors but of the Greek politicians who convinced the public that there was such a thing as a free lunch.
The short term economic implications of the recent Euro turmoil don’t seem so dire as to warrant all the recent volatility. The US economic recovery is unlikely to change course because of what is happening in southern Europe. As for the rest of the EU, I am hard pressed to determine whether the Greek influenced devaluation of the Euro is good or bad for the likes of Germany. The list of economists who believed that the Euro was not overvalued prior to the recent pullback was so short as to number exactly one by my count. Martin Feldstein, in one of the worst timed economic articles of recent memory, wrote in March of this year that the Euro was in fact not overvalued and would soon be heading back to the $1.60 level last seen in 2008. He might still be right I suppose but it isn’t looking good right now. For a far more accurate reading on the relative value of currencies, I always turn to the slightly tongue in cheek Big Mac index from the Economist. The most recent release on March 17th when the Euro traded at roughly $1.37 showed an overvaluation of roughly 30%, a number not inconsistent with what most economists have been saying. So on a purchasing power parity basis (which is the theory on which the index is based), the euro needs to fall to at least parity with the dollar. So why are so many pulling out their hair with the Euro still trading around the $1.25 mark?
The effect on the US economy, assuming the effects are contained to the Mediterranean profligates for now, seems unlikely to be more than a rounding error. Europe as a whole represents 20% of US exports and Greece’s share is tiny at just $2.4 billion. Add in Portugal, Spain and Italy and the yearly total amounts to a staggering 0.2% of US GDP. Even assuming economic disaster in these countries, I don’t see much effect on the US economy. Now obviously, the world economy is highly integrated and the lower Euro is bound to have some effect on world trade but I find it hard to believe this is what I should be worried about right now. Frankly, there are bigger issues around the world right now that have much greater potential to effect the world economy. The UK, due to its position as a financial center, worries me a lot more than the rest of the EU. China and Australia attempting to cool overheated property markets worries me greatly. The history of governments attempting to gently ease the air out of a bubble is marked by consistent failure to accomplish the task without knock on effects.
The US economic recovery, as measured by the continuous flow of government economic statistics, continues to impress. The death of the US consumer, like the effect of the Euro devaluation, has been greatly exaggerated - at least up to now. I have heard a lot of stories about how delinquent mortgage squatters are the only thing holding up consumption but like Barry Ritholz, I don’t find the evidence that convincing. Until proven otherwise, consumption is what it is and I’ll take it at face value. Of more concern to me on that front is that consumption, at least to some degree, is being driven by a falling savings rate which reminds me a lot of what happened after the last recession. Wholesalers don’t seem too sure of the rise in sales either and while inventories have risen, sales have risen faster and the inventory to sales ratio at the wholesale level is at an all time low. That bodes well for increased production and inventories continuing to add to GDP over the next quarter at least. We are also starting to see the beginnings of a capital investment cycle by corporations which happen to be sitting on records amounts of cash right now. How they use that cash could have a big impact on the US economy.
The one area that concerns me the most is the same one that has concerned me for most of the last year - jobs. We’ve seen some preliminary job growth now and if you believe the household survey, over 1.5 million jobs have been created just since the turn of the new year. On the other hand, new jobless claims are still over 400k per week and I have a hard time believing that we can get consistent job growth with that level of claims. I guess it is possible that this recession will require more churn than normal before we get to some kind of new equilibrium but that has never been true in the past. Is it different this time? I break out in a cold sweat every time I hear those words so I’m going to assume not and hope the jobless claims soon show a big drop.
As for the markets, I remain cautious on stocks as there is still enormous uncertainty over the course of economic policy in the next year. The mid term elections would seem to have greater bearing on future policy than usual and so the course of the polls may be as important to the market as the economic data. One thing that doesn’t seem uncertain is that the world’s central banks will maintain only mild restraint on monetary policy. That is most likely a positive for real assets although gold might be a bit overextended here. Signs of excessively optimistic yield hunting are already showing up in assets such as commercial real estate so the run to the real is already in high gear. Until the world’s central banks are finally forced to tighten policy - which probably won’t be soon- that seems likely to continue.
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