European Stocks, Anyone?

By now it has become trite to point out that the Chinese word for crisis is written by combining the characters for danger and opportunity.  That this is, in fact, not true doesn’t detract from its usefulness in the service of sophistry.  In that spirit, let’s take a peek at the ongoing crisis in Europe.

The global financial crisis that began in America in 2007 is currently on an extended tour of the European continent, with a focus on the warm, sunny nations along the Mediterranean.  So many pixels have been spilled on this subject that you’ll be forgiven if your eyes start glazing over.  We’ve all read ad nauseam how the profligate and aptly named PIGS (Portugal, Italy, Greece and Spain) brought this upon themselves through poor fiscal management and, in some cases, by outright cooking of the books.  Meanwhile, according to this story, the heroic Germans, after doing the right thing and keeping their own house in order all these years, are being blackmailed into bearing the cost of bailing out their lazy southern neighbors.  We’re told that the alternative is the end of the euro and, therefore, financial Armageddon.

This conventional narrative has it backwards.  In other words, the prospective break up of the euro is less of a danger and more of an opportunity.  Rather than viewing the European status quo ante as some sort of ideal economic equilibrium that was rudely disturbed by the US financial crisis, which spread like a malignant tumor to Europe and beyond, let’s recognize that the euro itself is the underlying cause of the disease.

Remember that the euro was always a political project.  That is to say, its creation was the culmination of decades of political integration with the objective of binding Germany to its neighbors and preventing another catastrophic war.  Although this integration has manifested itself in large part via the establishment of economic institutions such as the EEC (European Economic Community, later renamed simply the European Community, or EC), economic factors have always necessarily taken a back seat to this goal.  And the fact is that despite the inarguable progress made by Europe in terms of liberalizing trade and capital flows, the continent has never been an optimal currency area.  Unlike the United States, for example, the nation states of Europe don’t share a common fiscal policy and, in practice, workers enjoy relatively limited labor mobility from one country to another.  Thus two essential mechanisms for smoothing economic adjustment across the eurozone are absent, thereby forcing adjustment onto labor and markets for non-tradables to such an extent that political upheaval is the inevitable result.

The adoption of the euro led investors to change their behavior in ways that increased risk in the system, in the mistaken belief that currency risk had been eliminated.  The word convergence, as in the convergence of sovereign interest rates, was thrown around a lot in those heady days.  The most obvious example was the collapse in Greek sovereign borrowing costs following its entry into the eurozone, and the massive cross-border purchases of Greek sovereign debt.  Combined with the hyperleveraged nature of the European banking system, this created the recipe for an eventual crisis.

With this background in mind we can start to view the impending break up of the euro from a more optimistic perspective.  The euro imposes a rigidity on markets that forces an economically painful and politically impractical reduction of domestic wages and prices.  Removing this constraint would act as a safety valve, allowing movements in exchange rates to perform some of the required adjustment.  This occurs in two ways.  First, it permits an immediate improvement in the external balance, forcing foreigners to absorb some of the economic pain.  And second, it facilitates the reintroduction of a mix of fiscal and monetary policies that is appropriate for a country’s particular economic circumstances.  This is just a roundabout way of saying that it allows a government to use inflation to pay part of its bills.  This may sound cynical, and to some hard money advocates even unethical, but given current debt loads and ongoing fiscal deficits in a number of developed countries, there’s really no practical alternative to this.

Naturally there will be risks in the wake of such a shock.  Defenders of the euro argue that the dismantling of the common currency would unleash financial chaos and impose enormous costs on banking systems across Europe.  Contagion would be impossible to contain.  To these people I simply say, “Look around.”  We’ve already had chaos for at least two years.  Neither banks nor sovereigns are able to fund themselves via markets at acceptable terms in a number of countries.  There’s been a slow but steady ongoing run on bank deposits.  And as for the potential costs of writing down banks’ holdings of peripheral country debt, I would argue that these losses have already been born and we’re now just waiting to see whether they’re ultimately recognized in the form of default, devaluation or some combination of the two.  Banks all over Europe will need to be recapitalized regardless of whether Greece and/or other peripheral countries continue to use the euro.  You can’t squeeze blood from a stone, and debts that can’t be repaid won’t be, no matter what you call the unit of account.  The redenomination of contracts is likely to be a trivial problem when compared to the prospect of suffering many more years of grinding deflation.

What are stock markets in the eurozone telling us?  Well, the euro has also taken its toll on equity prices.  With the notable exception of Germany, which has of course been the primary beneficiary of the common currency, most markets across the region are trading at levels seen 15 years ago and at PE ratios of 9x or below.  These valuations are comparable to those seen at the start of the great bull market that began in 1982.  Stock prices in Greece are down 90% from their highs and are at more than 20 year lows.  Spanish stocks are down nearly 60% from bull market highs.  Italy is down more than 70%.  Even France is off 55%.  Thanks in large part to the euro, European stocks have been mired in a severe bear market for a number of years.

According to the politically incorrect narrative to which I subscribe, the euro is a straight jacket, the removal of which provides hope of recovery within a reasonable time frame.  Countries on the periphery of Europe have the choice between devaluation followed by some short-term pain, then eventually by recovery; or a cycle of perpetual deflation, fiscal retrenchment and political crisis.  Stock markets across the region have priced in the danger of this latter outcome, and therein lies the opportunity.