Black Swans in Camo: Continued Concern about the European Community

by Dechert LLP

photo of Rick JonesI have written periodically in this Blog about my persistent concerns about the European economy and its capacity to negatively impact ours. I get wound up, then I get swayed by the majority views of the chattering class who gently explain I’m indulging in alarmist adolescent flights of fancy and I should leave the big issues to the smart people, e.g., the overwhelmingly Europhile policy glitterati.

The worry always comes back, though, as it did last week while listening to the comments of both David Malpass at the CREFC Investor’s Conference in Miami and panelists on Jeff Fastov’s terrific panel “Why Do I Want to Go to Europe?”

I’m not indulging in some weird post Victorian form of neuralgia or the vapors. We should be concerned. The problems of the European fiscal and monetary systems have not abated. We just have stopped looking hard enough; we get distracted. Black Swans in Camo can sometimes be hard to see.

Look, the problems of the European community are fundamentally simple but, unfortunately, fairly intractable and severe. The reality is masked by noise, surficial complexity, and static from the 24 hour news cycle. Strip all that away and here’s what we’ve got: a majority of EC member states have economics that cannot support the goodies the populace not only want but has come to see as entitlements (Washington, you listening?).

When you look through the fog of chatter by governments, EC officials and the aforementioned Europhile glitterati, the fundamental structure of reality looks like this:

• Europeans are used to a high level of government transfer payments to fund pretty good lives for almost everyone. Generations have come to feel insulated from the economic risk of a faltering economy.

• Sheer demographics started to shake the foundation of the European system years ago.

• Slowing economies. Even the German economy is slowing; recession is spreading through most of the European community. Most EU countries are suffering an economic slowdown largely because of lack of competitiveness. Germany, while preserving competitiveness, exports a large percentage of its products to Europe. Europe slows; it slows.

• Now virtually unsustainable unemployment levels exist in much of the community. And it’s getting worse. A lot of someones have to get back to work to fund the goodies. As the number of employable people goes down, and governmental constraints continue to drag on employment markets and productivity, the machine simply cannot produce sufficient wealth. As Margaret Thatcher famously said “the problem with democratic socialism is eventually you run out of other people’s money.”

• Very high levels of government debt. Market complacency has been sustained for a time by, in large measure, “incenting” the European banks to buy the debt and soak up the excess supply (Federal Reserve, you listening?) and by promises of unlimited liquidity from the Draghi Put. The ECB is pushing on a string. Liquidity is not creating growth. It is only making it easier to pretend that things are OK for a little while longer. Spain borrows cheaply because Mr. Draghi promises to buy its bonds. What happens if the ECB actually does have to perform? The market will instantly understand this promise always was untenable. One cannot shovel back the tide with a spoon. Pretend time will end.

• There is both popular and intellectual hostility throughout Europe to the price to be paid to enhance competitiveness. The conviction that there is a form of painless economic dynamism that can fund the European entitlement state if the pols just get the laws and regulations right is unshakable. That’s largely because it has worked to date. Subtract unlimited debt growth, and it fails. The notion that the price of less fettered capitalism is more disparate outcomes and less the state can do to mediate the consequences of lack of individual economic success, that there are winners and losers, is anathema to large segments of the polity.

• Social unrest is bubbling at some level in every country where there are actual efforts to scale back the goodies.

• Further austerity, which has come to mean first higher taxes and then reduced governmental expenditures, is not likely to fix the problem. All the pain, but little gain.

The bottom line is that the European community cannot afford its goodies. It hasn’t been able to afford them for quite a while. It has been living on a credit card and that card is now just about at its limit. Fiscal, economic, social and maybe even political change cannot long be avoided on the road they are treading. I understand the conviction of much of the commentariat that European governments will be able to somehow walk the situation back down the tightrope stretched over the chasm of economic chaos to something sustainable, to a market where sufficient growth can be squeezed out of the system to provide enough government revenues to cover expenses. That conviction informs the enthusiasm for the current ECB liquidity bubble. Just keep the wolves at bay for a little longer and all will be well. They are going to fall off the tight rope. Social unrest is already forcing the politicians in Spain, Italy, Portugal and France to renege on efforts to scale back the entitlement state, loosen employment markets and encourage dynamic economic growth.

The Hail Mary choice for government’s wobbling on that tightrope is to reacquire control over monetary policy. If the ECB cannot provide it, the unwinding will begin. It’s not just Greece, I don’t see how Spain, Ireland even France avoids the need to devalue their currencies. It cannot be long before many European countries join the race to the bottom already underway around the globe. Maybe that won’t even be enough, but it’s got to be part of the endgame. In any event, it will be messy, it will hurt world economic growth, it will hurt us, and it won’t be good. We can ignore it for a bit, let the eye be tricked by this black swan in camo. But we should not pretend we’ll not eventually have to deal with more trouble in Europe.


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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