The European problem

Europe is having a problem right now. In truth, it is many problems more than a single problem. Countries in the former Soviet bloc are in a deep downturn which has been significantly worsened by turmoil in currency markets. Western European banks are hemorrhaging losses – some will probably be nationalized. Spain, the U.K. and Ireland have all seen massive property bubbles implode. Greece, Ireland, Spain, Portugal and Italy have all seen credit warnings and downgrades. And Ukraine, Hungary and Latvia are but three nations that have been forced into the arms of the International Monetary Fund for a bailout. Clearly, the credit crisis has moved to Europe in a massive way.

In my view, this was always inevitable given the available evidence after the panic in September. I have written a number of posts on this very issue:

Anyone who tells you this crisis came out of the blue is lying or ignorant. Yet, policy makers have largely had their heads buried in the sand. The Germans, in particular, took a very hard line. But, now that the German economy is in taters, they have come ’round. The question is: will the crisis in Europe lead to a catastrophic outcome? My answer is no, despite the challenges.

The Swiss I will explain why I see a deep downturn but no catastrophic outcome using the case of Switzerland as an example. Just two days ago, I profiled a somewhat sensationalistic analysis of the situation in Switzerland from the Swiss daily Tagesanzeiger. This post received a lot of traffic because it highlighted the severity of the problems besetting Europe if the Swiss were being considered a potential Iceland.

Once upon a time, Switzerland, as banking mecca and the fifth wealthiest country in the world, was considered the paragon of stability and prudence. The Swiss franc was backed by gold and had importance far beyond the Swiss economy’s size. Switzerland is home to some of the world’s largest companies in a wide range of industries from pharmaceuticals to banking to consumer products.

But, during the great moderation, the Swiss lost their way. They Swiss National Bank lowered interest rates to extremely low — dare I say it, Japanese — levels. The SNB starting selling their gold at depressed prices. And Swiss banks, known the world over for safety, secrecy and security, started to muscle their way into the globalized financial arena of investment banking and trading. The result has been a dangerous increase in Swiss franc credit abroad and a similarly dangerous increase in the balance sheets and leverage of the two remaining large Swiss banks, Credit Suisse and UBS.

This presents a problem in a world of deleveraging and asset deflation because the Swiss are a small nation of 7 million without the protection of the European Union or the Euro to fall back on. This makes them vulnerable. Hence the doomsday pronouncement from Artur Schmidt about Swiss bankruptcy.

I do not believe the Swiss will go bankrupt simply because they are too wealthy, too interconnected and too important to fail. No one wants a run on the franc. No one want a collapse of Swiss banks. As a result, policy makers will address the Swiss problem and work out a solution.

Nevertheless, the lack of specifics in the previous paragraph should give one great pause. I am merely making a reasonable conjecture. I am not saying that the problems with writedowns, bad loans and deleveraging are going to go away. They may in fact become much greater because of Switzerland’s interconnectedness with the rest of Europe. Which brings us back to the broader question of Europe’s many problems.

I would break the Europe down into four distinct spheres: The Eurozone, the non-Eurozone West (like the UK, Sweden and Denmark), the EU East (like Poland, Hungary and Latvia) and the non-EU East (like Ukraine and Croatia). The problems and potential outcomes in each of these regions is different. The crux of the matter is the Impossible Trinity of a fixed exchange rate, independent monetary policy and free movement of capital. You can have two, but you cannot have all three.

Paul Krugman says it best in an article from 1999:

The point is that you can’t have it all: A country must pick two out of three. It can fix its exchange rate without emasculating its central bank, but only by maintaining controls on capital flows (like China today); it can leave capital movement free but retain monetary autonomy, but only by letting the exchange rate fluctuate (like Britain–or Canada); or it can choose to leave capital free and stabilize the currency, but only by abandoning any ability to adjust interest rates to fight inflation or recession (like Argentina today, or for that matter most of Europe).

The Eurozone The Eurozone members have decided to forgo independent monetary policies. Individual member nations have free capital movement and a fixed exchange rate but zero control over monetary policy. That rests with the European Central Bank ECB) in Brussels.

The problems mount in recession. Some members are getting devastated. Spain, for instance is in depression already with unemployment at 14%. Ireland’s national budget is imploding with estimates for deficit reaching 10-12% of GDP. If you are Spain or Greece, you would like to print money– a lot of it. But that’s not happening in the Eurozone. The result is a potential national bankruptcy for the likes of Ireland, one reason their credit rating is suffering.

Will Ireland go bankrupt?  Perhaps.  It is unclear how willing other Eurozone members would be to support he country were it to run into that kind of difficulty.  The Germans are furious for having abandoned the Deutsche Mark for the Euro, which they see as a ‘weak’ currency.  Bailing out a Eurozone member would come with many strings attached.

Then, there is the case of Austria.  They too are in the Eurozone.  They have a weak banking system because of excessive lending to Eastern Europe — reaching a full 85% of Austrian GDP.  (Whether the Austrians were mentally re-creating their lost Empire, stripped after World War I, is a case for the Austrian psychologist Freud). If the Eastern Europeans run into problems, Austrian banks will fail en masse, requiring help from other Eurozone members (read France and Germany).

EU East

This brings us to EU East.  And by that I mean members of the European Union nations east of the Eurozone, which stops at Germany, Austria and Italy (Slovakia is also a Eurozone member as of Jan. 1st).  Countries in this region have seen fantastic growth rates over the past decade.  But, also a huge increase in debt, asset prices and current account deficits.  All of this points to excess.  The problem, of course, is the Impossible Trinity.  These countries want stable exchange rates, monetary policy control and free movement of capital.  But, with the excesses already highlighted, the first to go in this trio was always going to be the exchange rate.

Now, EU East loaded up to the nines with debt in Swiss francs, Euros and U.S. Dollars.  Companies, Individuals, even hospitals have huge foreign currency debt exposure (see my post “Reverse carry trade borrowing is deadly” from October).  A reader from Poland said it well:

Situation in Poland: 2008.07 – 1CHF = 2.0PLN – you can go to ANY bank and take a loan for 120% value of you new flat/apartment. i live in Warsaw, lot of my friends took that loan. unemployment rate – 10% but in Warsaw was close to 0% especially if you have a master degree and skills to work in office such as advertising agency or as financial advisor or similar type of job.

Now – you cannot take a loan or rent a money from bank. one square meter is down close to 25% from 2008.07. franc is up – 1CHF = 3.3PLN within my friends unemployment rate is close to 20%. banks are full of CHF loans, even if you sell the apartment you have close to half of the money you borrowed. did i mentioned that the loans we’ve given in rates even for 50 years?

Events in Poland are mirrored throughout the region. Obviously, if Austria, Ireland and Switzerland are having problems, you can imagine it is much worse in Poland, Latvia and Hungary. Hungary and Latvia have already asked for and received IMF assistance. I expect we will see a similar turn in Poland, Estonia and elsewhere. Moreover, these nations are part of the European Union. The possibility still exists that they could receive increased transfer payments in order to mitigate the worst of things. However, the Germans would be even less willing here, I suspect, not to mention countries like Britain and Sweden, which have their own worries.

Non-EU East Then there are those countries east of the Eurozone that do not have a rich uncle. We are talking about places like Serbia, Croatia, and Ukraine. Ukraine looks to be imploding. Other countries will surely see a severe contraction in GDP. The Impossible Trinity asserts itself here again as it did for the EU East. The biggest difference for these countries is they are outside the European Union. This means countries like Ukraine will go bankrupt, no ifs ands or buts. What this means for stability in the region is unclear given the strategic importance of Ukraine as an energy transit route. If Ukraine implodes, knock-on effects for the likes of Belarus will be severe. Russia is a whole different ball of wax that I am not considering. But, again, for much of non-EU East, the problem is foreign currency loans.

Floaters And that brings us full circle back to Switzerland. The Swiss are not a member of the Eurozone. They are not even a member of the EU. Like Norway (and Iceland, for that matter), the Swiss are on their own. This has benefits. The Impossible Trinity is a non-sequitur. One can print money and devalue at the heart’s content. The Brits have shown us the power of devaluing a currency from 2.11 per U.S. Dollar to 1.43 per U.S. Dollar. Surely, the Swiss can do the same. In fact, in the case of the Swiss, devaluation would mean that their debtors will be able to repay their loans more easily. I fully expect the Swiss National Bank understands this and is prepared to crank up the presses if they have not begun to do so already.

However, in the end, printing money is not much of a solution to what ails Europe. Banks are undercapitalized and some countries are overly indebted. This speaks to bankruptcy for individuals, companies, banks, and, yes, nations.

My advice on remedies is fourfold:

  1. Consolidate the financial services sector through merger, bankruptcy and nationalization
  2. Recapitalize banks full-stop.  Whether this is done with public or private monies is secondary
  3. Increase intra-EU transfer payments.  The European Union and the Eurozone are supposed to be analogous to the United States.  Call it the United States of Europe, if you will.  But, this analogy is false because Europe is much more heterogeneous than the United States.  There is an insufficient movement of private capital and people as an automatic stabilizer.  Translation:  European people and money stay put, American money an people do not.  In recession, you want movement because it evens out the rough spots.  In the absence of movement in the private sector, the public sector will have to step in.
  4. Capital controls.  The whole European mess is a result of an asset and credit bubble that failed to understand the importance of incompatibilities between stable exchange rates, free capital movement and independent monetary policy.  If you eliminate free capital movement, as Willem Buiter suggests, Europe would stand a chance of weathering the storm.

None of my ‘remedies’ is pain-free and there is considerable ideological resistance to the last remedy of capital controls.  But, Europe is in a bit of a pickle.  If politicians do not take on this challenge with both hands, much worse is to be expected.

Sources O Canada – Paul Krugman, Slate

Related Reading:

Soul Currency: Investing Your Inner Wealth for Fulfillment and Abundance
A Fistful of Rubles: The Rise and Fall of the Russian Banking System
The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means.(Further Reading)(Book review): An article from: Journal of International Affairs
Judenrat: The Jewish Councils in Eastern Europe under Nazi Occupation
From Your Wallets to Their Pockets: Understanding the Credit Crisis: Privatizing Profits and Socializing Losses

Related posts The case against the Euro Switzerland threatened with bankruptcy Denmark wants in on the Euro Greece sees credit rating cut by S&P European banking collapse including nationalisation of three banks


Originally published at Credit Writedowns and reproduced here with the author’s permission.

6 Responses to "The European problem"

  1. LFM   February 19, 2009 at 4:57 pm

    Spain can have an unemplyment problem, granted, but its public debt at less than 40% is significantly lower than in Germany, the UK, Belgium or France. Besides, no spanish bank has been up to now nationalised or bailed out, contrary to what is happening in Germany, the UK, Belgium, Sweden, The Netherlands…or the US.

  2. Guest   February 20, 2009 at 11:04 am

    The European Central Bank (ECB) in Brussels ….??? Ehm … the ECB was still located in Frankfurt when I last looked :-)

  3. PAUL94611   February 21, 2009 at 4:02 am

    Yes. Yes. Of course. And the collapse of Lehman was not a catastrophe. It was a simple corporate bankruptcy.Any given situation is governed by the way in which an observer interprets the data and measures that interpretation against their self interest, be it an individual, corporation or state. I dare say that many of those in the cross hairs of the disintegrating situation in the four zones of Europe, as you define them and the interested parties outside of the zones of interest may well fail to “take on this challenge with both hands” in the manner you and others are suggesting. What I believe we may well be in for is a protracted era of fixing the blame rather than fixing the problems. Especially since this process gathers the power of popular discontent as we are witnessing in Iceland and Latvia.Challenging times indeed.

  4. francisco   February 21, 2009 at 9:10 pm

    “The Germans are furious for having abandoned the Deutsche Mark for the Euro, which they see as a ‘weak’ currency.”this sentence is absolute rubbish. it is simply not true. Germans do not want the deutsche mark back. on the contrary. I do not read in any german newspapers that idea. on the contrary. germans are very much interested in a single currency and no one in any euro contry wants to get back to national currencies.this is cleary written by someone who throws things in the air, just like that, with no solid fundament.I live in germany, and i know germany profoundly well.you are wrong here.

  5. Guest   February 23, 2009 at 12:53 pm

    I live in Switzerland, the person who writes this drival should be sued.Switzerland is one of only two countries in the World with a current account surplus (i.e Norway and Switzerland) and the only currency backed up by the same value in gold.The page above is complete kindergarden drival.., as Warren Buffet once said, when the tide goes out, you can see who has been swimming naked… this also applies to certain countries (i.e the UK and US).PS: Besides controlling banks there should be some control over the rubbish espoused by these blog writing idiots. What the hell is RGE anyway?

  6. Anonymous   March 12, 2009 at 7:03 pm

    CHF is not backed by gold anymore