‘TWO VIEWS ON THE EURO & THE PAIN IN SPAIN,’ from John Maudlin’s Frontline Newsletter.

In Uncategorized on February 20, 2010 at 23:04

Two Views on the Euro

My good friends David Kotok and Dennis Gartman illustrate the two sides of the euro debate. Dennis has long been a euro skeptic, and of late has been especially forceful as he writes about the problems of the euro. David runs around with serious international thought shapers in Europe. David wrote a letter to Dennis this week, and Dennis responded. I am taking the liberty of reprinting part of that conversation, as it sets up the discussion we will have nicely.


Most of the time you and I are simpatico in view. But this time we are on totally opposite sides. You predict the EUR is toast. I think it emerges from this stronger than ever and that the weaker system is now the deficit-ridden US. I have organized and chaired conferences and seminars in Europe for the last decade as program chair of the GIC, The next one is in June in Paris and Prague, to which I am inviting you with this email.

In the course of this decade those meetings have ranged in location from south (Italy) to Baltic (Estonia) to west (Ireland). All of these meetings were multinational. None of them had language or cultural barriers. All of these various hosts were gracious and hospitable and welcoming. All of them had goodwill among nationals of the various European countries. None of them had internal antagonism.

Come with me in June and see this with your own eyes. Europe wants a hard currency and better economics and knows how to get it. The Greeks will end up better off and the politics will force it.

I am a euro bull. All the best. By the way, I still want you to come fishing with me.

David [Kotok]

Dennis answered.


I’m writing from Calgary this morning. Nice town, and not all that cold. Nice people out here in Canada’s west. I always feel better about the world when I get to the Canadian west.

We do indeed disagree on the EUR, David, and I hope you are right, but I fear you are wrong. These cultural differences are simply too great to be overcome. I have always been a EUR skeptic, and have been surprised that the whole experiment has lasted this long, but the Germans are not going to allow any of their money to be shipped to Athens to defend Greeks who have no pride in their own country [and are] tax-paying scofflaws. The German’s felt put-upon by the rest of Europe when they paid for the cost of reunification entirely, and they have no intention of now paying for Greeks who thumb their noses at law and fiscal responsibility.

Right now, the market’s sayin’ I’m right, and for now I’m going to press the issue until the market tells me I’m wrong, David. It’s all I know to do. Expecting Papandreaou to change his fiscal spots is simply not wise. He has been a profligate all his life; so too his father. It is genetic and it aint’ gona’ change.

Be well, my friend. We can disagree and still be impressed by one another’s work. I know I am.

Dennis Gartman

Who’s right? In an odd way, both of them.

Let’s look at what I think is the difference between my two friends. If you read European papers and briefings by serious economists and euro politicians, the idea of the eurozone breaking up is simply unthinkable to them. So much time and effort was put into creating the euro to begin with that there is a lot of vested interest in keeping it. (And by the way, let me be clear that the world is better off with a viable euro.) When David goes to Europe, as he often does, he meets with the top tier of business, investment banking, and central banking circles. And they assure him they will figure this out. These are the thought leaders who brought the euro together in the first place.

Dennis listens to the trading floors and people in the streets. He was a man born in the trading pits. He rightly looks at the politics of Greece and Germany and says that is a “dog that won’t hunt.”

In the short term, a Greek default will put significant pressure on the European banking system and through that the euro. But it is not the end of the world for the euro. Ultimately, in the grand scheme of things, the value of the euro, within limits, is not significant. If it falls to dollar parity there are winners and losers, of course. European exporters will be delighted. So will be their farmers. If you are a consumer buying goods outside the eurozone, you will not be as happy.

But the valuation of the euro is not in and of itself a reason for the euro to disappear. At one time it was $.82. Then over $1.60. All currencies fluctuate, some more than others. What destroys them is political malfeasance.

What would put the euro at risk of a bad political decision?  A Greek bailout without serious conditions would be the one thing that could be a very bad start to a downward spiral. If Greece is bailed out, then why not Portugal or Spain or Ireland? What about the emergency room crisis that is Austrian banks?

The line has to be drawn, and it has to be a hard line. And basically, what David is saying is that the serious leaders with whom he is in contact get it. But it is not certain how things will play out. Will Greek politicians and unions blink when faced with reality? Polls show that a majority of Greeks now favor making serious budget cuts. And the reality is that they will lose access to the credit markets if they do not make major spending cuts and get some kind of pan-European guarantee for their new debt. Losing access to the credit markets will mean even more (and immediate!) drastic cuts.

The real choice for the Greeks is whether to stay in the monetary union. Of course, leaving and defaulting on their debt also cuts them off from the credit markets. It is a sad reality they face.

The Pain in Spain

That of course brings us to the elephant in the room – Spain. While the eurozone can survive a Greek default or a serious Greek depression, Spain is another story. Spain is a very large country whose deficits, if not brought under control, could in fact tank the euro.

Spanish leaders have been all over Europe, loudly proclaiming that they are not Greece. However, their current fiscal deficit is in the same league (9%), and they have other problems. And just as Dennis and David disagree, this week I had two reports on Spain hit my inbox the same day, from two of the groups I respect the most. And they do not agree abut the future of Spanish debt.

The first was from the European team of the Bank Credit Analyst. I have been reading BCA for decades, and they have a real knack for being right. I pay attention when they write something. They are a serious research firm, and consult with the biggest firms in the world. It is not an exaggeration to say the central bankers pay attention to them.

And they think Spain is going to work out. Let’s look at a few paragraphs from their latest report:

“Listen to the current market commentary and you might be forgiven for thinking that history is repeating itself. We don’t want to minimize the country’s woes. Unemployment has after all just breached the psychologically brutal level of 4 million.

“But much of the analysis is backward looking. What the markets fear has already happened. A rerun of the Greek debt crisis is not inevitable, Spanish bonds are cheap relative to Bunds and many of the cyclical imbalances are on the mend. Spain has already undergone 18 months of painful economic adjustment. The current account deficit in relation to GDP has more than halved to 4.6% from its peak in 2008, when in absolute terms it was the second highest in the world after the US.

“The budget shortfall is beginning to roll over, a reduction plan is in place and the public debt-to-GDP ratio is 60%, barely more than half the Greek ratio. Most importantly, the inflation rate has converged with the euro zone average, one of many indicators confirming the decade-long adjustment to membership of the currency club is complete.

“Spain does not fit well into the caricature of a two speed Europe, with the south on a slow, unsustainable growth path. Its demographic profile is far more propitious to economic growth than Germany or France, never mind Greece and Portugal, and its policy makers are in many instances more vehement about the need for financial discipline. After all, it was Spain which recently attempted to get the EC to agree to penalties for countries that did not hit their economic targets, only to be blocked by Germany. If there is to be a euro crisis, it is not going to be Spain that causes it.

“… The shakeout in the labor market will bring a sharp short term jump in productivity, with policy changes providing additional help thereafter. Immigration creates the potential for Spain to grow its way back.”

It was just a few months ago that I published a report from Variant Perception on the serious problems of Spanish banks. Spain has almost 20% unemployment and the government deficit is almost 9%. They have a trade deficit of 4%. Real GDP is down by 5%. Getting back to growth and a less severe government deficit is going to take some serious willpower from a socialist government. So I was glad to read that someone I respect as much as BCA thinks things will work out.

Then I read a short report by Ray Dalio and the team at Bridgewater. It is hard to get their work, but every now and then someone gets me a copy. I don’t know Ray, but I have serious respect for his work. I am a huge fan. He is one of those men about whom the word brilliant can be used without risk of exaggeration. Bridgewater manages $80 billion or so for some of the largest institutions in the world. (

So what do they write about Spain? They are not as optimistic.

“[because of the recession] … the Spanish government decided to run big budget deficits that have been funded with big borrowings, but the more the debt increases, the closer this approach is to coming to an end. As of now, conditions are tenuous but acceptable because most investors a) are used to thinking of Spain as being safe and not having wide credit spreads and b) have been inclined to pick up yield by holding debt that was generally considered safe, so they funded these deficits with narrow credit spreads.

“We do a lot of work estimating what a country’s credit spreads should be in light of its cash flows and asset values and have made more than a few bucks doing this. Based on these criteria, we judge Spain’s actual credit spread to be just about the narrowest relative to what it should be on the basis of its fundamentals — i.e., the spread is 1.4%, and we would assess the fundamentals to warrant it to be 6.5%, on the basis of fundamentals alone.

“We judge Spanish sovereign credit to be much riskier than is discounted because it seems to us that there is a high risk that Spain won’t be able to sell the debt that it needs to fund its deficits, and there is virtually no chance that the government can cut spending (nor does it want to). That is because a lot of debt is coming due; the Zapatero government is weak, very socialist and supported by a collection of factions (e.g., those in states seeking independence); and the Spanish people are now politically fragmented and only care about what money the government is going to give them. Also, the private sector debt problems have largely been kept under the rug rather than dealt with via restructurings.

“In other words, 1) Spain has big debt/deficit problems; 2) it is not dealing with these problems by doing the tough, forthright things to alleviate them; 3) it doesn’t have the printing press to avoid the risk of default (unless the ECB helps them); and 4) it has a narrow credit spread. Situations like this, in the past, have been associated with both debt rollover and capital flight problems.

“… Spain’s external debts, have exploded without a significant offset of external assets. On net, Spain owes the world about 80% of GDP more than it has external assets. As a frame of reference, the degree of net external debt Spain has piled up in a currency it cannot print has few historical precedents among significant countries and is akin to the level of reparations imposed on Germany after World War I. We don’t know of precedents for these types of external imbalances being paid back in real terms.

“On top of the debt that needs to be rolled, Spain’s cash flows (current account and budget deficit) are extremely bad. Spain’s current living standards are reliant not just on the roll of old debt, but also on significant further external lending.

“For these reasons, we don’t want to hold Spanish debt at these spreads.”

And this, gentle reader, brings us to the heart of the problem. These are two very smart research houses with opposite conclusions. Having disagreements is not all that unusual. Disagreements are what makes for horse races and markets.

But the difference is in essence the same disagreement that David and Dennis have. It is one of political nuance. BCA thinks Spain will get its act together, and Bridgewater does not, or at least not until its hand is forced by the markets (my assumption, not theirs).

The amount of pain that Spain must endure to get it fiscal house in order should not be underestimated. Wages are going to have to fall relative to northern Europe for them to be competitive. The dependence on government is going to have to be reduced. This is not going to be easy for a socialist government with a very thin coalition.

And that brings us back to Greece. While Greece can be readily bailed out (assuming they accept large budget cuts) because it is small, Spain is too big to save. The European Union cannot set the precedent that countries that do not set their fiscal houses in order will be bailed out by countries that do.

This is the nature of the End Game I have been writing about. The decisions are now political. How do we unwind the debts and the leverage? How much pain do we postpone and how much do we take on today? It is the same question for much of Europe, Great Britain (serious problems there), Japan (which is a bug in search of a windshield), and the US. We now have a limited number of path-dependent options. By that I mean the political paths chosen by the various governments will dictate the economic path we go down.


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