First an update. We are scheduled to guest-host CNBC Worldwide Exchange from the London Studio on Friday, December 10. US viewers may see it at 5 AM New York time. We may start a little earlier. CNBC usually posts clips from these interviews on its website, www.CNBC.com
Let’s now get to the subject at hand.
Europe is confronting a contagion. It started in Greece but it does not end in Greece. It is spreading and has reached the obvious peripheral countries like Ireland, Portugal, Spain, and Italy. It is now affecting Belgium. The spread is not over.
The historical metaphor is the Asian contagion from 1997-1998. That started with Thailand and the baht and ended with the collapse of the Russian ruble and the Long Term Capital Management hedge fund. The end came when Greenspan and the US Fed intervened credibly and decisively. They stopped the bleeding. Markets then transitioned from being driven by fear to the process of restoration of stability. That was the sequence in 1997-1998.
In the Asian case, each currency was attacked and devalued. The countries did not have sufficient reserves. They were vulnerable and easy targets for global speculators.
The euro zone’s vulnerability is the huge overhang of sovereign debt. It is denominated in euros, so there can be no country-by-country devaluation. Each country has to be brought into a resolution process (rescheduling of payments). The present system is based on a 440-billion-euro fund, with all 16 euro-zone member countries participating. That fund has a flawed concept.
The European Financial Stability Facility (EFSF) was created with the idea of burden sharing in proportion to size. The problem with this system is that it assumes the ability to pay. Therefore, when a country crosses from being a participant with a pledge of capital to receiving aid it has to be removed from the 440-billion pool and it becomes an entry on the liability side of the ledger.
Greece was first. It is small. Its EFSF capital share is 2.82% or 12.39 billion euros. The creators of this concept hoped that Greece was the end of the story. They failed to consider the market forces of contagion.
Portugal is 2.51%. Ireland is 1.59%. Take out those three countries and the original 440-billion-euro fund is down to 409 billion. This is still manageable, but the trend and the systemic flaw are becoming clear. When a country morphs over to the receiving side it gets relief at the expense of the others. Notice where the political incentive lies.
Now consider what the contagion threat means. Belgium is under attack. You can see that attack in the credit default swap pricing. Belgium is 3.48% of the fund.
The big ones are the developing risk. Spain is 11.90%. Readers can easily see where this is going. So can the Germans and the French, who are the biggest in the fund. Germany is 27.19% and France is 20.385.
Clearly, the system must change. Equally clearly, the changes must now be made quickly and have to be done in the midst of the contagion. This pressured operational structure is the worst form of negotiation.
The solution lies with the European Central Bank. It must stop the bleeding with large and decisive action, just as the Federal Reserve did in 1998 with LTCM and just like the ECB and Fed jointly did after the Lehman-AIG fiasco. However, the ECB needs appropriate forms of assets (debt instruments) to acquire while maintaining its mandate. In addition, the ECB is divided internally by conflicting views on policy. Some would have had Greece default. Others fear inflation. Still others want to rely on hope and time instead of taking a proactive policy stance. They look at the debt-GDP ratio and believe it can be returned to manageable proportions over time.
The reluctant ECB members fail to realize a key issue. In a contagion, you do NOT have time. Time is not on your side.
Understanding contagion is hard for many policymakers and for investors. In a contagion, you cannot see the next freight train until it hits you. You do not know where the next shock originates. I use metastatic cancer as a metaphor. You know the source of the original tumor. It is Greece in the present-day euro crisis. It was Thailand in 1997. You know the type of cancer. It was lack of currency reserves in the Asian crisis. It is sovereign debt in the European crisis. However, you do not know where the cancer will next appear. You are unsure of its route of travel in the body.
The same is true of the financial linkages that intertwine the system of global financial interdependence. No one knows all of them. That is why we witnessed Sweden, Denmark, and the UK participating in the Ireland bailout. They are not in the euro zone but they do have banking interests, and those banking interests are linked to others who are bleeding. Bringing non-euro-zone members into a bailout was a first in European Monetary Union history.
Before this is over there will have to be a pan-European solution. It has to be big. It has to be rapidly deployable. It has to have the backing of the central banks. Moreover, it MUST be credible to markets. Europe has not reached that point yet, which is why there is more contagion risk and more contagion events in the future.
ECB president Trichet knows this. He is the one who lectured Bernanke about the Lehman failure. Now the shoe is on the other foot. That is why Trichet has tried to soothe markets with words. Now he must do it with deeds. We expect a large ECB response is coming. Markets expect it too, which is why they are rallying today.
In our firm, we have taken Europe to underweight. We have left the “strong euro” currency trade. We have taken the US stock market to overweight.
Let me add a personal note. After years of research, my co-author Vincenzo Sciarretta and I wrote a book called Invest in Europe Now. Our publisher got the manuscript in final form in September 2009. Wiley released the book in March 2010. Greece blew up a month later. The first five chapters of the book are still valid. The rest of the book is obsolete. It would be written differently today.