Monday, 12 September 2016

Richard Koo, please mind the gap: the Eurozone is not Japan

Richard Koo is well known for his balance sheet recession analytical framework (here a link for one of his most recent and detailed presentations: Richard Koo at May 2016's Acatis Conference in Frankfurt).

His analysis points to the fact that once a debt fuelled asset bubble bursts, leaving the private sector in a highly indebted and over-leveraged position (with many individuals and corporates in negative equity territory), monetary policy becomes ineffective. Following the implementation of a highly expansionary monetary policy, private households and corporates will take advantage of very low interest rates to repay down their debt burden faster. Not to consume more. Not even to maintain their consumption at pre-asset bubble burst's levels. The private sector unavoidably retrenches.

In such an environment, the only way to avoid an economic depression is to combine an expansionary monetary policy with an expansionary fiscal policy: the government has to step in, run large deficits and increase public spending. This is what the Japanese government has been doing following the burst of the country's real estate and stock market bubbles in 1989. Once the private sector has completed its deleveraging process, and monetary policy becomes effective again, the government can then revert to a normal fiscal policy and the central bank normalise monetary policy.


So far, so good. Richard Koo's analysis is insightful and his recommended expansionary fiscal policy sensible. For Japan.

But does it really make sense to apply the expansionary fiscal policy strategy to the Eurozone over the coming years as he proposes? At first sight, it does. After all, the Eurozone, on aggregate, suffers from the "Japanese disease": an over-leveraged, over-extended private sector in parts of the periphery that needs to de-leverage; national governments that need to step in and spend more to offset the private sector's retrenchment. However, once you look at things into more detail the picture changes. And you realise that Richard Koo's Eurozone analysis overlooks a few things. Namely:

1. And this is fundamentally true for any balance sheet recession scenario (Japan included) - if you have a private sector balance sheet whose left side is suddenly smaller than the liabilities on the right side (as a result of the burst of a debt fuelled asset bubble), you have two ways to correct the problem of negative equity. One is by inflating the left side via an ultra-expansionary monetary policy while slowly reducing the liabilities on the right side - this is part of Richard Koo's proposed strategy. But contrary to what Richard Koo argues it is not the only feasible strategy available. There is another option: to radically and swiftly shrink the liabilities on the right side via debt restructuring and haircuts. This will lead to massive impairments in the banking sector and arguably the financial sector cannot be let implode. But that doesn't imply bail-outs and debt transfers from private investors to the taxpayer. All what is needed are bail-ins. Bank shareholders and debt-holders, who freely decided to invest in bank shares and bonds, bear the pain as would investors in any other private firm in a similar situation. There will be massive turmoil in financial markets while this process is ongoing but once it is finished financial markets' will recover quickly. And with private debt restructured and a swift de-leveraging process having occurred, monetary policy will be effective again. No need for ZIRP, no need for QE. No potentially dangerous financial, economic and political distortions as a result of an ultra-expansionary, unconventional and highly experimental monetary policy. Ok, I know, the Eurozone has descended way into unconventional monetary policy territory by now. But just making the point that there are alternatives to the path followed by ECB & Co. And endorsed by Richard Koo.

2. Japan is a fiscal union with a current account surplus. The latter means that it is not dependent from external financing - Japan's private sector savings are directly or indirectly (via pension funds or private bank purchases) financing the country's large public deficits. The Eurozone is a multi-sovereign state entity. Not a fiscal union. The EU's peripheral countries, which according to Richard Koo should implement an expansionary fiscal policy, have just about reached a balanced current account after many decades running current account deficits. An expansionary fiscal policy would unavoidably generate current account deficits again. Meaning: widening fiscal deficits in the periphery would have to be financed by international investors. How many would be ready to do it? And for how long? With fiscal and current account deficits ballooning again, a sovereign credit rating downgrade to non-investment grade and a sudden-stop in international financing would likely occur sooner rather than later. An expansionary fiscal policy strategy in the periphery is not really a sustainable option;

3. The Eurozone is structurally an economic unbalanced entity, with the core running historically current account surpluses and large parts of the periphery current account deficits. The adjustment process that the peripheral countries pursued over the past seven years to balance their current accounts was an uneven one: only 1/3 of the current account adjustment is explained by an increase in the countries' exports; 2/3 is due to a fall in imports - the reflection of economies operating way under full capacity and with high levels of unemployment. Having large parts of the periphery mired in a state of semi-economic depression is not a sustainable option either - the Eurozone would fall apart. So, what to do? The peripheral countries (think Spain, Portugal, Greece) need to return to high economic growth. But it has to be an export-led growth. Not one led by increased public spending. On the other hand, the Eurozone's core countries are awash in savings and in need of attractive investment opportunities to deploy them (think German pension funds). This makes it easy to create a win-win situation for both sides.

How? Simple: the peripheral countries need to attract massive amounts of foreign direct investment (FDI) to significantly expand their export base, create jobs and generate sustainable growth; these FDI projects in turn can be financed by the surplus countries's savings - international companies can issue Euro denominated bonds to finance their investment projects in the Eurozone periphery, which can be bought by the savers from the Eurozone's core (yes, the German pension funds). Surely a more compelling investment opportunity than US subprime real estate and overvalued Spanish real estate in the past or Eurozone government bonds today.

What needs to be done for a FDI-led growth strategy to pan out in the Eurozone periphery? To attract massive amounts of FDI (i) the peripheral countries have to continue to implement structural reforms to become an attractive location for international firms; (ii) the European Union needs to support them by creating incentive mechanisms for international firms to locate some of their operations in the countries (e.g. by classifying these countries as "special EU investment zones", which would offer, among others, exceptional tax advantages to investors for a 10-year period); (iii) on top of it, the European Union needs to finance a yield top-up on Euro bonds issued by international firms to finance their investment projects in the periphery. Thus creating an appealing investment proposition to channel the savings from the core to the periphery via financing of FDI projects.

After seven years of an economic structural adjustment process in the periphery carried out with varying degrees of conviction across the different countries, it is time for the European Union to start thinking about incentive mechanisms to support massive amounts of FDI to flow to the Eurozone periphery financed by the core's high savings. Thus creating a win-win situation for both sides. This has to be the EU authorities' top economic priority. Not an expansionary fiscal policy in the region. Remember: short-term fixes cannot, and will not, solve long lasting structural problems. Only buy time to fix them. 

Boys and girls, dear Eurozone leaders: it's fixing time.

Monday, 6 June 2016

The German economic trinity is easy to agree with

“It’s impossible to agree with a German economist. They don’t get it.” How often did we hear this kind of statement over the past five years?

Implied is that Germans are so much detail obsessed that they miss the big picture. To be fair, Germans are indeed obsessed with detail. They are the engineering nation, aren’t they?

Then again, they are also a nation of philosophers, who almost by definition are big picture thinkers. And when it comes to economics, philosophers are indeed what German are. Big picture thinkers in search of sound economic principles (not surprisingly, in Germany econometrics is normally not a mandatory subject in an economics degree programme and the overall level of mandatory math courses is quite shallow).

The German economic model itself is the result of a big picture approach to problem solving. It goes like this: reality is far too complex and unpredictable to be mathematically modelled with great detail. So, let’s focus on what we know and put in place some principles that if followed will guarantee the achievement of sustainable economic prosperity. The result is the German economic principles trinity.

Principle one: a fully independent central bank whose only mandate is price stability

Why? Because…..

….the only way to increase a country’s economic living standards sustainably over time is by increasing productivity. The way to increase productivity is by continuously investing in education, training on the job, innovation and technology (increase a country’s human and physical capital). How can we force companies to continuously re-invest part of their profits in training, innovation, technology instead of paying out bigger dividends to shareholders? By putting them continuously under competitive pressure. How do we do that? By having a stable currency.

If we devalue whenever there is a loss of competitiveness relative to foreign competitors, local companies won’t make a great effort in investing in training, innovation and technology. Why should they? When in trouble, they know that a currency devaluation will bail them out and restore their competitiveness. However, if a regular currency devaluation is not an option – and on top of it currency devaluations do happen regularly in countries where some of their competitors are based – they know that the only chance they have to remain competitive is by continuously investing in their human capital and technology.

How can we make sure, that politicians do not resort to regular currency devaluations? Simple: by ringfencing monetary policy from their interference (politicians are not allowed to access the “printing press”). This is achieved by creating a fully independent central bank, whose only mandate is to keep price stability and thus a stable currency. In addition, such a fully independent central bank will over time make the “promise” of a stable currency credible by committing to it. This credibility will lead to lower interest rates (with no risk of recurrent devaluations, international investors will ask for an ever lower interest rate risk premium to lend money to local issuers – government and corporates). Lower interest rates will reduce the cost of financing for the local government and companies. Making in turn massive investments in human and physical capital more feasible. Thus, companies have the pressure to continuously invest in human capital & technology and the financial means to do so.

In short, principle number one intents to set in motion a virtuous sequence of events: fully independent central bank whose only mandate is to keep price stability ---> stable currency---> put companies under permanent high competitive pressure----> forcing them to permanent high investment in human capital, innovation and technology ---> increase in productivity ----> sustainable increase in citizens’ living standards

Principle two: a balanced current account (or a current account surplus)

How do we know if the country is staying internationally competitive? By monitoring the current account balance. If the current account is balanced or in surplus nothing needs to be done. Everything is under control. If the current account swings consistently into deficit, something is not working. Structural reforms are needed to improve the countries competitiveness (think about Schroeder’s Agenda 2010)

Principle three: solid & solvent public accounts at all time

No matter how well the economy is run, there will always be recessions, unexpected disruptive events, negative external shocks that adversely impact the economy. In such situations, decisive government intervention is needed to stabilise it. In order for the government to be able to act forcefully, and run large public deficits in times of economic crisis, it has to have available fiscal space at inception of a crisis. It has to be solvent and public debt low when the crisis hits. Putting it differently, to run large deficits when the going gets tough, the government has to run a reasonably balanced budget in good times.

Finally, principles two and three combined also mean that the economic authorities don’t have to worry much about private debt levels. If the current account is at least balanced and the government is running a small deficit (in good times) it follows that the private sector (families and corporates) is running a surplus. So, either it is not accumulating debt or the debt is backed by assets denominated in the same currency as the debt - which makes dealing with situation of overleverage, and its impact on the financial system, much easier.

If you look at the Eurozone crisis from the perspective of the German economic trinity principle, you quickly understand why Germans insist so much on structural reforms in the peripheral countries. Since the second world war, Spain, Portugal and Greece have run current account deficits the vast majority of the time – making them dependent on external financing. Such external imbalances will eventually trigger a “sudden stop” in international financing and a financial crisis. They way out of this structural weakness is to expand the countries’ export base. This in turn can only be realistically achieved by attracting massive amounts of foreign direct investment. How to do it? By doing structural reforms that make the countries’ attractive to foreign direct investors (the Siemens, the Sanofis, the Googles, the deutsche Mittelstand & Co of the world).

So the question is: should we waste our energy and intellect in building ever more complex and elegant mathematical models instead of focusing on what we know about economics and keep things simple? The German answer is “Nein”. That’s surely not something so difficult to agree with, is it?

Sunday, 24 April 2016

Value Investing in a nutshell

As an entrenched value investor, I'm often asked to explain quickly and in simple terms what value investing is all about. And I'm always afraid of failing spectacularly in the task.

The difficulty doesn't lie however in the investing philosophy's extraordinary complexity. The opposite is the case: the value investing's principles are truly so simple and powerful that I'm always afraid to introduce complexity where there is none.

So, what is value investing? It is investing in companies that comply with the combination of 3 plus 5 principles:

Three qualitative principles:
1. Simple, understandable business models

2. Businesses with an intrinsic durable competitive advantage ("moat")

3. Talented management team, with high ethical standards, whose interests are aligned with those of the shareholders

Five quantitative principles:
a. Follow the cash: sustainably cash-flow generative businesses

b. Businesses whose return on capital employed is sustainably above the cost of capital (reflects the existence of a moat)

c. Bridge to the future: sound capital structure (low debt levels) and liquidity position

d. No accounting shenanigans (reflects management team with high ethical standards)

e. Margin of safety: the company is trading at a discount of at least 30% to its conservatively estimated fair value

You may find my explanation too long and wordy. In that case, worry not:

Charlie Munger is alive, well, and kicking. In YouTube.

After listening to Charlie Munger you will understand why Leonardo da Vinci once said that "simplicity is the ultimate sophistication".

Monday, 21 March 2016

Helicopter money: great minds think alike. And they don't change

Would the FED and the ECB allow financial markets, and especially equity markets, to suffer a massive fall? Or would they, if deemed necessary to avoid such an outcome, extend QE and start to buy equities at some point? Could they resort to helicopter money and e.g. deposit, on a non-refundable basis, ten thousand euros / US dollars on each Eurozone / US citizen's bank account (possibly conditional to the money being used to pay down debt)?

Normally, to gain a deep understanding of reality - how the economic system works and things are likely to play out - you have to quantify it. Occasionally, however, you can gain the required understanding by analysing the top decision-makers' intellectual framework, background and the incentives guiding them. Let's do the latter to answer the questions above.

Who were/are the main top decision-makers in the post-2008 financial crisis world? Where do they come from? What's their intellectual background? The main decision-makers were/are: Ben Bernanke, Mario Draghi, Mervyn King, Olivier Blanchard, Larry Summers. The "PR department & fan club" cheering publicly their actions was/is led by Paul Krugman, Joe Stiglitz, Jeffrey Sachs.

All of them did their PhD studies in the same city and University in the 1970s. With the exception of Joe Stiglitz and Mervyn King. Stiglitz is a bit older than the others and finished his PhD at the end of the 1960s. In the same city and University. So, not an exception after all. Mervyn King studied in Cambridge, UK. And came later to the city and University for a 2-year tenure as visiting professor. During his time there he shared an office with the then assistant professor.....Ben Bernanke - so, not an exception after all either. Mario Draghi, by the way, was the first Italian to obtain a PhD from the University in question.

The University's economics faculty had 4 intellectual giants: Samuelson & Solow, who shared one office, and Dornbusch & Stanley Fischer, who shared another office. Samuelson is Larry Summers uncle. 

The University is the MIT (note: Larry Summers, who did is BA at MIT, and Jeffrey Sachs were PhD students at Harvard. But the MIT had an open door policy allowing Harvard PhD student to attend lectures. Summers and Sachs did just that. And Dornbusch's lectures with many of the students-turned-policy-makers-and-or-international-VIPs are legendary)

Cutting a long story short, if you know what the 1970s MIT's view of the world - and how to deal with financial crisis - is, you will understand the boys-turned-central bankers approach to the financial crisis to date and what they are likely to do in the future. This begs the question: what was 1970s MIT's analytical approach to problem solving and resulting view of the world? Answer: MIT's analytical style was based on developing simple and concrete mathematical models directed at answering important and relevant questions. I fully identify with this style - you don't analyse and try to find solutions for a complex reality by building models that are even more complex than the reality you are trying to analyse. You keep the models simple by identifying what are the key variables impacting the dynamics of the problem at stake and modelling accordingly (even because if you have a model with 20 variables most of them will be correlated and therefore redundant). 

However, once you get into this simple-model-analytical-framework mindset you risk being captured by it and think that for every economic problem there is a simple and straightforward solution at hand to solve it. As policy maker you will then tend to become too interventionist in areas you shouldn't and don't let the system correct its excesses. This is what happened in the post-2008 financial crisis world. Instead of focusing on the right side of the balance sheets and incentivising painful debt restructuring measures, balance sheet repair and debt-to-equity swaps in an over-leveraged economic system (starting with the banking sector), policy makers focused on the left side of the balance sheets and in reflating asset prices. Misallocation of resources is the result and we all will have to bear the consequences of it at some point down the road.

Are policy makers likely to change their crisis resolution approach, start to focus on the balance sheets' right side and on supply side / structural reforms (which arguably include public investment in human capital and infrastructure)? Very unlikely. People don't change - especially when it comes to their over many decades developed intellectual framework. The top decision-makers would have to be replaced for a radical change in economic and central bank policy to take place.

One could now argues that a major replacement already took place: Ben Bernanke is not the FED's Chairmain anymore. But that's irrelevant. Janet Yellen is intellectually very close to Ben Bernanke. And the current number 2 at the Fed, appointed de facto by Yellen, is....Stanley Fischer. Yellen, by the way, is married to George Akerlof - Nobel Prize winner and PhD from.....the MIT.

Do I need to say more?

Wednesday, 2 March 2016

Cubism Economics: 3-year blogging highlights

Cubism Economics was born in March 2013.

The purpose was threefold:

1. Create a legacy for my children (and control instrument for my wife. And friends): how did papa think as he was a grown-up Londoner teenager? Did he change? I intend to remain a grown-up teenager for many, many years. But this way they can control my evolution more easily by looking at how my writing style changes over time. And warn me, before it's too late, if I start failing in my intentions and becoming a spectacularly boring grown-up

2. Monitor how my thinking evolves over time. And answer the question: how often am I wrong and why? So that I can learn from my mistakes and improve my analytical skills and decision-making process

3. Engage in a regular broad framing exercise: look at the big picture, quantify it, and put forward my ideas in a punchy, crispy, provocative manner. With the aim to obtain the broadest possible feedback and diversity of opinions from the outside world. Not to confirm my initial views but to challenge and falsify them. Thus improving my understanding of the world, the quality of my decisions and helping me to avoid making mistakes in the first place. Yes, Karl Popper is my hero. And any professional investor's most cherished philosopher

So here we are. Three years later. More than time to say to the outside world: many, many thanks for following and challenging me. And be assured that although some good posts were published over the last 36 months, the best ones are still to come. Promise!

Below is a selection of the most popular "masterpieces" published so far. Enjoy!

- Greece's debt position and fundamentals are much better than you think

- An Eurozone periphery debt restructuring is unavoidable (eventually via successive maturity extensions and lowering of interest rates)

- Attracting massive amounts of FDI is the ultimate goal of structural reforms in the periphery. And the solution for Eurozone's economic imbalances

Link 1


Link 2

- Paul Krugman has an obsession with short-term thinking. And for him it's always zee Germans fault even when they are the ones undergoing a crisis. Oh dear...

- ...which could be partially explained by academic macro-economists love for flows. And lack of understanding of balance sheets

- The European Union doesn't deserve one Nobel Prize. It deserves two

- Europe and China. Economics is not a dismal zero-sum game. Seriously!

- Climate Change is not above believing. It's about risk management

- Mario Draghi is a resourceful man. Accept his Christmas 2014 present and stop complaining

- Yanis Varoufakis strategy was flawed from inception because he didn't run the numbers

- The Troika has been much more supportive of Greece than people think. Starting with Martim Wolf

- China won't be a remake of 2008's western financial crisis. At least not in the next three years

- Equities: a 2016 US profit recession is mostly priced in

Thursday, 28 January 2016

Equities: a 2016 US (profit) recession is mostly priced in. It's happy days for value investors

The S&P500 ended 2015 with a 1% loss. And the largest performance dispersion since 1999 when the Internet bubble was about to peak: the top 10 performing S&P500 stocks (led by FANGs - Facebook, Amazon, Netflix, Google) gained around 23%, the other 490 index constituents lost, on average, 3.5%.

From its July 2015 peak to its (so far) 20th of January bottom, the S&P500 lost nearly 13%. If you exclude last year's 10 top performers, the loss amounts to 26%.

Since WWII, the S&P500 tends to fall, from peak to trough, by 1x-1.5x the underlying constituents percentage profit fall during a recession. This means that excluding the last year's 10 top performers, the S&P500 (let's call it the "S&P490") is currently pricing in a 17% to 26% profit recession for 2016 (note: a similar conclusion would be reached if we used the Russell 2000 index).

How does this compare to previous recessions? The following chart provides the answer:
With the exception of 2009's financial crisis there has been no case since WWII where US corporate profits declined by more than 25% during a recession. And in the vast majority of cases the decline was limited to less than 20%. So, even if a US recession were to take place in 2016 it is highly unlikely that the "S&P490" would fall by more than 5%-10% from its current level.

Similar conclusion can be reached by looking at Shiller's cyclical-adjusted PE (CAPE) for the S&P500:

It's current level is 24. The "S&P490" CAPE however is only 18 and a 10% correction would put it comfortably below the post-WWII average CAPE of 18.6.

Cutting a long story short: the 10 top performers in 2015 are distorting the valuation picture of the S&P500. Following the heavy correction since the July 2015 peak, finding US stock bargains is not an almost impossible task anymore (and the same applies to European equity markets). Quite the contrary. For value investors happy days lie ahead.

PS A China economic collapse and / or major devaluation of the renminbi would change my optimistic view for US and European equities. However, my view on China didn't change. A severe crisis may happen. But not in the next 2-3 years. Here is why. Again (note: the capital account seems to be more open / leaky than I thought but nothing that good old capital controls can't solve, if necessary): China: a remake of 2008's financial crisis?

Wednesday, 2 December 2015

Spain: Uber-Iglesias and with Ciudadanos Podemos

We are less than three weeks away from the Spanish general election, which will take place on the 20th of December.

Polls abound. Candidates for Prime-Minister make proposals on a daily basis. Analysts debate passionately the possible election outcomes and government coalitions. And in the process the most important tends to be overlooked: the big transformation of Spanish politics already happened.

The driving force behind it has one name: Pablo Iglesias, the formidable leader of Podemos (a left-wing party. Note: "Podemos" means "We can"). In less than 24 months, almost single handedly, he disrupted the entire Spanish political establishment. As a result of what at some point looked liked an unstoppable rise in popularity, Pablo Iglesias / Podemos achieved the impossible trinity:

1. they forced the renewal of the leadership teams of Spain's main political parties. With the exception of Partido Popular (which is in government) the leaders of all main political parties are now 35 to 45 years of age. And the same applies to the vast majority of the top decision makers  in their teams.

These individuals rose to power 15 years ahead of "their time". In Spain, the 35-45 year old generation is much more international, better educated and prepared than the preceding ones. It is also the first since the 1930s civil war able to have a reasonable fact-based discussion about politics, society and economics, leaving the "fachas" vs. "rojos" childish, cartoon-like arguments on the sidelines. Coming to power 15 years earlier than expected is a blessing for Spain's political, economic and social development.

2. they (and new parties that erupted on the wake of Pablo Iglesias' "anti-establishment revolution") won the support of many discontent voters in Catalonia who would have otherwise voted  for pro-independence parties. This gives the new Spanish government to come out of the December election a 2-3 year window of opportunity to reform the country's constitution and accommodate Catalonia in a politically reformed Spain. Catalonia's secession, which looked unstoppable 2 years ago, can now be avoided. Avoiding the related political and economic turmoil is good news. Taking into account that one of Spain's main strengths is the dynamic resulting from the healthy rivalry between its main regions (and this doesn't apply only to football's Barça-Madrid) keeping Catalonia as part of a politically reformed Spain is very good news. For everyone involved.

3. they generated a new wave of interest and enthusiasm for politics among Spaniards, especially the young, and gave ordinary citizens new hope for a better future. Dreams, even when potentially unrealistic at inception, are essential to create a dynamic of positive change. And interest, hope and enthusiasm is all what is needed for new, innovative social and political movements to be born. Projects able to offer effective solutions for the problems Spain is facing.

Podemos only shortcoming is its economic illiteracy. It is a major shortcoming.

However, the disruption of the Spanish political establishment, and the new wave of political enthusiasm, triggered by Pablo Iglesias / Podemos created the space for new political movements to flourish. According to all polls, one of them became in the meantime a top 4 political party: Ciudadanos, the centrist party led by Catalan born Albert Rivera. It has an excellent economic and institutional reform programme ( More importantly, it is almost certain that it will be part of a future Spanish government coalition as no party will have an absolute majority. And if only half of its proposals are implemented by the new government Spain will be a benchmark for quality institutions and economic policy in 5 years time.

Whatever the outcome of the 20th of December election, one thing is clear: a country that is able to create political leaders of Pablo Iglesias' spectacular dimension and political movements capable of designing economic and reform programmes of the quality of that of Ciudadanos has a very bright future ahead. And should be proud of its very lively civil society.

Monday, 28 September 2015

Independent Catalonia: the Spanish flag and Barça's greatness

Plebiscitary regional elections were held yesterday, 27th of September, in Catalonia. The coalition "Junts pel Sí" won (note: "Junts pel Si" comprises parties across the whole political spectrum solely united by their desire of Catalonian independence). And combined with the left-wing CUP party, also pro-independence (and anti-system), they have a majority of seats in the regional parliament. However, the combined votes of the pro-independence parties fell short of a majority of popular votes (48%). Where does this leave us? In a grey zone. What will happen next is not clear. Except that negotiations between the Spanish government and the new Catalan regional government will have to take place at some point to accommodate Catalonia's growing discontentment with the current status quo. Possibly something along the lines of a new-Spanish-constitution-creating-a-federal-state-followed-by-a-referendum-in-Catalonia-to-decide-on-be-part-of-a-federal-Spain-vs.-independence?

Whatever the next steps in the Catalan saga will be, it is time to ask the question: why do so many in Catalonia want to be part of an independent country? There are basically three reasons:

1. The "independence dividend". The pro-independence movement calculates that Catalonia pays EUR 16bn (c. 8% of Catalonian's GDP) more in taxes to the central government than it receives in benefits. We could discuss at length the appropriateness of the methodology used for the calculation (e.g. monetary flows vs. tax contribution-benefit method). However, we don't need to go that far to see what is at stake (for those who want to go into detail: CAT fiscal transfers).

The pro-independence movement assumes in its calculations that the Spanish government would have to continue to pay the pensions of Catalans, who paid their national insurance contributions into the Spanish social security system over the years, following independence. While 100% of the Catalan citizens' national insurance contributions post-independence would flow to the new Catalan government. The argument is that there is a "pension contract" between each individual taxpayer and the Spanish government that the latter has to honour. It is an apparently sound and compelling argument. And then it is not. It is disingenuous and wrong.

Spain's pension system (like basically all others in Europe) operates on a pay-as-you-go basis. Not on a funded basis. This means that pensions paid to current pensioners are financed from contributions paid by current workers. It is an inter-generational contract supervised by the state. The older generations pay healthcare and education for the younger ones while they are growing up, and once the latter enter the workforce they start paying the pensions of the former who retire.

In such a system, if the pensioners move to a new country after retirement (Germans, Swedes who decide to move to Spain after retirement or Spaniards who worked in Germany or Sweden and after retirement decide to move to Spain) the inter-generational contract remains intact. The pensioners will have reached an age where they will not make any additional (roughly speaking) contributions into the social security system anyway. No matter where they decide to spend their lives. And the younger generations remain in the country that pays the pensions. Working, paying their social contributions and keeping the pay-as-you-go system running.

Things change if a significant part of the entire population, young and old, working age citizens and pensioners, decide that the region where they live should become and independent country. In that case both the younger and older generations "move" to a new country. The younger generations of the "new" country will have to pay the pensions of the "new" country. Even because the shrunken number of young people in the "old" country, from which the "new" split off, will not be able to pay the pensions of both "old' and "new" country pensioners (the inter-generational contract would effectively be broken). So, the inter-generational contract remains in place but supervised by the newly created independent state and binding young and old generations of the "new" country.

Once you take this into account, the numbers change dramatically. Pensions paid in Catalonia amount to Eur 19bn per year. With the "new" independent Catalonia state having to pay for them the "independence dividend" turns into an annual "independence burden" of Eur 3bn.

The "independence dividend" is not the reason to become independent.

2. The construction of a new model state - the Sweden of Southern Europe

Spain has weak political end economic institutions. The judiciary is not fully independent. Neither is the press. Corruption abounds. Being part of Spain holds Catalonia, a more dynamic and entrepreneurial society, back. So the pro-independence argument goes.


Have there been notably less (proportionally to population size) corruption cases in Catalonia than in the rest of Spain in the last 10 years? 20 years? Is the Catalonian press less captured by corporate and political interests limiting its freedom of reporting and opinion? Are smaller countries, by design, less corrupt than larger ones? Is the former long-serving (23 years) president of the regional government (Jordi Puyol) not under investigation for money laundry and corruption? Has any president of the Spanish government (current or former) been under investigation for similar crimes? Do the political parties that comprise the coalition "Junts pel Sí" and the CUP party share a common political and economic agenda for the post-independence period?

The answers to all these questions are the opposite of what would be consistent with the "construction of Southern Europe's Sweden" pro-independence argument.

This leaves us with one last and powerful pro-independence argument:

3. Emotions, national identity

A large part of Catalans may feel that they are significantly different from the rest of Spaniards in the way they think, behave, approach life. That having their own language is a sign of a well defined and separate identity. These are all very respectable reasons to want to be independent. But then it should be made clear, and people be fully aware of it, that these are the reasons to want to be independent. Not something else.

This should also help to clarify what an independent Catalonia would likely to be politically, economically and socially in 20 years time (after a more or less long, more or less painful transition period). Looking at Spain's and Catalonia's history, at Spain's and Catalonia's path of development over the past 40 years of democracy and 30 years of EU membership, the conclusion seems reasonably straightforward: an independent Catalonia would tend to be more or less the same thing as a Catalonia part of Spain.

A prosperous country, just as the rest of Spain. More prosperous than today, just as the rest of Spain. With a 25%-30% higher GDP per capita than that of the rest of Spain, just as today. With stronger political and economic institutions, just as the rest of Spain. With a more independent judicial system, just as the rest of Spain. With a more independent press, just as the rest of Spain. Part of the Eurozone, just as the rest of Spain. With an ageing "native" population, higher retirement age and more immigrants, just as the rest of Spain. With a more innovative economy, just as the rest of Spain. A place with a high quality of live, just as the rest of Spain.

And with two important differences: there would be no Spanish flags hanging on official buildings. And FC Barcelona would have become an irrelevant club in European and world football.

Catalans should ask themselves the question which of the two differences does the more good to their emotions and sense of national identity. By answering it, they will know if they want to have an independent Catalonia. Or not.

Thursday, 10 September 2015

Greece's 3rd bail-out: make or break?

Greece's third bail-out programme was given green light in August. All went according to plan. So far.

The relevant question now is: after the failures of the previous two, what are the risks of failure facing this one? There are four main risks:

1. The banking sector's comprehensive restructuring and recapitalisation doesn't take place

Greek banks need to write-off bad debts and be recapitalised to provide financing to the private sector. Without it no sustainable private sector driven economic recovery can start.

The third bail-out package includes Eur 25bn to recap the Greek banking sector. This accounts for around 6.5% of the Greek's banking system total assets. It should be more than enough to recapitalise the Greek banks properly.

Existing shareholders in some banks (all but National Bank of Greece?) will most likely be wiped out - sorry guys, the EU's Bank Recovery and Resolution Directive (BRRD) will only enter fully into force in January 2016 but given Banco Espirito Santo's bail-in precedent in August 2014, January 2016 is too close for the EU authorities to let shareholders off the hook. Bondholders (both junior and senior) will be (partially) bailed-in. But all will be ok.

The Greek banking sector not being comprehensively dealt with and recapitalised is not a risk.

2. Primary surpluses demanded by the Quartet (European Commission, ECB, ESM and IMF) are detrimental for growth

Too aggressive fiscal targets imposed on Greece by the Quartet could be too restrictive for public spending. Social unrest would pick up new momentum. Implementing the structural reforms agreed as part of the third bail-out package become an impossible task. The programme would fail. Again.

These are the final primary surplus targets agreed between Greece and the Quartet: -0.25% of GDP for 2015 (a primary deficit) vs. 1% (surplus) that was agreed earlier in the summer; 0.5% in 2016 vs. 2% agreed earlier in the summer; 1.75% in 2017 vs. 3% earlier; 3.5% in 2018 vs.....3.5% earlier.

And there will be surely some willingness to accommodate a deviation from the agreed 2015 primary surplus target to take into account any unexpected adverse effects on GDP growth following the bank closures and imposition of capital controls in July. As long as the Greek government implements the agreed structural reforms for 2015.

There is hardly anything too aggressive and demanding here. So, no significant risks on this topic either.

3. Public debt restructuring will not take place

A silent and significant debt restructuring has been taken place since 2011 as I showed in detail some time ago ( And more is to come via maturity extensions and lowering of interest rates as long as the new Greek government implements the agreed reforms. And as soon as the first review of the third bail-out programme is favourably concluded.

With an average maturity of 31 years the loans of the new bail-out programme are a clear signal of where the debt restructuring journey is going.

Absence of further debt restructuring is clearly not a risk.

4. Lack of political will to implement agreed reforms

Mr. Tsipras went as close to the edge of the Euro cliff as one could possibly go. Seeing the Grexit abyss he stepped back and agreed to a new comprehensive third bail-out package. If we wins the upcoming general elections (20 September), and forms a majority government, not implementing something that he agreed to is surely not a realistic scenario to contemplate. Even if of one argued that he only agreed reluctantly to some of the measures in the MoU, the electoral victory would give him the mandate to implement them.

What if the opposition (ND led government) wins the election? Not much changes. With the pro-Grexit parties likely to end up with only 15% to 20% of the votes, any Greek government will have a clear mandate to do whatever it takes to stay in the Euro. And after the dramatic quasi-Grexit events in July, that plain and simply means implementing the agreed reforms.

Greece being Greece, not all agreed reforms will be implemented. However, even if the implementation ratio is 50% (instead of the rather 10% in the past) that would be good enough.

Arguably Syriza winning now would be a superior outcome for mid to long-term policy continuity purposes. If after 3-4 years in government Syriza lost the general election in 2018-2019, a new ND-led government (potentially in coalition with Potami) would tend to continue along the roughly same economic path as defined by the third bail-out programme. No dramatic reversal of economic policies would take place allowing Greece to reap the full benefits of the difficult reforms implemented in the meantime. The same cannot be said with the same degree of confidence if Syriza loses this election and wins the next one. There is always the possibility that at that point in time even a more moderate Syriza tries to reinvent the wheel, once more, and reverses some of the reforms implemented in the meantime.

Then again, will it make any substantial difference for reform implementation over the next 18-24 months who wins the 20 of September election? Not really. The Quartet's first review on the progress of reform implementation will take place in November. Greece will pass. Further debt relief will then be conceded by the EU. And the ECB will be able to extend its QE programme to the purchase of Greek government bonds. With bond spreads narrowing, capital controls slowly being lifting, foreign investors returning to the country and the economy starting to recover, Greece could well be 2016's economic suprise of the year. And with a cyclical-adjusted PE of under 5x, Greece's equity market could do much better than most expect over the next 18 months.

No one ever said that Greece is a boring country. And rightly so: over the coming 18 months it is likely to continue to be a box full of surprises. This time good ones.

Tuesday, 25 August 2015

China: a remake of 2008's global financial crisis?

I appreciate the arguments that there are pockets of excessive debt in the Chinese economy (local governments, real estate). And that a mis-allocation of capital (both private and public investments generating returns below the cost of capital) has been taken place in some sectors of the economy (public infrastructure, heavy industries).

However, I cannot see how all that can lead to a major economic and financial crisis in the country until the mis-allocation of capital translates into sustainable current account deficits. And makes China dependent on external financing.

My opinion on China's imminent economic implosion remains the same as in March 2014. Please read:
Don't be fooled by the availability bias

Monday, 13 July 2015

A-Greek-ment: the day after

The medicine Greece has to take now is very unpleasant and aggressive. The way it is being administered by the Eurozone - even if they had objectively speaking all the reasons to do so - shockingly humiliating.

But let's not forget that it was Syriza who put Greece in its hopeless negotiation position. Greece was the fastest growing Eurozone economy in 2H2014. It was running a primary surplus. A current account surplus. The economy was turning the corner. And debt relief via maturity extensions & lowering of interest rates (plus refinancing of ECB held bonds and IMF loans) after June 2015 was implicitly on the table. 

But Tsipras & Varoufakis were not on top of the numbers. Otherwise, they wouldn't have put debt relief at the top of their Eurozone agenda after all the debt relief that had already taken place since 2012 ( And the one that was implicitly agreed to take place after June 2015. The priority should have been to implement reforms, win the other Eurozone's countries trust, and then ask for additional, substantial, debt relief.

The key assumption on which Syriza based their entire Eurozone strategy - a Grexit would lead to massive financial contagion and therefore force the Eurozone/Troika to make material concessions - was flawed. And, once again, they were not on top of the numbers. Otherwise, they could have falsified and rejected the assumption by running them ( Or, more philosophically, by simply asking themselves what was the worst that could happen if their assumptions proved wrong. And if there wasn't an alternative strategy that offered similar upside in case of success but much more limited downside in case of failure. But they didn't. Now we have a sad story to tell.

However, as sad as the story may be, let's not fool ourselves: the main responsibles for it are Tsipras / Varoufakis / Syriza and their very, very poor strategic decision-making. At the receiving end of the now needed additional austerity will be ordinary Greek citizens - the ones Syriza allegedly wanted so much to help and protect.

Thursday, 9 July 2015

Greece: a response to Martin Wolf

A response to Martin Wolf's Financial Times article "Grexit will leave the Euro fragile" published on 8 July 2015 (

Dear Martin,

banks / private creditors shouldn't have been bailed-out and should have suffered the full losses of a Greek debt restructuring. Agreed. 

However, you are missing a few points: 

(i) there was a bail-in of banks / private lenders in 2012. The net present value of the resulting debt relief amounts to Eur 100bn, i.e., around 50% of Greek GDP.

(ii) you argue "the financing provided by the Troika was of negligible benefit for Greece". You are wrong. 

Greece was running both a public deficit and a current account deficit of over 10%. Even if the banks/ private lenders had borne the full burden of a Greek debt restructuring, Greece would still have had to deal with this twin deficit. Without the financing provided by the Troika the adjustment would have had to take place in a few weeks or in a few months at best. The resulting massive spending cuts in such a short period of time would have led to a rapid collapse of the Greek economy (assuming a public spending multiplier of 2 - a conservative assumption in an economy cut off from external financing - public spending cuts accounting for 10% of GDP would have led to a 20% sudden collapse in GDP).

The financing provided by the Troika gave the Greek authorities the chance to adjust more slowly. The consolidation of public finances - the so-called austerity - would always drag the GDP down. Structural reforms (reform the judicial system, open up protected sectors to competition, fight tax evasion....) would push up GDP by attracting foreign direct investment (FDI). To be fair, Greece has implemented a massive austerity programme. But it barely delivered on structural reforms. The unwillingness to touch vested interests is not the Troika's or Eurozone's member countries fault.

(iii) you implicitly state that the Troika hasn't so far provided any meaningful debt relief to Greece. You are wrong again. As Paul De Grauwe shows: And as I had written in 2014: 

On a different note, the risk of financial contagion from a Grexit is now zero. It would be very different in 2010 or even 2012. But in the meantime the Eurozone has put mechanisms in place that make a contagion impossible. As a result, only countries that do not want to stay in the Eurozone will leave. There is no way that financial market forces can push a country out. Here is why:

The time has come for Greece to ask itself why it wants to stay in the Eurozone. You cannot impose reforms on a sovereign state unwilling to be reformed. And If Greece doesn't really want to reform, its Eurozone membership turns into a mere political prestige project. It has much more costs than benefits. In this case, let's face reality and be honest with oneself: EU membership outside the Eurozone is the best option for Greece. As well as for the Eurozone, and European Union, as a whole.

Sunday, 28 June 2015

Grexit and the risks of financial contagion

Availability bias. Representativeness heuristics.

When trying to anticipate future events we tend to be over-influenced by what we tend to view as similar (representativeness) recent dramatic events, which are - precisely because of their dramatic character - strongly present (availability) in our memory. We then tend to extrapolate almost linearly the sequence and consequences of the events we are currently faced with from those past, and perceived as similar, events.

This explains why many today think that Grexit will be Eurozone's Lehman moment. They are wrong.

The FED initially downplayed the consequences of defaults on subprime real estate loans and the contagion risks arising from the financial system's high degree of connectivity. The line of though was a simple one: if subprime real estate loans just accounted for 1%-2% of the total banks' balance sheet size, there was no way that a collapse of this market segment could have meaningful adverse consequences on the whole financial and economic system. This proved to be a major error of judgement.

The European authorities, and first and foremost the ECB, have a complete different view about Grexit. They know that the Greek economy may be tinny in the context of the Eurozone but that the risk of contagion via the sovereign bond market is significant. As a result, they have put in place a massive firewall (ESM and ECB's QE programme) that effectively stops at inception any risk of contagion.

There will be in the very short-term (this and next week) turmoil in financial markets following the call for what can be perceived as an In/Out (of the Euro) referendum by the Greek government. Stock markets will fall. Spreads between peripheral and German sovereign bonds will widen. Investors (read hedge funds) that will be betting on a widen of the spreads will make money. As the market moves their way, they will increase their positions. And then, at some point, the ECB will intervene massively and force the spreads to narrow down again. Investors betting on a widening of the spreads will burn their fingers. And stop playing the game. Some of the more savvy investors will not even start to play it as they understand that this is not a pure economic game. It is a game with an overwhelming political dimension. And that commander-in-chief Mario Draghi has de-facto unlimited resources to squeeze any profits out of tentative short-Eurozone players "a la John Paulson".

To put numbers to the story:

- Portugal, the first country at risk of contagion in case of a Grexit, has a total public debt of around Eur 200bn

- Around 45% of it is held by the Troika. This leaves Eur 110bn being held by private investors

- Let's say that 100% of the Portuguese sovereign debt is turned over a 12-month period (a generous assumption given that many of the debt is held by pension funds and retail investors, who don't trade it actively). This would mean less than Eur 10bn of Portuguese public debt being traded each month

- The ECB only has to intervene at the margin to influence the price setting. Let's say that it would have to buy 25% of the average monthly traded volume of Portuguese sovereign bonds to stabilise their price and narrow down sovereign spreads to a pre-determined level. This would amount to interventions of Eur 2.5bn per month. The ECB QE programme alone allows Mr. Dragi to buy up to Eur 60bn of Eurozone sovereign bonds on a monthly basis

- On could always argue that the ECB will need to buy sovereign bonds from other countries as well. Sure. But then again: (i) there would be Eur 57.5bn left (approx. 96% of total available resource) to buy sovereign bond markets of other countries; (ii) if the ECB stops contagion to Portugal (arguably the weakest link in the chain) it will stop contagion from Portugal to other countries. Or are we saying that investors would be asking more yield to buy Spanish and Italian government bonds than Portuguese ones?

Cutting a long story short, with the safety mechanisms that Eurozone's authorities have put in place no country can be forced out of the Euro by financial market forces. Only countries that don't want to stay in the Euro will leave.

And if a Grexit does occur, with the devastating short-term consequences for the Greek economy visible to everyone, there won't be any other country willing to follow Greece out of the Euro.

Dear candidates to become Eurozone's John Paulson, I wish you luck. Dear Alexis Tsipras & Yanis Varoufakis, if your strategy is to put pressure on the Eurogroup via financial contagion of a potential Grexit to reach better deal terms, I wish you luck as well. To all of you: even a lot of luck will not be enough.