Economic Domino Theory in the Eurozone, Part 2

On Wednesday, the Dow Jones Industrial Average surged 490 points, almost 5% in response to the announcement by the Federal Reserve that it was initiating a secondary capital injection in the European market.  This was the largest one-day jump since March of 2009, but was it enough to salvage the economic quagmire that is the European Union?

As the European dominoes have continued to fall—due mainly to the inability of those countries to maintain a sustainable level of debt—financial institutions across the world have developed strategies to limit the crisis and prevent the spread of this fiscal cancer.  With the interrelated nature of the worldwide financial system, this is not just a European problem; it is a problem for East Asia, the Middle East, and it is a problem for the United States.

The first step for the heads of the US financial system was to assess the exposure of American banks to European debt.  Last Wednesday, Ben Bernanke, Chairman of the Federal Reserve, announced that US banks would undergo a “stress test” over the course of the next few weeks.  This is, in essence, an effort to analyze the books of the six dominant financial institutions and determine the amount of European debt present.

These institutions—Bank of America, JPMorgan Chase, Citigroup, Wells Fargo, Goldman Sachs, and Morgan Stanley—currently hold approximately 66% of the US GDP, or about $9 trillion.  Most of them have engaged in complex transactions known as foreign exchange swaps, which are defined as “an agreement to exchange stipulated amounts of one currency for another currency at one or more future dates.” 

These transactions allow for more flexibility in financial dealings and serve as a hedge against future alterations in the exchange rate, but they also increase exposure to international debt.  A source at the Treasury Department revealed that initial estimates of US exposure range from $1-$2 trillion and could reach as high as $3.5 trillion; the most vulnerable are Bank of America, JPMorgan Chase, Citigroup, and Goldman Sachs. 

In terms of American institutions, the only solution available to them is to play the confidence game.  On Tuesday, in response to this stress test, Standard & Poor’s, one of three ratings agencies on Wall Street, downgraded the credit rating on all of these banks and many of their European counterparts.  As they seek to maintain some level of confidence, one strategy has been to constantly move money throughout the market as a means of reducing the actual debt and European exposure present on their balance sheets.  The financial confidence game is a fickle beast. 

While the American banks seek to maintain confidence, the Treasury Department and Federal Reserve, in tandem with their worldwide counterparts, have sought to address the crisis at its core.  European countries are being crushed under a mountain of debt and they lack the necessary liquidity to write-down their debt; as a result, their credit markets are practically frozen stalling any economic activity. 

The lynchpin of European economic activity is France—specifically the French banks.  All the major European nations—particularly Germany—and the United States have large sums of money in these institutions.  Moody’s, another of the three ratings agencies, originally announced that they would be downgrading both the French banks and France itself today, which would have led to the nightmare scenario. 

A simultaneous downgrade of France and its financial sector would result in a large-scale run on the banks in which major financial institutions, such as American and European banks, as well as countries themselves, such as Germany and the United States, would attempt to withdraw their money at the same time.  Since the current financial system is built on leverage and no bank in the world has enough liquid capital to return the money of all of their investors, the entire system could potentially collapse.

On Wednesday, the Federal Reserve in collusion with the European Central Bank (ECB), the Bank of England, and the central banks of Canada, Japan, and Switzerland announced an immediate process of quantitative easing.  Since Europe as a whole, and France in particular, needs to increase liquidity to write-down their debt, this process would involve an infusion of capital in the market.

According to the source at the Treasury, since the Federal Reserve cannot legally lend directly to France, they have lent money at a 0% interest rate to the European Central Bank which will then loan to the International Monetary Fund which will loan to France.  This capital injection will allow France to write-down a substantial percentage of their debt and potentially stave off a cataclysmic financial event. 

Moody’s announced on Wednesday that it will hold off on downgrading the credit rating of France and its banks for 10 days, meaning the complete process of loan and write-down must take place over that period.  The capital injection was the only legal action the Federal Reserve could take.  It is now up to the European Union nations to handle this fiscal crisis in a responsible way, but in many ways the damage may already be done. 

There is a perspective broader than economics in which the Eurozone crisis may have dangerously destabilized the worldwide geopolitical balance.  The European Union has been brought to the precipice of financial ruin and is still hanging by a thread.  In many ways, it has always acted as a constraint on the power of individual nations within it and surrounding it. 

The destabilization of the EU has created an excuse for Germany to possibly drop the euro and leave the Union altogether.  It has, by default, strengthened the geopolitical positions of nations like Russia and China and created a relationship of dependence, evident by the fact that exports from China to Europe have dropped precipitously over the last month.  Russia’s increased strength has the potential to simultaneously result in further destabilization in the Middle East as their influence in countries north of Afghanistan grows. 

None of these scenarios are in America’s interest.  The geopolitical balance in the world over the last decade has been tense, but it has been a balance nonetheless.  The US government and the US financial institutions have done all they can to maintain confidence and liquidity in the worldwide financial markets.  Now it is up to the Eurozone to ultimately fix the problem they have created.

Economic Domino Theory in the Eurozone, Part 1

In 1992, the thirteen nations of the European Communities met in Maastricht, Netherlands to sign the Maastricht Treaty.  By doing so, these nations, which included Italy, France, West Germany, the United Kingdom, and Greece, bound themselves in an association known as the European Union, now comprised of 17 nations.  In the process they created a unified currency—the euro—which forever linked the fortunes of these economies, whether good or bad, in an essentially unbreakable chain.

Douglas J. Elliot, a Senior Fellow at the Brookings Institute, wrote on CNN Money that “the road into the Eurozone ran only one way.”  What he meant was that the Eurozone countries made it almost impossible to dump the euro without leaving the European Union; there is no mechanism in place for such an act.  The fear was that if a country like Greece were to dump the euro as its currency, they would set a weaker exchange rate leading to a run on their banks and a domino effect rushing through the Eurozone. 

At this moment, however, the very foundations of the European Union are buckling under the weight of debt and instability.  The governments of Greece and Italy have both been ousted after promising substantial austerity packages.  The euro itself is in danger of folding and the nations of the Eurozone watch as each domino continues to fall.  How bad is it?  Simon Wolfson, the CEO of European retailer NEXT is offering a $400,000 prize for a plan to break up the euro peacefully.  

The root cause of this crisis is essentially government debt, a prescient warning for American technocrats. The Maastricht Treaty mandated that annual government deficits not exceed 3% of GDP while government debt not exceed 60% of GDP.  Most European nations, however—particularly Greece and Italy—used complex currency and credit derivatives to mask the realities of their debt situation. 

Currently all the major Eurozone nations have debt to GDP ratios over 60%: the United Kingdom (77.8%), Germany (75.7%), France (83%), Italy (118.9%), and Greece (140.2%).  These staggering ratios—particularly those of Italy and Greece—have strained the relationships between banks and clients, investors and business, government and business, and government and citizens.  As a quick aside (and a story for another day), the American debt to GDP ratio is 99.6% for the year and ironically crossed the 100% plateau on Halloween according to projections by the International Monetary Fund. 

German Chancellor Angela Merkel and French President Nicolas Sarkozy have led the efforts by the more structurally sound European nations to maintain stability and find a long-term solution.  But experts worry that they are playing a losing hand.  The fiscal monstrosity that is the Greek and Italian bond market, combined with their astounding levels of government debt, has led some to fear the “doomsday scenario.”  

On Tuesday, the yield on 10-year Italian government bonds reached 7.039%, a rate at which economists believe the refinancing of Italy’s debt becomes unsustainable.  Were Italy and Greece unable to refinance their debt and default, economists and heads of state alike worry that the domino effect will spread through Europe and beyond—quickly.  Spain and Portugal would fall, followed by Ireland, and eventually the cancer would reach France. 

While France may not be a dominant geo-political power, they do dominate the banking sector of the Eurozone.  Germany, the most reliable of the bunch, houses almost all of its capital in French banks.  France also holds approximately $1 trillion in American money.  Meanwhile, the French banks have overleveraged themselves in the unpredictable Eurozone market resulting in France’s rocky fiscal infrastructure and dim economic outlook.  As rating agency Standard & Poor’s stated in downgrading the French banking sector, “we see weaker economic prospects for Europe, including the peripheral countries to which some French banks are significantly exposed.” 

Eurozone leaders have taken action.  At a summit in October, they decided to write down—essentially reduce in value—the Greek debt held by the private sector by 50%.  Meanwhile, Lucas Papademos has replaced George Papandreo as interim Prime Minister of Greece and promised a strong effort to pass a significant austerity package. 

Last week in Italy, the Parliament voted to approve an austerity package—which includes cutting 300,000 public sector jobs, increasing the retirement age for government benefits, simplifying the tax code, creating incentives for venture capital investment, and reintroducing the property tax—paving the way for Silvio Berlusconi to resign as Prime Minister. 

But there are flaws to these measures.  The write down of Greek debt makes very idyllic assumptions.  An article in The Economist after the deal was struck commented that the Eurozone’s main rescue fund, the European Financial Stability Facility, “does not have enough money to withstand a run on Italy and Spain” while other sources of liquidity—Germany and the central bank—have ruled out further bailouts.  The Italian austerity package is vague—such as when it outlaws deficit spending “except in the case of exceptional events” and fails to define “exceptional events”—and the country itself currently lacks a government. 

As the dominos continue to fall, the worry shifts from the collapse of the European bond market and banking sector to the impact on American markets.  The universality of the worldwide financial system means that the economic domino effect does not stop at the water’s edge. 

America, the Case For Hope

Writings about our country have long been dominated by benign, soporific eulogies to the greatness of America past.  We are the country that evicted the domineering, imperialistic behemoth that was the British Empire.  We successfully created a representative democracy outlined in the redoubtable words of the longest lasting constitution in world history.  We settled the west, fought for equality for all, defeated totalitarianism in Europe and Asia, went to the moon, and invented the microchip, the internet and a cure for polio.  But…

The malaise of the last few years has set in so that every comment about the greatness of America past ends with a “but”.  But now we are in a lost decade.  But now capitalism has failed and our economy cannot recover.  But now our political system is defunct, never to regain its ideal form.  But our people have lost their moral core.

These are all valid concerns and valid challenges.  Our economic recession, resulting from the financial crisis of 2008 which illuminated serious flaws in the financial system and its inter-related relationship with government, has now spanned three years.  A lost decade like Japan’s 1990s is not out of the question.  The hyper-polarized nature of our political system, which culminated in the debt ceiling debacle this summer, has done harm to our external political reputation and our internal political confidence. 

Americans, however, are a people of resilience.  As political philosopher Alexis de Tocqueville commented, “the greatness of America lies not in being more enlightened than any other nation, but rather in her ability to repair her faults.”  In our history, we faced the challenges of economic disaster and emerged stronger than before.  We confronted atrocities abroad and emerged victorious.  We foresaw the changing landscape of the turn of the millennium and developed the greatest technologies in the world.  And we can do it again.

On the great seal of the United States are three Latin phrases.  Novus Ordo Seclorum, translated as “a new order for the ages,” represents the unique nature of the American experiment.  This experiment combined the political philosophies of ancient Greece and Rome, a Judeo-Christian legal foundation, and the practicalities of the British Parliamentary system into a government never before seen in world history. 

Annuit Coeptis, translated as “providence, [or God], favors our undertaking,” represents the spiritual foundation of the American experiment.  We are an inherently spiritual people, bolstered in our spiritual foundation by the success God has shined upon us in our history. In some ways, we have lost our spiritual fervor, but the moral infrastructure is still in place, ingrained in every aspect of public life.  Tocqueville stated that “Americans combine the notions of religion and liberty so intimately in their minds that it is impossible to make them conceive of one without the other.”  It may not always seem to be the case but I still honestly believe that it is. 

The third phrase on the great seal is E Pluribus Unum, translated as “out of many, one.”  The diverse nature of the American population has always been a sign of the great success of the American experiment.  Greater yet, however, is the fact that through that diversity has come one voice, one rallying cry for the values on which this nation was founded: freedom, liberty, unity,  suffrage, morality, leadership.  These values have been challenged—as they were during the Civil War—but the strength of American convictions has always been sustained.

As the challenges of the Civil War commenced, the dome of the US Capitol, the great exclamation point on the temple of American liberty and deliberation, sat unfinished.  With the future of the Union unknown, President Lincoln ordered the dome to be finished, stating “if people see the Capitol going on, it is a sign we intend the Union shall go on.” 

The future of our American Union may be unknown, but as Lincoln ordered in the 1860s, we should continue to seek and strive for a “more perfect Union.”  Discussions of America should no longer be benign, soporific or elegiac.  If history has revealed anything, it is that there is no challenge we cannot face, no conflict we cannot overcome, no task we cannot complete. 

The Great Seal of the United States cannot and will not be broken.  We are one nation born from many peoples, religions, ideologies, and cultures.  Our diversity makes us stronger and it will make our successes greater.  The success and consistency of our history changed the world forever.  In the next few years, we can and we will do it again.  It may not yet be morning in America, but the dawn is not far off.    

Jobs, Taxes, and the Republican Primary

Economic factors are always paramount in presidential elections.  But in a year when the unemployment rates remains above 9% and the Eurozone debt crisis looms, the importance expands exponentially.  With the first Republican primary less than two months away, each of the potential candidates has outlined a tax and jobs plan that will, according to them, bring the United States out of this recession and restore it to its once great position as the only viable superpower.

Mitt Romney, the unflappably stagnant former governor of Massachusetts, introduced his 49 point jobs plan last month in Las Vegas.  It entails cutting corporate tax rates from 35% to 25%, eliminating the estate tax, and extending the so-called Bush Tax Cuts.  He also recommends reducing the regulatory burdens on business by repealing Obamacare and Dodd-Frank (the financial reform bill) and expanding drilling in areas such as the Gulf Coast, the Plain States and Alaska. 

Texas Governor Rick Perry, the unflappably flappable candidate, introduced his tax and jobs proposals in recent weeks.  His jobs plan focuses mainly on increased energy production in oil and natural gas which he states will “unleash 1.2 million American jobs through safe and aggressive energy exploration at home.”  His tax plan proposes creating an opt-in flat tax, meaning those who choose to do so, can have their taxes reduced to a flat rate. 

Former Godfather Pizza Executive Herman Cain, the ever-present attention seeker, has infamously proposed his 9-9-9 plan to reform the tax code.  It would throw out the existing tax code and replace it with a 9% corporate tax rate, 9% individual income tax, and 9% national sales tax.  Cain has not explained his plan much beyond that except to say that his advisors have crunched the numbers and it will be deficit neutral.

Former Utah Governor and Ambassador to China Jon Huntsman (disclaimer, I volunteer on Huntsman’s campaign) has proposed a tax and jobs plan that synthesizes many aspects of Romney, Perry and Cain’s proposals.  He calls for tax reform in which loopholes and deductions for corporations and the rich are eliminated and the base is broadened.  The corporate tax rate would then be reduced from 35% to 25% and the personal income tax would be reduced to flatter, fairer rates of 8%, 14%, and 23%.  He has also called for expanded oil and natural gas exploration, regulatory reform, free trade expansion, and stronger relationships with foreign nations.

Other candidates have made various similar and sometimes outlandish proposals.  Rick Santorum, has proposed cutting the tax rate for manufacturing to 0%, an interesting thought.  Ron Paul has proposed eliminating the Departments of Education, Commerce, Energy, Interior, and Housing and Urban Development.  Michelle Bachmann has not been able to formulate a sentence that does not end with “repeal Obamacare.” 

Many of these proposals are seriously flawed.  Romney’s tax plan leaves the existing tax code, loopholes, deductions, and all, in place allowing for companies like GE to continue to make billions of dollars and pay no income taxes.  Perry’s tax plan also leaves the existing loopholes and deductions in place because those benefiting from them will not choose to opt-in to the proposed flat tax.  Cain’s plan is simply simplistic; as a tax lobbyist I spoke to recently put it, “I have serious questions about a tax policy that can be summed up in a catch phrase.”

 Santorum’s proposal concerning tax rates on manufacturing is intriguing but has little chance of success in Congress.  Paul’s proposals are simply ludicrous; maybe in a perfect world we could do away with five Executive Agencies and be fine, but that is not this world.  Huntsman’s jobs and tax plan was called “big and bold” by Reuters and “as impressive as any to date in the GOP presidential field, and certainly better than what we’ve seen from the front-runners.”  Because of my stake in the Huntsman campaign I will let you decide for yourself.

What is clear is that the Republican candidates for president have displayed many similarities and many differences in these proposals.  The distinctions may seem minute, but they are clear and integral in this time of economic woe.  The candidates now have approximately eight weeks to distinguish themselves from each other and from President Obama.  It should be interesting to watch.