'EU bailout is too little, too late, with too little detail'

Satyajit Das entered the world of professional banking in March 1977, and dived almost straight into the unfathomable world of derivatives. “Just bluffed my way in,” he says in his first bestseller, Traders, Guns and Money: Knowns And Unknowns In The Dazzling World Of Derivatives, released in early 2006. Nearly 35 years later, Das sits on the other side of the table, as it were, as one of the pre-eminent observers of the world of finance. His latest book, Extreme Money: Masters Of The Universe And The Cult Of Risk, will be launched in India by Penguin in a few days. In an interview on Saturday, Das explained why the European bailout package is a sham:

Q: The deal over the last weekend with the 50% haircut for lenders to Greece, the capitalisation of European banks and the levered $1 trillion plus bailout fund ... is it the bazooka we needed or is it just Band-Aid?
A: It’s not a bazooka. It’s one of those cartoon guns where a banner comes out of the barrel with the words ‘Bang!’ on it. They have at last got the agenda items right. But it’s too late, too little, too few detail. It would have worked in mid-2010, but I doubt whether it can do the job now. Also, there is no certainty that all the bits will be agreed and implemented.

A few things illustrate the problem with the deal. The writedown is actually around 30% when you do the numbers properly. Greece is still left with a debt-to-GDP of 120% and no access to market till 2021. They may need a much deeper writedown. The €106 billion recapitalisation is probably insufficient as it only factors in Greece. If you write down the holdings of other sovereigns based on current prices, then the amount is say €200-250 billion. Then, you have to factor in the effects of slower growth in the euro zone and the resulting bad debts.

The increase in the European Financial Stability Fund (EFSF) is smoke and mirrors. They admitted they don’t quite know how it is going to work. They are not even sure how much is left in the fund - it’s about €200-250 billion. The proposals assume you can lever this by using it to partially guarantee the debt of, say, Spain and Italy. In other words, leverage is going to solve the problems of leverage! None of the basic problems of the fund - the fact that Spain and Italy guarantee 30% despite being likely beneficiaries - is dealt with in any way.

The most remarkable thing about this package and the market reaction to it is that the euro zone did not commit a single new euro to it, not one! The commitments are the same as the one in July 2011, which is pretty much the same as in May 2010. That’s because no one can go beyond the present level of commitments. Even mighty Germany and France risk being downgraded by the rating agencies if they increase their commitments. If this were to occur, the entire bailout structure would unravel.

There is serious disappointment ahead. Euro zone leaders can book their hotels in Brussels for the “next emergency summit to end all summits”. After all, this was the 13th such summit in the last 20 months, each of which provided a “comprehensive” and “final” solution to the crisis.

Q: Even as this is being done, news is money supply (M1) in Portugal has plunged @21% annualised in the last six months, and that the country is already out of control, is the next Greece. It’s said Spain, Italy and Portugal have lost a third of their competitiveness to Germany since the 1990s. Where is all this going?
A: The assessment is entirely valid. The EU refuses to address the growing problems in Portugal and Ireland — which may also need debt writedowns. Spain and Italy have deep problems which are proving intractable — budget deficits, high unemployment, lack of competitiveness and major structural problems such as the lack of flexibility in the labour markets and the inability to politically address this fully.

The EU package does nothing to address these issues. Italy has promised to increase its retirement age from 65 to 67 years by 2026. That’s promising.

Locking weaker countries into the euro continues and worsens their problems. These countries are caught in a trap; they need to continually reduce their cost base — read living standards — which plunges the country into recession that worsens public finances and then the cycle starts all over again.

The hypocrisy of Germany is astonishing. Who lent the money to Greece, Spain, Italy? Who benefited from exporting to them? Look at their trade surpluses with the rest of Europe.  Who gained from a weaker euro? Without the peripheral countries and only the hard countries, the euro would probably be at $2. Germany wants to have her cake and eat it too.

There has been a noticeable absence of discussion on and dealing with these problems in any meaningful way at all!

Q: So the euro zone is getting caught in a “toxic” cauldron of extreme fiscal tightening, extremely high debt costs and looming recession…
A: That’s right. Europe must become Germans or, at least, Teutonic, to survive - that’s the basic strategy. Austerity won’t work - we have seen that in Greece, Ireland, Portugal and the UK. Cutting government spending and raising taxes just shrinks the economy, which exacerbates your budget problems requiring more austerity and so on.

A complicating factor is the weakening global environment - America has anaemic growth, Japan is not growing significantly and the emerging markets are slowing down in the face of their own problems. So, the lack of export growth makes it even harder. I think the best case is Europe becomes trapped in a low growth or recessionary environment.

Q: How wise do you think is the decision to let China get involved? Obviously, China will seek its tonne — not just pound — of flesh, maybe through trade or industrial concessions, despite the fact that it needs Europe back on its feet. What happens to global trade imbalances then?
A: China hasn’t agreed to do anything yet. But they have “skin in this game”. Europe is China’s biggest trading partner. China has around $800-1,000 billion invested in euros and European government bonds. Continuation of the problems does not help them.

At the same time, they are facing an internal political backlash and criticism for investing Chinese savings poorly. They are deep under water on their foreign investments. In addition, they have a number of serious domestic problems — inflation (partly as a result of the weak currency policies of the developed nations) and the attendant wage pressures, a serious bad debt problem in their banking system and pressure to accommodate the economic aspirations of an increasingly restive population. I am not sure how much flexibility they have to act.

Their position to date has been that Europe must get its act together and then they will assist. At the moment, the European position is different — Chinese money is needed to help get Europe’s house in order.
Personally, I don’t see any mileage in throwing good money after bad. There is no sign that the Europeans have a clear understanding of their problems and how to deal with them. Why would you just increase your commitment without reasonable prospect of success? In any case, most of Europe will be for sale, at bargain prices, at some stage in the near future. Perhaps, it’s best to wait.

The channelling of money through the IMF is also curious. If China wants to invest, then why can’t it invest directly? Would European tolerate Chinese interests buying, say, Renault, Deutsche Telecom or any major European bank? The wild card is the geopolitics. China seems desperate to be seen as a “global power”. Ego might seduce them into committing more money.
The negotiations would be fascinating, don’t you think — I give you €100 billion in return for your acknowledgment of Chinese sovereignty over Tibet, the Dalai Lama, Taiwan, oil in the South China Sea, a commitment to no criticism of currency and trade policy, human rights, press censorship etc. Maybe, you also will need to throw in some Greek Islands, antiquities and the champagne districts of France!

Q: In the circumstances, when do you see the ECB starting to print money?
A: Well, you have to go back to basics. People have made a whole lot of bad loans, which aren’t going to be repaid. So, someone has to pay for the losses - banks, savers, taxpayers. Basically, you have vapourised a fair bit of wealth and it’s going to reduce spending and consumption, going forward. This means Europe has three options — fiscal union (basically Germany pays the bills); debt monetisation (the ECB prints money); sovereign defaults.

Fiscal union is difficult. The constitutional court decisions earlier this year probably mean that Germany cannot do this without creating a new Constitution and effectively a new country. For the moment, they cannot or will not go above €211 billion in guarantees for the bailout that has been committed - that’s already about 7% of its GDP. I don’t think they can afford fiscal integration as the cost would be greater than Germany is willing to pay or can sustain without affecting the country’s creditworthiness. Remember Germany’s GDP is around $3.2 trillion and its debt to GDP is around 75%.

While everyone else is doing it, the ECB is not allowed to print money. Theoretically it would need a change in European Treaties. But they have broken all other rules and they may break this one as well. The added problem is the German, especially the Bundesbank’s (the German central bank), hard line position on debt monetisation. Also, there would be deep-seated unease about printing money in Germany, which is haunted by the memory of hyperinflation in the Weimar period. It would be a brave German politician who goes down this path. Given that around 80% of Germans oppose the bailouts, adding the spectre of printing money wouldn’t be the best re-election policy. That doesn’t leave much in the way of options, does it?

Q: Will the problems stay in Europe?
A: You can’t have selective globalisation. An American journalist told me that Greece doesn’t matter - it is like Minnesota defaulting. My thought was the comparison is inaccurate - the weather in Greece is a whole lot better, for a start. The US exports over $400 billion (22% of its total exports) to Europe. It also exports intermediate goods to Asia which are then re-exported to Europe. That’s going to be affected. American banks have around $100 billion of direct exposure to European sovereign debt, but an unknown and probably larger exposure to banks which have direct or indirect exposure to European sovereign debt and other affected debt. In addition, a portion of US savings, like pensions, is invested in Europe. How can you be immune? The same holds for Asian countries like India. They are directly exposed through exports. They have investments in European sovereign bonds. Asian companies and fund managers have investments in Europe. How can you ignore that?

The emerging markets are also affected in two other important ways. A disruption to money markets would affect availability and cost of funds for all borrowers. At the moment, term debt markets are very fragile. This will affect countries and companies, which need to finance investments or roll over debt. In addition, the policies followed by developed nations — printing money, deliberate devaluation — will fuel inflation and other problems for emerging economies.

Q: The conditions set for Greece could be tantamount to almost an intrusion of sovereign rights by the EU. How long can this last before the political opposition or aggrieved people go off kilter?
A: There is an increasingly social and political dimension to the financial problem. In countries like Greece, Spain, Portugal and Italy, there will be increased social unrest and upheaval at the austerity measures. In turn, there will be deep resentment at what is seen as external interference in sovereignty. The fact that it will be seen to be German- and French-driven will not be helpful, given European history. In the “donor’ nations, there is increasing resentment at bailing out “lazy” Club Med members. While the argument is both simplistic and incorrect, it doesn’t matter and plays well electorally, appealing as it does to nationalism, racism and xenophobia. There will be a rise of nationalist parties — like the Trues Finns in Finland and the resurgence of the Far Right in France. I think quite a few governments, like the fragile coalition in the Netherlands, will have difficulties.

Political pressure will manifest itself in “beggar-thy-neighbour” economic policies — trade and capital restrictions, anti-immigration policies and (perhaps) in repudiation of sovereign debt in some cases. It’s all vaguely reminiscent of the 1920s/ 1930s, isn’t it?

Q: What is the way out from hereon?
A: As the comedian Lily Tomlim observed, “Things are going to get a lot worse before they are going to get worse”.

Q: Then why are the financial markets so bullish?
A: Blame Twitter. Financial markets have always had very short attention spans and Twitter makes it worse. They only read the tweet — ‘European leaders conclude deal- agreement on 50% Greek debt writedown bank recapitalisation and boosting the bailout fund to €1 trillion’. 140 characters can’t do justice to the issues and complexity. Besides they don’t really want to know the truth as it doesn’t fit mantras like “stocks for the long run”. It’s truly amazing what people will believe and say if paid enough to say it.

I think there is also a deeper problem and disconnect between the financial and real economy. Over 50% of stock trading is now between super-fast super computers using mathematical algorithms. The average holding period of a share is a few seconds. In The Girl with the Dragon Tattoo, journalist Mikhael Blomkvist sums up the stock market’s role: “You have to distinguish between two things - the … economy and the … stock market. The … economy is the sum of all the goods and services that are produced every day … The stock exchange is something very different. There is no economy and no production of goods and services. There are only fantasies in which people from one hour to the next decide that this or that company is worth so many billions more or less. It doesn’t have a thing to do with reality or with the … economy.”