Q2 Insights: The end of the free ride

http://www.tradingfloor.com/posts/q2-insights-free-ride-836842257

A free rider in economics refers to someone who benefits from resources, goods, or services without paying for the cost of said benefit.

This term can best describe how the world in the first quarter moved from a free-riding concept to blatant public disagreement on how to keep the party going. The stock market is hitting new highs but employment and growth, the two factors that really matter in the long term, are hitting new lows month by month.

 Attempts to free ride can be seen every day  in competitive devaluations, lack of reform in Europe and the US, the inability of the European Council to agree on a bailout (or bail-in) programme, the stock market rise, and how interest groups (read public sector) refuse to reform despite the obvious need and greater good of doing so.

The economic crisis has evolved into a full-blown political crisis. When government debt becomes too large and the fiscal deficit explodes, it is much more difficult to induce all interest groups to co-operate. The later the financial reconstruction is initiated, the bigger the deficit – and it is more likely to be unsuccessful because of the parties' lack of "interest". This is the case in the US and Europe right now: they have bought so much time that the problem has moved from being an issue that couldbe dealt with to something that must be dealt with.

Three months into the year and we see growth being lowered and fiscal deficit projections increased by all of the Club Med countries, plus France and now also Germany. The International Monetary Fund (IMF) has lowered world growth and we are looking at a 2013 that is, from the outside, a mirror image of 2011 and 2012. But there is one difference: the German election on September 22 – the main event of the year.

The German election can't come soon enough. We need to break this negative cycle that is spiralling out of control, in which politicians are standing idly by. The bet that Germany will, ultimately, write a big cheque and accept fiscal union is prevalent in the market, but perhaps history is a better guide.

The single biggest "cheque" ever written was the Marshall Plan offered by the US to Europe post-World War II. Its size? An impressive USD 13 billion in a USD 258 billion economy – or, in other words, 5 percent of US GDP. Let's assume Germany is willing to bail-in the rest of Europe with a number equivalent to the US Marshall Plan: Germany's GDP is USD 3.6 trillion and 5 percent of this is USD 180 billion, or EUR 140 billion – hardly enough considering it is estimated that between EUR 2 trillion and EUR 3 trillion is what is needed to stop the EU debt crisis once and for all. We are again seeing that hope is based on a "free ride" that there will be a German willingness to help, but the facts state otherwise.

The Cyprus bail-in or bailout created no winners – only losers. Nor did it give any credibility to the EU process. It has left European decision-making bleeding and without hope of recovery as the EU Commission and the IMF exchanged harsh words in the name of a power game, never for the sake of future Europeans.

We saw in Cyprus how principles go out the door when the Eurozone needs to find a solution that fits the political spectrum. Cyprus was a first in three ways:

·         Capital controls: one euro in Cyprus is not the same as one euro in Berlin or Paris any more. You cannot move your money off the island.

·         Bail-in of senior bondholders: in Greece, it was only junior bondholders.

·         Bail-in of depositors with more than EUR 100,000 in their accounts.

The more serious "violation" is the capital control. An economic and monetary union no longer exists across the Eurozone. The lack of coherent policy solutions raises the question: who is to pay for future bail-ins? Is it open season on uninsured depositors for policymakers? It would appear that this source of revenue is far more efficient, or implementable, than raising other types of taxes in countries such as Italy, Spain, Greece and Portugal.

One can speculate that the ultimate goal could be to introduce a Swedish-type banking model financed by a levy on assets from depositors and shareholders. To build a fund big enough to recapitalise all of the banks in the Eurozone, the bill would be EUR 3 trillion, or 30 percent of the bloc's GDP, according to Citigroup's chief economist Willem Buiter. I repeat, EUR 3 trillion.

A deposit tax is already in place in Italy and Spain. Italy has had a 0.015 percent tax on assets under management since December 2011 and only a few weeks ago, the Spanish courts allowed the government to impose a 0.2 percent to 0.3 percent deposit tax.

So Cyprus was a first in many ways, but also an extension of practices already in place. Let me warn again: the fact that deposit taxes are currently low should not make you sleep easily. VAT was introduced in Denmark in 1967 at 9 percent, but it has since risen to 25 percent. The point is that deposit taxes are easy to collect, come from the private sector and will be deemed fair by many non-creditors – again back to the free riding. If you have no money in the bank, a deposit tax seems fair and with the present policy of non-reform, this group is getting bigger and bigger by the day.

This was best seen in Italy, where Beppe Grillo and his Five Star Movement polled 25 percent with no programme except being anti-establishment. This is a warning for all politicians in Europe. Voters are not going to sit this one out, despite having been free riders for a long time. The ultimate challenge of finding jobs and getting back to normal is now more important than looking for the "system" to bail them out. Since Cyprus, this move should get stronger as savings – if in excess of EUR100,000 – will be targeted by the Eurozone Troika. The EU and its politicians are running out of time. By this time next year, without change and reforms, there will not only be economic consequences to pay, but also political – not only for domestic politicians, but also for their EU counterparts as electorates will have no patience with their plans to have a plan for a plan in 2018.

Meanwhile, the short-term solution is for everyone to engage in competitive currency devaluation. Officially, they are all conducting domestic-driven monetary easing, but the flow of capital chasing yield from Japan and the US is now driving locals in Singapore out of their own country. Likewise for the man on the street in Zurich, it is getting extremely difficult to maintain a standard of living while non-domiciled foreigners bid up the cost of houses, food, energy and everything else. Another social tragedy.

The main beneficiary remains the stock market, which has become a refuge in itself. Many people revert to the Marxist argument that property rights are only truly protected in equity and property, with the US being the main beneficiary.

This plays well to our general theme of a stronger USD and we believe that the bulk of investment return for the remainder of 2013 will come from foreign-exchange exposure. We do not see an equity market collapse, but the present levels of the S&P index and global stocks almost by nature dictate a pause as we approach expensive levels for stocks, particularly in the context of lower global growth and weaker earnings. For stocks to continue rising, we would need to see a big improvement in economic growth and a major new source of monetary easing beyond the expected rate cut from the European Central Bank.

In Q1, the world money printing machine became Japan, so now the race is on for economic conditions to improve before the monetary experiments in the UK, US and Japan fail. The UK will probably try to expand further to become the "new" impulse in Q3 – but probably not fully before the change of Bank of England governor in July. This leaves Q2 vulnerable to more political issues for want of new QE impulses. Most importantly of all, Q2 comes right before the German general election. This means Chancellor Angela Merkel will need to expend great energy in explaining her country's role in Europe to voters. I do not envy her this task,  especially as the crisis radar has already zeroed in on Slovenia as a potential new bailout candidate in the second quarter.

We are looking at a mandate for change. This would best be achieved via a proactive recognition of the need to reform, but change, most likely, will be triggered by another failure, such as not keeping Cyprus or Greece in the Eurozone. However, we also need to learn that failing is a part of life and signals new beginnings. The Kingdom of Spain has been bankrupt 14 times in history and if we look at our own lives, it tells us that we are at our most rationale and logical when we have our backs up against the wall.

And therein lies my optimism. As I like to say at the start of my speeches: "I'm the most optimistic I have been in 25 years, only because things cannot get any worse."

The free-riding spree for politicians is over. They now need to do something they have never excelled at: face facts and devise real solutions. As they are unlikely to rise to the task, the micro economy will do it for them instead.

 

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