Economic Reforms Sacrificed For Political Gains
John Mauldin's Outside the Box

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Introduction

This week we will turn once again to a group headquartered in Hong Kong with offices in Stockholm and New York called GaveKal Research Limited. Louis- Vincent Gave's GaveKal Ad Hoc Comments for Friday, April 8, 2005 looks at the political and economic climate in Europe and what that might mean for the Euro and European government bonds.

The European Union, now with a few years behind it, is looking to make some changes and as we have seen throughout history, what is good politically is not always good economically. Gave looks at the current issues and why this is bearish for Europe. The problem is not the concept of the EU but the implementation when politicians get involved and that is why this became our latest Outside the Box.

It is one of the reasons I wrote last week that I am somewhat nervous about the euro in the short term and prefer to play my overall bearishness on the dollar with Asian currencies. (Go to www.investorsinsight.com for last week's letter.)

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Economic Reforms Sacrificed For Political Gains

By Louis-Vincent Gave
April 8, 2005


When told of the 1938 Munich accords that allowed Hitler a free rein into Czechoslovakia, Churchill said: "they sacrificed honour for peace, and they shall have neither".

Witnessing recent events in Brussels, Churchill's statement comes to mind. Two weeks ago, European leaders tore away the Stability and Growth Pact (SGP) and dismantled any hopes of liberalization of European services (the Bolkestein reforms) in the hope of securing a "Yes" votes in the May French referendum on the European constitution. In so doing, Europe's leaders sacrificed necessary economic reforms in the hope of political gains, and they will have neither.

1- The Death of the SGP: A Legal Disaster

While we are not great specialists in international law, we do know that in the order of laws, a treaty usually sits at the top of the ladder, even above national constitutions (France & England went to war in 1914 solely to respect treaties they had signed). So to see a treaty cancelled without unanimous support, is to make a mockery of the rule of law.

As we all know, capitalism and democracy can not function without a strong adherence to the rule of law. But in Europe, the rule of law has been replaced by the will of the powerful. And "Might over Right" is never conducive to trust, or economic growth (that the treaty was torn apart by France and Germany who, just a couple of years ago, were arguing that nothing is more important than the respect of international law, further adds insult to injury!).

2- The Death of the SGP: A Diplomatic Disaster

The European construction was based on the idea that the European interest should always prevail against narrow national interest. There was even a strong effort to create a European "patriotism" (i.e: common passports, European anthem, flag etc...). But today, national interest in its ugliest format (i.e.: the need win the next election) is raising its very ugly head.

A schism has now emerged in Europe. On the one hand, we find France, Spain and Germany. On the other the UK, Scandinavia, Austria, the Netherlands & Eastern Europe. In these latter countries, there always was a deep suspicion that the rules accepted by everybody would apply to France and Germany only if they suited. These fears have now be proven right. And as result, any future talk of further European integration, reforms etc... will start off on a basis of mytual suspicion, instead of understanding. France and Germany have managed to develop an atmosphere of "us against them" in the corridors of Europe's ministries. And this is not conducive to progress. Goodwill has now disappeared and there will be no more national sacrifices on the European altar.

Let us make no mistakes about it: we have witnessed the end of the movement which started decades ago with Monnet, Adenauer, Schuman and Gasperi. Protectionism, corporatism, cronyism are now the wave of the future in EuroLand. And the politicians who will gain success at the polls will be those who position themselves against Europe (as Chirac has done) and promise to "get the most" out of the European Commission for their domestic economy. What a step backwards!

3- The Death of the SGP: An Intellectual Regression

With the burial of the Stability & Growth Pact, European leaders have just come out with the message that "government spending is necessary to stimulate economic growth". This is a very important intellectual regression. Indeed, we had hoped that the Keynesian idea of creating growth through government spending had died intellectually at the end of the 1970's, and practically with the demise of the Soviet Union. Unfortunately, it now seems to be making a strong come-back.

This is hardly good news. Worse yet, it shows that Europe's leaders have little ability to learn History's lessons. If increases in government spending helped to create growth, then Europe and Japan today would be on top of the world. In a recession, the easiest way to jump-start growth is through tax cuts and easier monetary policy. Europe today needs tax cuts, privatisations and deregulations. Not more government spending or hiring of civil servants.

4- The Death of the SGP: Economic Problems Ahead

Fact #1: France, Germany and Italy are running important budget deficits of between 3.3% to 4.2% of GDP. And the end of the SGP now gives governments a freer rein to increase these deficits.

Fact #2: This state of affairs is not new. And as a result, European governments either have an important debt inventory (Italy is at 100% of GDP, Belgium is at 107% of GDP), or a rapidly rising one (government debt in Germany has risen from 48% of GDP to 65% in the past decade and from 40% to 65% in France).

Fact #3: This debt needs to be serviced and almost by definition, of all the government expenditures, debt is always the first to have its pound of flesh

Fact #4: Tax receipts in Euroland have had a miserable growth rate. It is also unlikely that tax receipts start growing faster than the anemic GDP growth.

And this begs the question of how Europe's governments will pay for a) a growing interest bill and b) all the services they provide to their local populations?

 
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On the chart below, we index in 1995 at 100 tax receipts in Germany and the servicing of the debt. On this scale, tax receipts would today be at 114, while the servicing of the debt would be at 148. This means that, if, in 1995, 20% of German tax receipts were used to service the debt, the debt- servicing figure would now be (20%*(148/114)) or 26 %. So if in 1995, the German government had 80% of the tax receipts to play with, today the German government would only have 74 % of the tax receipts to distribute.

 
Chart 1

To be sure, this would be 74% of a bigger pie. But the pie has not grown fast enough for the German government to maintain its level of spending. After all, 74% of 114 (tax receipts) is equal to 97%. So today the German government has roughly 3% less to distribute in absolute terms than in 1995.

Worse yet, the real interest rates on the debt (for our computation, we have assumed 50% short-term debt and 50% long debt) is still growing at twice the rate of GDP. The same is true in France, and even worse in Italy (which is arriving at the end of a creative accounting period linked to privatization).

We simply do not understand how countries can grow their debt by 5% a year and their tax receipts by 1% a year, starting with unfunded and funded liabilities well above 100% of GDP. At some point we will witness either:

a) massive tightening of belts from EMU governments (but given the battle over the SGP, this now seems even less likely than before)

b) a collapse in the currency as the governments' growing liabilities get financed by printing presses (our belief)

c) an implosion and a political crisis.

5- The Solution: Protectionism?

To add insult to injury, not only did Europe back out from its fiscal restraint promises, but it has now pushed back what was one of the cornerstones of the Lisbon agenda: the liberalization of services, or what is widely know as the Bolkenstein reforms.

The Bolkenstein reforms were the last step in the ambitious project of a European Union where goods (accomplished), people (accomplished), capital (accomplished) and services would be allowed total freedom of movement.

Now why, all of a sudden, become protectionist on the exchange of services? What do the bigger nations have to fear? Countries like France (who blocked the reforms) are net exporters of services; and services represent the fastest growing part of the economy! What does France have to gain by turning to protectionism? And what does Europe?

In Brussels, we saw a French president give echo to the more protectionist thesis of the greens, the reds and other fruitcakes. We saw a French president blame Europe for "dumping social, dumping fiscal, dumping ecologique".

By making Europe a scapegoat for all the challenges faced today by European society, Europe's politicians (and Chirac in the forefront) are obviously encouraging the rise of the "No" vote in the coming referendum. The French president (and other who voted with him to block the liberalization of services) are also committing an unforgivable political sin: they are turning to protectionism in times of economic difficulties.

And protectionism, always and everywhere, only makes a bad situation worse.

The fact that policy-makers are using the excuse of a forthcoming vote on the European constitution to justify their ghastly deed is all the more disturbing. It shows that policy makers believe that they can bribe electors into guaranteeing an election result. And in itself, this shows a contempt of democracy, and economic realities, which should lead voters to vote the other way.

6- The End Result: a No Vote

Following Mr Chirac's performance in Brussels, an increasing number of people in France see the EU as either: a) a tool of evil capitalists waiting to break apart the French social harmony (after all, that is more or less what Chirac said it was...) or b) a useless talking shop which just adds another layer of administration, and taxes, unto an already bloated system. So it is hard to see how a majority of Frenchmen will vote in favor of this new European constitution.

It is all the harder to see how people will go vote in favor of a constitution that no-one has read. Asking around, we have yet to meet anyone who has read the 800+ pages of the new European Constitution. And who goes to vote to adopt a new constitution without reading it, except the most hard core believers in the European technocratic elite? It is like a signing a contract without having read it!

Maybe the constitution would have had more of a chance had the government send every household their own copy; but then again, that would most likely have triggered a post office strike. Can you imagine the poor French facteurs on their bicycle delivering 800+ page constitutions to every household? Then and there, the whole postal worker vote would have been lost.

 
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7- So What Does It Mean For European Asset Prices

In A Study of History, Toynbee contends that historical movements are the consequences of the challenges confronting a society, the role of the elite being to analyse the challenge and find appropriate responses. If the challenge is tackled successfully, the society progresses and finds a new equilibrium. If the answers are not the right ones, the challenges returns, until such a time as the elite can be replaced (revolution) or the society itself disappears (end of civilisation).

Europe's challenge today is demographic and sociological in nature: how to make an old and rich society co-exist with young, poor and desperate societies, in the same geographic zones, in the knowledge that there can be no military solution? The implosion of social welfare systems, immigration, internal troubles, deteriorating educational systems...all of these problems are rooted to some extent in the demographic collapse of Western Europe.

Turning to protectionism, and increased government spending, will simply not succeed. Tackling a historical challenge requires imagination, optimism and courage; not old, worn-out, tied and failed, policies. Unfortunately, the current batch of leader (Chirac, Raffarin, Schroder...) have now shown that they posses none of the qualities. The voters will therefore deliver the punishment that these leaders deserve.

But the more important question, to us, is whether the markets will also punish this disappointing behavior? We want to stress that recent developments should be seen as massively bearish for Europe. Indeed, compared to a few months ago, European governments have proven themselves to be a) more spendthrift (bearish), b) more protectionist (bearish) and c) more pettily politician (bearish).

This is of course very bearish for the Euro. But it is also bearish for European government bonds. Today, all political trends point towards a depreciation of the European currency and a likely pick-up in inflation.

So far, the market does not seem concerned. But will the coming "No" vote in the French referendum shake the market out its torpor? Could a resounding "No" vote (which is what we expect) be what George Soros called "a moment of truth", i.e.: a time when the obvious becomes evident to everyone simultaneously? Who knows. But being long the Euro, and European government bonds at this juncture makes little fundamental, or valuation, sense.

Conclusion

I hope you enjoyed this weeks Outside the Box. You can find out more about GaveKal and their research by going to www.GaveKal.com.

Your bearish for at least the short term on the Euro analyst,


John F. Mauldin
johnmauldin@investorsinsight.com

Disclaimer

John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

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Posted 04-18-2005 3:18 AM by John Mauldin