The thin veneer

Baruch is staring-eyed and stressed. This sovereign debt crisis is beginning to wear him down. He’s beginning to worry. He wouldn’t mind if he was just dealing with risk; he can quantify and hedge that. No, he feels deeply uncertain. Here’s why:

The general hopelessness of european policymakers is just too evident. We don’t have a fiscal head, a SecTreas, to make reassuring noises. We have a cacophony of differing national agendas, and a bunch of governments up for re-election. Arguably reasonable when they do stuff separately, when they act together everything they do has an air of compromise, half measure, and to the uncharitable, incompetence. The ECB, as the heir of the Bundesbank, should have a certain astringency when it comes to dealing with crisis — which in Europe hasn’t come about very often — that the Fed has long since abandoned. If the Fed, especially under Greenspan, was always the loving Mommy, the Bundesbank was the harsh Prussian Vater, prepared to let its kids die if they thought it was good for them. We think that’s what the ECB is supposed to be like, but we just don’t know. It might also tend more to the Banque de France part of its inheritance, which was if possibly even more of a pushover than the Fed is. It’s essentially untested. That’s not risk; that’s uncertainty.

This general European hopelessness in the face of this particular crisis is actually surprising considering how much is at stake. That’s because it is not just about trivial economic issues: what is at stake are key national interests and core principles of post war foreign policy, harking back to a period where tanks roamed the continent blowing things up. It’s also about domestic policy, the fabric of the settlements between right and left in Europe, insofar as what seems to be happening is that the world has decided to stop funding Europe’s social model.*

Baruch was taught to understand the Euro, and the whole European project, in the context of a historic compromise between France and Germany to prevent war from ever breaking out on the continent again. Germany was permitted to become a normal state again, and to thrive, so long as it was separated into BDR and GDR, and vitally, integrated into a number of key institutions, in which the French would be the senior partner (and French the main language — they like that sort of thing). They started with the European Coal and Steel Community, and moved on to the EEC, the Single Market, and later, the EU, gathering more and more members on the way as it was clearly proving to be A Good Thing.

The USSR falling to bits put paid to this cosy arrangement; suddenly half the bargain was going to be broken as the Germans clearly wanted their Eastern relatives back. That this was a real problem at the time is easily forgotten; the Blessed Margaret famously fretted whether Reunification should actually be “permitted” at all. EMU and the Euro was the agreed-on price. Unified Germany would be even more tightly integrated to the rest of Europe, with the added bonus that, at a stroke, the more feckless European economies would be given the envied central banking credibility of the Bundesbank, the model for the ECB. For countries like Italy and Greece, where the smallest notes in circulation had lots of zeros on them, this was also seen as A Good Thing.

This is up in the air now. The Euro is at more risk than it has ever been. And for the new generation of politicians in France and Germany the compromises of  the 1990s may not mean so much. We don’t know how much they are prepared to risk to defend the status quo. They don’t have direct memories of firebombed cities, of fathers not returning home, of mothers and sisters raped by the Red Army. I don’t think we’d have the same worry if Kohl and Mitterand were still around. We would trust them more not to fuck about. Again, like the ECB, Merkel and Sarko are untried; their being in charge implies less risk, more uncertainty. And the French disengagement on this whole issue worries me.

I think that what I learned in 2008 about debt markets and leverage (they seem to go together) is that there’s nothing there without confidence; take it away, and trillions can become worthless in the blink of an eye. And all you get is a stupid coupon. Say what you will about equities (yes, Felix, I like the videos), there tend to be tangible realities behind them, stuff you actually own. Even if it is the nebulous brand value of a TV sock puppet selling online petfood, it is more than zero. This, Baruch thinks, is why bonds are not an asset class for serious people.

Subprime blowing up and its ramifications were, with hindsight, pretty obvious for some time before the crap really hit the fan. When confidence there evaporated the implications for valuing other asset classes were only indirect. The debt of developed western governments may be another matter. Aren’t they the anchor for the whole risk spectrum? All my company DCF models use respective 10 year government yields for the basis of the rate I discount their earnings at. Banks around the world have worked to derisk and delever their balance sheets in the past 2 years; you don’t get safer than AAA/AA government bonds. They must be stuffed to the gills with it. Mrs Baruch turned to me the other day and whispered, you know dear, after all this, corporates are going to be viewed as less risky than governments. She’s almost always right when she talks like this. I don’t know the ramifications of that. I have no idea. The limited bits of CAPM I remember don’t include that contingency. Again, uncertainty, not risk.

Confidence in bond markets is a veneer. We saw what was underneath in 2008 when the veneer thinned. I feel it thinning now, and am really worried that if subprime blowing up meant that commercial lending disappeared, and factories in Shanghai closed their doors for a month and global economic activity froze, the blowup of Eurozone sovereign debt can easily have the same impact.

As I write, eurozone finance ministers are meeting and, we are told, Have a Plan. I hope it is fittingly thermonuclear.

* this is not my original line, it came from an obscure Korean fund manager quoted in a Bloomberg article I read last week. I can’t find it any more. 유감스러운.

UPDATE: Wow, Angela Merkel must read my blog! Wait — hang on — did I just save the Eurozone . . . ?

12 responses to “The thin veneer

  1. Baruch,

    You’ve finally gone macro, and John Mauldin’s letter of May 7th is entitled “The Center Cannot Hold” and starts with Yeats’ The Second Coming. Interesting times.
    I’m staying in cash, but what is the intrinsic value of a fiat currency in a crisis of confidence?

    Cash

    • Ha! Yes. I admit it. Touché cher Cash. But while I am only really interested in the micro the macro can sometimes come and bite me on the butt. Anyway a post like this is more like therapy. I have been really worried. I don’t know when I should start worrying again, maybe next week, but right now I have a sense of relief.

  2. It’s good to be long only equity in the U.S. of A. Whatever happens to the Euro at this point, it won’t hurt the dollar, and I am thankfully not in the position of having to worry about whether somebody else’s money might vaporize as the result of a Portugese or Spanish bank with too much exposure to Greek public debt.

    What’s that old saying again? Oh, yes:

    “Buy American.”

    • ::yawn::

    • And now, Michael, you are no longer in the position of having to worry about the principal export market for your excellent American stocks drying up, nor their stuff being priced out of the market due to their high cost base as the Euro implodes!

      Don’t be silly. Go and write a heartfelt thank you note to Angela Merkel for protecting the value of your domestic stocks. Accept her genius. And learn German.

  3. Guillaume

    It took us a year to realize that things won’t be the same again… I have the sense that 700 billion doesn’t mean as much as it did a year ago. Shock maybe, awe not at all.

  4. M. B. Drapier

    This general European hopelessness in the face of this particular crisis is actually surprising considering how much is at stake. That’s because it is not just about trivial economic issues: what is at stake are key national interests and core principles of post war foreign policy, harking back to a period where tanks roamed the continent blowing things up.

    Anyone who is surprised by this should review the history of the European response to the breakup of Yugoslavia.

  5. Read the internet long enough and you see things that you never thought you would– like people looking at Mitterand as an economic wise man.

    Sado-monetarism…

    • Sado-monetarism is a funny line. However, ignorance, you mischaracterise my argument: Mitterand (or for that matter, Kohl) does not equal econo-genius in my book, far from it. But he was able to bend economics and economic policy to fit his national interest. He knew which came first.

      I was thinking this current lot didn’t have the cojones to do the same sort of thing, but am very pleasantly surprised. I am proud to be a European today — take zat, anglo saxons macro hedge fonds perfids!

  6. Angie, the only physical chemist I know to have become a head of state, has been the recipient of my forlorn and unrequited love notes for years.

    Do you think she held the French poetry against me? I probably should have stuck with Goethe.

  7. Here’s something that I have been wondering about–what does this do to the German model of being a country that makes things and exports things? Does that look wise, at this point, given that, with these new austerity measures, the market for German goods in Europe is going to shrink? And, when it does shrink, what then happens to the Euro?

    If the guarantor of the Euro can’t sell what it makes, then will this create a downward spiral?

    Just curious.

  8. Baruch, mon vieux,

    Now, stay with me here:


    Looking at the current state of the world economy, the underlying reality remains little changed: there is more debt outstanding than is capable of being properly serviced.

    It’s just that simple.
    Or maybe not; who could say? But it seems to me that there may just be way more money in the world than there is stuff. Call me old-fashioned, but I keep coming back to land, commodities, industrial plant and other tangibles as the natural basis of money, and you can’t print that stuff.

    In other news, Google Android Outsells Apple iPhone In The U.S.

    Also, Cyanogen’s Android 2.1 (eclair)-based software is now in beta for the G1. The old dog can still learn a few new tricks.