Why Germany needs Greece in the Euro-zone

 

Yes, you read correctly, and no I am not taking a leaf out of the Daily Mail guide to click bait strategy.

I believe that the only way that the euro will survive and flourish is if it agrees on a formal and regular wealth transfer from Germany (read North) to the troubled periphery (read South). Most other fudging strategies at best can only hope to lead to a soft landing and stagnation, and at worst a hard landing, irreparable social division, and devastated economies.

Markets are sentiment led, and so I believe its not too late to resolve. I will do my best to give a simple explanation why.

The euro has hugely benefitted Germany

This is key as some estimate that since the euros inception it has boosted the German economy by between €200-400 bln per annum. In 2010, a McKinsey study estimated that the single currency boosted the regions wealth by €332 billion euros ($424 billion), or about 3.6 percent of gross domestic product with roughly half of that going specifically to Germany.

It's estimated that if still active, the deutsche mark would trade around $1.50, 25% higher than its current value at $1.17. Over the past fifteen years, the euro has been on average around $1.35 and now looks like it might head back to parity. That is a significant competitive advantage for German exporters.

The reason for this devaluation has been the inclusion of periphery nations like Greece, Spain, Italy, Ireland, Portugal.

Whenever the eurozone is in crisis, the price of the euro falls. Last summer when the market was calm, the euro strengthened to $1.40. Before that in 2009-10 when the crisis heightened it fell to $1.19, and in the big bull run heading into the 2008 crash, it hit $1.60.

A clear and easy observation to make is that when crisis and structural instability cause the euro to fall, it is hugely advantageous to Germany.

A word on debt and currencies

The UK just paid off considerable chunks of historic debt, some of which dates back to the South Sea Bubble crisis of 1720, the Napoleonic and Crimean wars, slavery's abolition and the Irish famine. This should be a reminder that national debts go back a long way and don't just disappear.

We should also consider that Greece has a troubled history with debt, having been in technical default from between 1932 and 1964, and having defaulted five times since the Napoleonic wars.

The periphery nations will also have debt dating back centuries. This historic debt is priced in the original currency. All new debt is priced in euros.

Most importantly, both old debt and new debt is paid back in euros.

An alternative play could be that during the initial euro price dip, periphery nations took advantage of the German level borrowing costs and favourable currency moves to service old debt. However, regardless of favourable borrowing rates, a 60% increase in repayment costs over 7 years will put strain on any treasury department.

Why is this important?

In the same way that having the periphery in the eurozone has kept the euro discounted when compared to the deutsche mark, from a periphery perspective having Germany in the eurozone has placed a premium on their membership cost.

They entered into an economic union to share a currency with much stronger economies, and for them the euro has seen the value of their operating currency increase.

Prior to joining the euro, borrowing costs ranged in the double figures for most of the periphery 10 year Government bonds. For example, in 1995, the Italian 10 year was 13.45% while the Greek was 19%. When these nations joined the euro, automatically these repayment costs increased because the euro was a stronger currency than the lira and the drachma. Remember, original currencies were valued to the euro, and the euro launched at $1.17.

Lets use the example of Greek 10 year bond sold in 1995 with a 19% yield.

In 2005, half of that bond would have been paid back in drachma, and half in euros. That 19% would actually have been higher in real times due to currency revaluation.

Additionally, from launch to 2008, the euro appreciate some 40% in value. True, the single currency did move below parity for a period shortly after its launch, but it soon strengthened significantly.

This is a big deal.

A roleplay scenario

• Imagine being a periphery finance minister experiencing national debt being revised higher.
• Imagine then seeing the value of the currency the debt has been revalued in climb 40-60% over the following years.
• Imagine having no means to follow the traditional devaluation out of debt route.

Then imagine discovering that another consequence of joining the euro is that you can now borrow at German interest rates.

Debt costs are spiralling due to a soaring euro, but its never been easier to borrow. Prior to the euro, Greece borrowed at 15-25% on a 10 year Government bond, but afterwards at 4% based on the markets assumption that Germany was the underwriter.

It was a classic debt trap.

The periphery had no currency to devalue its way out of debt so options were limited.

We know Greece became an active player in the bond market, and look how its debt exploded during the euro years.

Sadly, there is very rarely a happy ending in the debt game.

So the answer is to pay the Greeks to be themselves?

Well... yes.

We have established that a weak euro is beneficial to the northern nations for the past 15 years, and that the source of this weakness has been the inclusion of the periphery states.

Rather than bail out the periphery nations, layering on more debt, destroying their economies, causing generations of hatred and institutionalising political serfdom, Germany could pay them a cut. Its very simple.

Greece has €300 bln debt. The bailouts it receives could be changed to annual payments solely for trimming down the debt - in exchange for structural reform - because nobody denies that the Greeks and their cohort need to improve things.

Each year, Germany and northern states could pay the periphery to reform their economies. The cost would be offset by the net benefit of having a devaluing force on the economy. In the long run an improved and efficient periphery would no longer be the periphery, but equal partners.

That sounds awfully politically unpalatable

It does doesn't it, which is why we should keep an eye on what happens with ECB QE. The Euro has already been in free-fall in anticipation. The Swiss removed their Euro peg in anticipation. We are just waiting for confirmation.

Germanys contribution to the ECB's working capital represents 17%, so it could b argued that any ECB QE would effectively be said wealth transfer to the troubled periphery. However, the other two big contributors, France (14%) and Italy (12%) look to be real long term causes for concern over Eurozone stability.

Alternatively, the UK and the US have very successful currency unions because there is an understanding that not all regions are economically equal and should not be treated as such. Rather than special case situations, the wealth transfer is one of structure, not bail out.

Until Europe finds its acceptable terms of transfer, I suspect that it won’t find peace and stability.

Thanks!


By Thiago Duarte
Chief Strategist at Duarte Investment Group 
thiago@duarteinvestmentgroup.com
@thiagotrader