Why the IMF Cried “Uncle!,” and How Big Companies Are Preparing for a Euro Crash

This week we witnessed an intellectual revolt by the International Monetary Fund (IMF), the key partner involved in this European crisis with the European Commission and European Central Bank (ECB), aka the Troika. And it validates my long-term, euro bearish view.

The IMF finally concluded that austerity measures are squeezing the life out of the euro-zone economy. Most of the economies imposing strict austerity are fading fast. They include: Greece, Portugal, Spain, and Italy.

Here is the policy path that the IMF had endorsed until its about face this week: A country with a massive welfare society can cut spending, while raising taxes and expect the economy to grow and produce more tax revenues.

That’s hardly how the real world works.

The IMF has finally realized that the path of austerity and tax increases leads to a viscous downward spiral of lower growth, lower tax revenue, more cuts, lower growth, lower tax revenue … etc. It is what many have been saying for a long-time and why most have predicted a Great Depression era settling over the zone.

I think this about face by the IMF exposes the primary flaw facing the euro zone — it is a structural competition problem.

Weaker Members Put
at Severe Disadvantage

All countries locked in the straightjacket of one monetary policy and one currency — the euro — are forced by the market to compete against one another based on the efficiency of their respective economies.

For example, granted a simplistic one, but to the point: If goods in country A can be produced more efficiently than similar goods by B, then A wins. In the real world, even if country B’s manufacturing industry is not as competitive, the country’s currency by virtue of a less efficient economy could fall in value relative to country A’s currency, thereby making B’s goods relatively attractive even though its labor efficiencies lag. Thus giving country B a chance to create some wealth in its competition against country A.

But the example above cannot play out in the euro zone — with Germany as country A, and weaker countries representing country B. Instead of using the currency, weaker countries must find a way to deflate domestic wages. This is what austerity has been all about …

Germany’s efficiency holds a competitive advantage over weaker euro-members.

The theory makes sense. But politically and economically thus far it has been devastating. And estimates are that this process may take a decade or more to pan out, which seems daunting given the level of social unrest and growing resistance among those distributing wealth.

So, the IMF stepped in with an intellectual lifeline of sorts. But it stretches only so far …

The idea of more spending will not do the trick. If that were the winning strategy, seven years of borrowing and spending during 2000 until 2007 by the weaker euro-zone countries would have helped their relative competitiveness. Labor efficiencies, based on wage rate productivity moved further out of line i.e. the gap for German competitiveness widened during the time weaker euro-zone countries had access to all the capital they needed.

When credit is flowing freely and consumers are spending wildly thanks to rising debt levels and not real wealth production … everyone is happy! And the structural competition problem remains effectively hidden.

But when you look at the numbers during the euro-zone consumer boom, you see that Germany filled a massive amount of this demand. And it is why Germany’s current account surplus was soaring during this period, while the other countries were recording increasingly bigger deficits.

The Key Point Is This …

In one sense it is good the IMF is finally acting like a grown up and pointing out that austerity is killing the euro zone. However, more spending by governments will not solve the core competitiveness problem. If the weak countries cannot create real wealth on their own, this game will end — the euro will break apart in time.

Based on our daily research, it seems more and more multi-national companies and analysts are coming around to the idea that there will be a breakup. The big companies — international and European based — are actually sweeping their cash accounts each night into what is perceived as stronger countries’ banks, and then bringing the cash back in the morning for operating capital.

Big companies are taking precautions in the event of a euro crash.

Many firms have either formed committees to monitor the ongoing breakup risk in the zone in real time or have drawn out strategic contingency plans to deal with a breakup, defining risks and costs.

JR and I have floated an idea before, which was a bit out of the box a year ago but now seems to be gaining some traction among analysts: If Germany leaves the euro zone, everyone would be better off, including Germany.

That’s because:

Countries competing with Germany cannot compete using the same currency. And if Germany leaves and the D-mark rises in value against the remaining currencies, as most suspect it will, then those still using the euro will be able to compete on final goods exports. And even on a foreign direct investment basis in a much devalued euro relative to the D-mark, their assets will look cheap.

Moreover, the incentives for Germany to remain the paymaster within the euro zone are fading fast …

German taxpayers are grumbling. And the country’s central bank — the Bundesbank — is not happy. The way the payment system is structured in the euro zone between the ECB and Bundesbank, Germany takes on a huge risk, now estimated at around €900 billion and rising. And as the euro zone craters down into another deep recession, the zone loses its captive export market appeal for German manufacturers.

So, I believe this week’s admission by the IMF that austerity is the wrong policy to correct what ails Europe is a damning admission. It says to the world that to date, those umpteen summits designed to impose just the right amount of austerity to trigger recovery and confidence the single currency was “here to stay” were nothing more than a massive waste of political, and more importantly, economic capital.

Plus, they were a waste of a very precious commodity for the euro zone — time.

So Now What for the Euro Zone?
Two Possibilities …

There might be a new round of massive fiscal spending that may stabilize the zone and reduce social unrest. At the same time, though, it will push debt-to-equity ratios even higher from an already very lofty perch. But it would be an admission the welfare state cannot be dismantled anytime soon. And from a pure supply and demand standpoint, it will mean a much bigger supply of euros will be thrown onto the market. That alone should lead to a lower price for euro relative to all currencies.

Or …

Leaders in key countries come to their senses and realize if they had control of their own currencies and monetary and fiscal policies, they could design economic policies better tailored for their own needs to help their industries compete on their own terms. If that conclusion is reached by a critical mass of countries, based on the implicit and unintended backing of the IMF, this thing called the euro would unravel quickly.

We think the first possibility is the more probable: A massive number of euros will be thrown on the market by the ECB and increased fiscal spending will follow. The law of supply and demand would then take over, and the euro falls of its own weight.

Best wishes,

Jack

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