Weekly Geopolitical Report By Bill O’Grady

July 18, 2011

The Italian Job For most of the past quarter, European sovereign debt problems have weighed on the financial markets. The media has been focused on Greece which was forced to legislate new austerity measures in order to secure new financing from the EU and the IMF. Although the Greek Parliament faced massive street demonstrations opposing the measures, the plan passed with a very narrow majority. This news offered some relief to the financial markets despite the fact that the new lending will probably do nothing more than delay the inevitable restructuring Greece will be forced to take at some point. A borrower can’t fix a solvency crisis by accepting liquidity in the form of new debt. However, this “kicking the can down the road” does give the markets and banks additional time to prepare for the eventual restructuring. Ireland and Portugal, the other two nations that have required bailouts, remain under pressure as the rating agencies have lowered both nations’ debt to junk status. Although the three junk rated nations are struggling with high interest rates and poor economic growth, their economies are not large enough to force a major policy adjustment. On the other hand, debt pressures have been increasing for Spain and Italy. The latter is especially critical because it is the third largest economy in the Eurozone and a member of the G-7. If Italy faces a credit crisis, Eurozone policy makers will probably not be able to use the delay tactics they have employed with Portugal, Ireland and Greece.

Instead, a structural response will probably be necessary. In this report, we will discuss Italy’s financial and economic condition in the context of the Eurozone. We will also touch on the history that led to the creation of the European Union (EU) and how the current situation puts the entire project at the crossroads. It would seem that either the EU must expand its power to become a true economic union, or it must cede power to the individual nations and allow them to exercise full sovereignty. As always, we will conclude with the potential market ramifications from either decision. The Italian and Eurozone Problem The creation of the Eurozone and the single currency, as we will discuss below, was designed for political aims. The currency union has its own central bank but no centralized fiscal authority. To prevent imprudent nations from taking advantage of other nations, a series of rules were put in place. This agreement was called the Treaty of Maastricht, named for the Netherlands city in which the meetings were held. Specifically, the treaty outlined certain criteria for Eurozone nations including, limits on the amount of government debt a nation could have (around 60% of GDP), and limits on annual deficits (less than 3%). In addition, there had to be convergence of inflation rates. The “hawks” within the German Bundesbank pushed for these parameters in order to limit the size of the Eurozone. However, the political goals trumped the economic and financial concerns. .

Weekly Geopolitical Report – July 18, 2011

Essentially, the European nations were willing to forego currency control for the benefits of the euro. However, they did not want to give up fiscal sovereignty. Thus, fiscal policy remained in the purview of the national governments, restricted by the aforementioned criteria. And even these criteria were jettisoned. Belgium and Italy had fiscal debt to GDP ratios well above 60% prior to their inclusion, but Europhiles did not want to exclude either the seat of EU governance (Brussels) or the third largest economy in the Europe (Italy). Both nations were allowed into the Eurozone despite these impediments. Interestingly enough, during the mid-1990s, the budget deficits of France and Germany each exceeded 3% of GDP; none of the penalties for breaking the agreement were assessed. Italy’s economic problem is similar to those of the peripheral nations of the Eurozone. It has high government debt and low productivity. Until Italy entered the Eurozone, it addressed this situation by a steady depreciation of its exchange rate.



1,200

3.6

1,100

3.2

1,000

2.8

900

2.4

800

2.0

700

1.6

600

1.2

500

0.8

400

0.4 80

82

84

86

88

90

92

94

96

98

00

02

04

LIRA PER DM RELATIVE UNIT LABOR COSTS Sources: OECD, Haver Analytics, CIM

06

08

10

12



GERMAN AND ITALIAN UNIT LABOR COSTS AND THE LIRA/DM CROSS RATE

This chart shows the D-mark/lira exchange rate on the left axis and relative unit labor costs on the right axis. We have rebased the unit labor costs (productivity-adjusted labor costs) to 1980. When the D-mark/lira rate is rising, the lira is depreciating against the D-

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mark. When the unit labor cost line rises, Germany is increasing its competitiveness against Italy. Note that the long-term trend in unit labor costs has tended to favor Germany. However, during the 1990s, after German unification, German productivity weakened, partly stalling the overall trend. Absorbing East Germany was very costly for Germany. The process of unification required Germany to deploy austerity policies for most of the 1990s. These policies included deregulation of labor markets and cuts to social spending. This austerity improved German competitiveness and by the end of the decade, the structure of its economy had improved significantly. Until the mid-1990s, Italy offset its steady loss of competitiveness to Germany by steadily depreciating its exchange rate. In the early 1990s, the lira plunged against the D-mark due to the crisis in the European Exchange Rate Mechanism (ERM). In the late 1980s, Britain entered the ERM, which was an exchange rate regime where the European nations pegged their currencies to the D-mark. The currencies traded in a band around the D-mark but, occasionally, various nations would devalue against the D-mark to improve competitiveness. In 1992, the British were forced out of the ERM as financial problems and slow growth hurt the pound. It was in this event that George Soros made his reputation as a hedge fund manager by betting against the pound. Italy was also affected by this event and the lira temporarily plunged. The lira strengthened into 2000, when it was absorbed into the euro. Since the establishment of the euro, by design, the currency relationship between Germany and Italy is fixed. However, until the 2008 recession, Italy’s unit labor costs have been rising relative to Germany. Simply put, Italy’s economy has been

Weekly Geopolitical Report – July 18, 2011

steadily becoming less competitive with Germany and, by entering the euro, it has lost its primary tool for offsetting that loss of competitiveness, a weaker currency. Italy’s problem is common with all the countries in the Eurozone involved in the financial crisis. Their economies are all less competitive than Germany’s economy. However, joining the Eurozone caused their interest rates to converge on German rates. These nations typically had higher interest rates than Germany because of currency risk. Eliminating the currency risk led to rate convergence, causing a borrowing frenzy in these weaker economies, as low rates boosted loan demand. This led to housing bubbles in Spain and Ireland. EUROZONE LONG-TERM BOND YIELDS (Germany and the P.I.I.G.S.) 20

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12

8

4

0 80

82

84

86

88

90

92

GERMANY PORTUGAL

94

96

98

00

ITALY GREECE

02

04

06

08

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12

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The problem that Italy poses is that Greece, Ireland and Portugal account for only 6% of total Eurozone public debt. Italy alone represents 25%. The IMF estimates that Italy will only grow around 1.5% annually into 2016; that would mean that Italy’s growth since joining the Eurozone is 0.8%. Its deficit to GDP ratio is around 4%; the IMF has estimated it will dip towards 3% but probably didn’t count on the rapid rise in borrowing costs. The Geopolitics of the EU The EU was formed to deal with the German problem. Germany is a major economy situated in a dangerous place. It has no natural defenses; in fact, its accessibility is one of the keys to its success as the ease of transportation supported its economic development. Unfortunately, Germany is also located between two major powers, France and Russia. Germany has historically had the economic and military wherewithal to deal with one of these powers, but not both simultaneously. Because of Germany’s attractive economy, these powers have had an incentive to invade and control it. Two world wars were fought in central Europe because of the natural instability of Germany.

IRELAND SPAIN

Sources: OECD, CIM

This chart shows how long-term rates of the P.I.I.G.S. converged on German rates as the euro was adopted. We have shaded the period marking the official creation of the euro through Q1 of last year, when the Eurozone crisis became acute. Note that since then, we have seen wide rate divergence. Recent history has shown that once a Eurozone nation’s 10-year government bond yield exceeds 7%, bailouts become unavoidable. We note that Italy’s yields are currently around 5.63%, up 75 bps since June.

After WWII, the German situation was addressed by partitioning the country and wedding West Germany to Western Europe via the EU. The union was economic in nature; European elites were never able to overcome the nationalistic impulses of the nations of the continent but tried to tie them together by economic interest. Before unification, Germany was content to allow the U.S. and France to determine its foreign policy. However, after unification, Germany began to stake out its own path. Despite Germany’s increasingly independent path, EU elites continued to

Weekly Geopolitical Report – July 18, 2011

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drive for continental political unification through economic means. The creation of the euro was the crowning achievement of that process. Unfortunately, the euro was an incomplete project—it created a currency union and a single central bank but did not create a central fiscal authority.

ones. That obviously won’t sit well with those three nations but the P.I.I.G.S. will be grateful! However, that same process will require the creation of Eurozone Treasury to manage the fiscal spending of its members. This process will require the loss of fiscal sovereignty.

In the interests of European unification, the Eurozone was expanded to include members that were probably unsuitable. Earlier we noted that Italy needed a steadily depreciating currency to offset its weaker productivity compared to Germany. Joining the euro removed that policy as a means of maintaining competitiveness. Now Italy and the rest of the lower productivity nations face a problem. For their economies to function, they need to reduce their debt. This can be accomplished by aggressively saving via consumption cuts or by restructuring (default). It will be impossible to inflate their way out because they don’t control the exchange rate or inflation. If this can’t be accomplished, the best outcome for the P.I.I.G.S. is probably to exit the single currency.

In a recent speech, ECB President Trichet expressed the need for a Eurozone bond and a unified fiscal authority. This would complete the goal of political unification long sought by European elites.

Italy’s size is changing the situation for the Eurozone. As long as the problems were confined to small countries, Eurozone officials could delay the crisis by adding liquidity to the problem nations. However, Italy’s massive borrowing requirements preclude this as an option. Thus, the Eurozone has two options. The first option is to form a fiscal union which would require the creation of a Eurozone bond, backed by the full faith and credit of all the members. This would allow the Eurozone members to borrow at a rate consistent with the payment capacity of the entire Eurozone. In practical terms, it means that the P.I.I.G.S. will pay lower rates, while the Germans, Dutch and French pay higher

However, we would not expect the northern European nations to give up centuries of nationalism without a fight. If a centralized fiscal authority cannot be established, the Eurozone needs to create a process for current members to exit. Simply put, the Eurozone needs to create an orderly way for Greece, Portugal, et al, to exit and reestablish national currencies. The possibility of being ejected from the Eurozone would give marginal nations an incentive to quash excessive borrowing and run a disciplined fiscal policy, which may preclude the need for a centralized fiscal authority. The rules-based fiscal program of the Maastricht Treaty failed to bring discipline; the threat of exile probably would work better. However, it should be noted that if the Eurozone starts ejecting members, the EU project has probably come to a close. The use of economic policy to force political unification would be over. Although it is hard for the current generation of Europeans to consider the risk of war that comes from a Germany untethered from Western Europe, it would not be a major stretch to see Germany increase its ties to Russia (Germany needs Russia’s natural resources and Russia needs Germany’s investment) and become less interested in funding the

Weekly Geopolitical Report – July 18, 2011

spending, work and retirement habits of Southern Europe. From 1870 to 1945, this situation led to war. Such an outcome, while unlikely in the near term, could become an issue in a few decades. Ramifications We expect that, ultimately, the internal contradictions of the Eurozone will lead to a major restructuring. Either the highdebt/low growth nations will leave the single currency and use devaluation to address their debt, or Germany and the stronger nations will re-establish their national currencies and leave the euro as a “rump” currency of the credit challenged.

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pressure until they remove the members unable to cope with the single currency, namely, the inability to maintain competitiveness with Germany. Once it becomes clear that credit risk states can be forced to leave, the euro will strengthen. It appears that Italy, due to its size, will likely be the catalyst that forces a resolution to this underlying problem.

Bill O’Grady July 18, 2011

Overall, we believe the former is more likely than the latter. Thus, the euro will be under This report was prepared by Bill O’Grady of Confluence Investment Management LLC and reflects the current opinion of the author. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

Confluence Investment Management LLC Confluence Investment Management LLC is an independent, SEC Registered Investment Advisor located e firm provides professional portfolio management and advisory services to in St. Louis, Missouri. The institutional and individual clients. Confluence’s investment philosophy is based upon independent, fundamental research that integrates the firm’s evaluation of market cycles, macroeconomics and geopolitical analysis with a value-driven, fundamental company-specific approach. The firm’s portfolio management philosophy begins by assessing risk, and follows through by positioning client portfolios to achieve stated income and growth objectives. The Confluence team is comprised of experienced investment professionals who are dedicated to an exceptional level of client service and communication.