How’s My Crystal Ball?

Prediction is dangerous, especially when it involves the future.”

Yogi Berra                                   

Greece appears to be moving steadily toward implementation of the brutal terms imposed by the troika (EU, ECB, and IMF) as conditions for the provision of more liquidity to Greek banks and a new ESM loan to the government. There can always be further twists and turns to the Greek tragedy, but we’ve come far enough to assess the accuracy of my prior predictions in this blog. By my count, I got one of my three predictions mostly wrong, and a second correct in principle but wrong on magnitude. Here’s my scoring:

1) Who’s on First? I thought Greece’s new Syriza leadership (Prime Minister Tsipras and Finance Minister Varoufakis) entirely misunderstood the strength of their negotiating position. When you are going hat-in-hand to someone to whom you have previously lied when borrowing money, in order to borrow more money you simply must have in order to survive, you cannot possibly expect to dictate terms. Germany’s Angela Merkel was the key player on the other side, and she was never going to make any deal that would leave her constituents paying indefinitely for Greeks to enjoy better public-sector benefits than they themselves received. Score this one correct.

2) Outside looking in. I predicted that Greek hubris and miscalculation would place them outside the Euro by midsummer. I missed this one on two grounds. First, I underestimated the utter determination of much of the Eurozone to keep Greece in, despite the endless provocations of Tsipras and company. Second, I did not anticipate the ultimate complete surrender to austerity by Tsipras. While we can’t entirely discount the possibility of Tsipras and company snatching even-worse-defeat from the jaws of defeat, I score this one wrong.

3) Buy on the cannons. My final prediction was that significant market dislocation attendant on a Grexit would provide a buying opportunity for European equities, followed by a strong rally. I’ll score this one both semi-correct and unresolved. European markets declined but did not crash, making a low on July 8, then rallied a bit more than 6%. We’ll have to wait and see where European stocks go in the coming years, compared to U.S. equities.

There is one poorly understood aspect of the Greek drama I got substantially correct. The central problem for Europe was keeping Greece within the Euro while simultaneously discouraging the growth of anti-austerity parties in other Eurozone nations. Greece’s comprehensive failure to improve its position by electing a radical-Left government has been noted in other countries, such as Spain, where anti-austerity party Podemos has been losing support.

A quick aside. One of Warren Buffett’s fundamental principles of investing is that we are much better at understanding today’s values than we are at predicting tomorrow’s outcomes. In this respect, it is worth pointing out that my commentary on Europe’s crisis is intended to provide context for understanding our investment strategy, which remains entirely driven by relative prices and relative yields, and not by predictions–mine or anyone else’s.

The Beginning and End of Big Europe?

The Second World War in Europe ended 70 years ago Friday before last. VE Day (Victory in Europe) preceded by three months VJ day when Japan surrendered, and humanity’s most destructive conflict finally ended. The end of the war was the beginning of the postwar project of European reconciliation and integration. A collection of brilliant statesmen began the planning of what ultimately became the European Union. Their purpose was to so completely integrate Europe’s major powers (Germany, France and Britain), in particular economically, that it would ultimately become impossible for them to go to war with each other.

Since 1945, the European project has faced many challenges, starting with the Soviet post-war domination of Eastern Europe, which led to the Cold War and the creation of NATO. Despite the East-West tensions and the Iron Curtain dividing Europe, European economic ties became ever-stronger, with Great Britain acting as the grumpy cousin who did not want to play nice with the rest of the family. The European Economic Community was formed in 1957, the Western powers won the Cold War and the Berlin Wall fell in 1989, the EEC became the European Community in 1992, the common currency of the Euro began to circulate in 2002, and the European Union was formed in 2007.

Around the turn of the 21st century, the project began to hit some bumpy patches in the road. First, several countries said “No” in various languages to steps toward closer integration. Much of their discomfort arose out of recognition of the fundamentally undemocratic character of the EU’s emerging super-bureaucracy. But the most significant challenge to the EU since the adoption of the common currency in 2002 has been the slow-motion disintegration of Greece.

We know now that Greece never qualified for its 2001 admission to the Eurozone, defined as those countries using the common currency for all transactions, because it did not meet the explicit “convergence criteria” defined by the EU in the Maastricht Treaty. The Greek government engaged in deliberate fraud, cooking the national books with the aid of American investment bank Goldman Sachs, in order to conceal current account deficits far beyond those permitted by the convergence standards. (Greece reported a 1.5% deficit in 2003, below the required 3% threshold, but the real deficit was over 8.5%.) Athens used the benefits of membership to borrow lots of money at preferentially low rates, which was spent largely on social benefits for Greek’s public sector workers and retirees, and also received a great deal of development aid.

In 2010, Greece’s financial manipulations were revealed. It became clear that large amounts of Greek debt, borrowed under fraudulent pretenses from European banks, would not be paid on time if at all. At the beginning of the crisis, there was a real risk of contagion. Banks are leveraged entities, and writing off billions in loans, even to tiny Greece, could have endangered the European financial system, in a manner similar to how bad mortgage loans substantially decapitalized the U.S. banking sector in 2008-2009.

That is no longer the case. A Greek exit from the Euro, either on purpose (“Grexit”) or by accident (“Grexident”) would be a disaster for Greece, but it seems likely it would be an economic non-event for the other members of the EU. So why is Europe, ably led by Germany’s Angela Merkel, going to so much trouble to try to keep Greece in the Union, if not for economic reasons?

The reasons for retaining Greece within the EU are geopolitical and ultimately spiritual. Having gone 70 years without any armed conflict between major European powers is a blessing almost beyond price. If any member of the EU leaves, even one as feckless and underdeveloped as Greece, it calls the entire European experiment into question. The fact that Greece is cozying up to brutal, expansionist Russia is an immediate reminder of past tensions and conflicts.

How long can Merkel’s desire to keep intact Europe’s experiment in peaceful coexistence continue to trump everyone’s frustration with Greece’s serial follies? (Not least that of German voters, few of whom relish the prospect of providing perpetual subsidies to Greek pensioners and civil servants.)

Not, I suspect, much longer. Either Greece will substantially roll over on its refusal to reform its dysfunctional statist economy, or they are likely to be outside looking in by midsummer.

Grexit at Last?

On Monday the European Central Bank’s deadline for Greece to submit a realistic reform plan expired. On Tuesday Greece submitted a plan long on assumptions and short on details, one that included higher spending on pensions and an increase in the minimum wage. What comes next?

I find myself in pretty substantial disagreement with many of the comments I’ve read about a possible Greek exit from the European Union. Here is my read on three common beliefs:

1) When push comes to shove, Germany will do whatever is necessary to keep Greece in the EU. I disagree. When push comes to shove, Germany will do what is necessary to keep from being the perpetual banker for the improvident weak sisters of the EU. Merkel believes she can avoid being the deep pockets while keeping the Eurozone substantially intact. In the short run (Greece only), I think she is right.

2) Greece leaving will set a dangerous precedent, leading other nations to abandon the Euro. Really doubtful. Greece out of the Euro will be an absolute economic basket case. Far from encouraging other EU countries to exit the common currency, observing Greece spiraling into dissolution, while hitched to the falling star of bankrupt, brutal Russia, will be an object lesson for other nations with structural deficit issues. Even the Greeks understand this. As a Greek economics professor observed last year, “Outside of the EU, Greece is Africa.”

3) The bold Socialists of Syriza will be able to negotiate a better deal. You can’t make a better bargain if you hold no bargaining chips. In reality, Greece has no negotiating room. Greece’s only card to play is leaving the Euro. But every time Greece threatens a default (which amounts to an exit), it triggers a further run on Greek banks, already close to insolvent. There are two rules about bank runs: 1) Avoid a bank run at all costs. In a panic, everyone loses.  2) If there is a run, make sure you panic first. Only then will you get your money. Greeks will panic and withdraw their money. They have to.

So here is my uncharacteristically bold prediction. Greece will fail to extract any meaningful concessions from Germany and the ECB. Their flirtation with Putin’s Russia will harden sentiment against them. Due to poor message discipline, they will trigger larger bank runs, and Greek banks will become insolvent. Whether they choose to leave the EU or are pitched out does not matter. They are gone. Outside the EU, Greece will find itself in immediate economic freefall.

Here’s a further contrarian prediction. Greece’s exit will be a relative non-event for Europe as a whole, and for its banks. Against expectations, European markets will rally within weeks, and possibly within days. (For compliance reasons, I hasten to add that this is my personal prediction, that it in no way represents a promise or a guarantee, and should not form the basis for buying or selling any investment.)