Inside investment: Driving lessons from Greece
Central bank policy has evolved from unorthodox to downright strange as politicians have failed to take control of the post-crisis economy. Sooner rather later they will confront a stark choice signposted Greece or Ireland.
When I was a senior in high school, we moved to a different town. In the old locale there were farms; the new one was a suburb just outside a city with family-owned companies. The biggest of these companies gave turkeys to its employees on Thanksgiving and Christmas. It was a company town. I thought of this when I read in the Wall Street Journal recently that the Bank of Japan, as part of its quantitative easing activity, has a special exchange traded fund-buying programme; it is a gift to the managers, but instead of ribbons there are strings attached. Ideally, the BoJ would like fund managers to create special ETFs that include companies that can offer an “improving working environment, providing child-care support, or expanding employee-training programs” and boost “human capital”.
The ECB also seems possessed by a penchant for social intervention; it will be paying banks 0.4% a year, a negative interest rate, for up to four years to borrow money from it provided that the money is used to stimulate the “real” economy. (I suppose this means no evil M&A or housing loans.) With the fiscal authorities having left town, the central banks have occupied city hall.
I just finished reading Mohamed El-Erian’s new book, ‘The only game in town’, which discusses the implications of the unprecedented dominance of the central banks over the world economy. He writes: “In the last three years plus, central banks have had little choice but to do the unsustainable in order to sustain the unsustainable until others do the sustainable in order to restore sustainability.” The problem, El-Erian points out, is that while the banks are continuing to do the unsustainable, the political authorities have so far failed to do the sustainable. A great deal of time has already passed, and sustainability has not been restored. Meanwhile, unbridled central bank policy has gone from orthodox to unorthodox to heterodox to outright strange.
Redemption or perdition?
The unsustainable cannot be sustained much longer, El-Erian believes, and there is only one way out of town, a road that ends in a T-junction where we must choose one of two directions. Reflecting upon his text, it seems to me that the sharp right turn has a sign marked Ireland and the sharp left one a sign marked Greece. These are opposite directions, although both start at the same point of misfortune and woe, the crisis of 2008.
From there everything is different. Greece resists reform and still has not made the necessary changes. For this reason, it is mired in John Bunyan’s Slough of Despond, weighed down by the sins of the past. Unemployment is 24%, economic growth is 0%, government bonds yield 8.8%, capacity utilization in industry is 64.5%, and the stock market has fallen to its 1990 level.
Ireland, by contrast, is enjoying the fastest economic growth rate in Europe: 7.8% in 2015. Unemployment is 8.8% and improving, while retail sales grew at a 4.1% annual rate in January. This is because Ireland took drastic action to reform its economy immediately upon the onset of the crisis. The tax base was broadened, VAT and income tax went up, and all categories of expenditures were cut.
Capital expenditures were slashed. In addition, all public-sector salaries were cut, and public-sector employment was reduced. All categories of welfare benefits, including child support, got direct cuts and access to welfare was made more difficult. (Consequently, the percent of the population classified as deprived rose from 11.8% in 2007 to 22.5% in 2010.) Pension benefits went down. It was not uncommon for agency budgets to be cut by 50%, and many agencies were completely eliminated. Healthcare and education spending was slashed, as was transport and environmental spending.
Fiscal balance was restored mainly through smaller government. Irish government 10-year bonds now yield 0.84% and the stock market has returned to normal levels. The country is booming.
We want to leave town, but, approaching the T-junction, we have our hands off the wheel. If we do nothing the car is programmed to turn left toward Greece, for that is where people who do nothing go. A wrenching effort will be required to turn right toward Ireland; but the power steering is no longer working. An investor does not know whether or not the effort will be made, but where will our bond and stock markets go if we default to the left? Will the US 10-year Treasury eventually breach 8%? Will the S&P500 return to its 1990 level of 340?
These are extreme outcomes, and we could certainly put on the brakes and reverse before we get there. Nonetheless, even going halfway to Greece would be very painful for a long while. Were we to turn right to Ireland, there would also be great pain, but the pain would be relatively brief, and we would have hope. In both directions, stock and bond prices decline, either briefly or for a prolonged period.
The problem with company towns is that when the company fails, so does the town.