The
Economic Impact of Evil
By John Mauldin
“Political
leaders still think things can be done through force, but that cannot solve
terrorism. Backwardness is the breeding ground of terror, and that is what we
have to fight.”
–
Mikhail Gorbachev
“...
Europe exemplifies a situation unfavorable to a common currency. It is composed
of separate nations, speaking different languages, with different customs, and
having citizens feeling far greater loyalty and attachment to their own country
than to a common market or to the idea of Europe.”
–
Professor Milton Friedman, The
Times, 19 November 1997
“There
is no example in history of a lasting monetary union that was not linked to one
State.”
–
Otmar Issing, chief economist of the German Bundesbank in 1991
The
world can change quickly, and last week it did. The most immediate and
heartbreaking impacts of the Paris attacks were suffered by the victims
themselves and their families, but from there the ripples of terror spread
outward around the world.
The
Paris events didn’t happen in isolation. Recent bombings in Lebanon, Iraq,
Mali, and Nigeria, plus the Russian airline disaster, showed us how far evil
can reach. It isn’t just ISIS: al-Qaeda is getting stronger in some places;
Boko Haram continues to strengthen in West Africa; there is a resurgent Taliban
in Afghanistan; and the list goes on…
In
addition to the catastrophic human cost it exacts, terrorism has economic
impacts.
It misallocates resources, distorts prices, and prompts adverse
government policies.
We all feel these effects, even if we live far from the
terror zones.
Terrorism
is global. So is the economy. We can’t separate them. I’m sure you have spent
time reading about the reaction to the terrorist attacks in Paris. I have been
reading and thinking a great deal about the effects of recent events on the
European Union. Much of what I’ve read seems to miss what I think is the larger
context and what may be the real longer-term economic and geopolitical
implications of these attacks. It should make for an interesting, and somewhat
sobering, letter.
The
European Union works marvelously as a free-trade zone of separate nations, but
the visionaries who launched the EU wanted it to be a political union, not just
a free-trade zone. They felt that if they could create a political union, then
even though the economic problems would be immense, the member countries would
eventually come together on the economic front as well. That has not happened.
In fact, a fitful political union has made the EU’s economic problems worse.
Europe
has three basic economic problems, which I’ve dealt with at length over the
years:
- Capital
and goods flow from the peripheral countries of Europe to the core. This
huge trade imbalance has no way to resolve itself. The peripheral
countries were able to borrow money at German rates for many years, while
the politicians in those countries exhibited no discipline in their
budgeting process and ran up huge debts and deficits. Then the bill came
due.
In
the modern world, the normal way to resolve trade imbalances is through
currency fluctuations. But in the Eurozone there is now just a single currency,
and one size does not fit all.
- Many
Eurozone countries have run up unsustainable debts relative to their
potential growth. Unsustainable, that is, under a normal interest-rate
regime. After the collapse of Greece, the European Central Bank, worried
about contagion effects, lowered interest rates dramatically; and
countries like Italy took on large amounts of additional debt. What is now
nearly a 140% debt-to-GDP ratio in Italy is manageable when interest rates
are only a few points. That ratio would be a disaster at 6 to 8%, and
Italy would soon be Greece. It should be noted that, even with the low
rates, the Italian debt-to-GDP ratio increases each year.
As
you may recall, I visited with a senior economist at the Italian central bank a
few years back and confronted him about the logic of the country’s debt level
and the question of potential interest rate increases. I came away with the
distinct impression that the answer was “[ECB President Mario] Draghi has our
back.” I remember remarking to you on the Bank of Italy’s confidence in the
sustainability of what was then a 125% debt-to-GDP ratio.
Draghi
gives at least one speech every few months begging the peripheral countries to
reform their labor markets and fiscal budgets during this low-interest-rate
regime he has given them. He knows it can’t last forever and that without
market and labor reforms the peripheral nations cannot grow their way out of
the debt problem.
- As
bad as the entitlement situation is in the US, it is worse in most of
Europe, especially in the problem countries (including France!). Given the
demographics involved, these countries simply cannot sustain their
governments’ promises. They have no room to increase taxes without
severely damaging their economies even further.
Let’s
deal briefly with the first problem: trade imbalances in the currency zone.
Many
of us take our national currencies for granted, and we assume there have always
been dollars, pounds, or yen. In fact, for a long time individual banks issued
notes promising the holder to exchange the notes for gold upon demand. The
concept of a national currency is actually one that came about very late in
history.
Before
the euro was created, the economist Robert Mundell wrote about what made for an
optimal currency area. His work was so important that he won a Nobel Prize for
it. He wrote that a currency area is “optimal” when it has
1.
Mobility of capital and labor
2.
Flexibility of wages and prices
3.
Similar business cycles
4.
Fiscal transfers to cushion the blows of recession to any region.
Europe
has almost none of these. Very bluntly, that means it is not a good currency
area.
As
Otmar Issing, chief economist of the German Bundesbank stated in 1991, “There
is no example in history of a lasting monetary union that was not linked to one
State.”
And that state has to be a fiscal union, which the Eurozone and the EU
in general are not. Further, there are significant differences among the
economies of the various countries composing the Eurozone.
The
United States is a good currency union. The same currency serves just as well
in Alaska as it does in Florida and as well in California as it does in Maine.
If you look at economic shocks, the US has absorbed them pretty well. If you
were unemployed in Texas in the early 1980s after the oil boom turned to bust,
or in Southern California in the early 1990s after post-Cold War defense
cutbacks, you could pack your bags and head to a state that was growing. And
that is exactly what happened. That doesn’t happen in Europe.
Greeks don’t pack
up and move to Finland. Greeks don’t speak Finnish (no one does, outside
Finland). And if unemployed Americans stayed in Texas or California, they would
have received fiscal transfers – employment benefits and various forms of
welfare – from the central government to cushion the blow. There is no central
European government that can make fiscal transfers. So the US works because it
has mobility of labo r and capital as well as fiscal shock absorbers.
There
are other good currency unions around the world. China comes to mind, as does
Canada. There are numerous countries that work very well as currency unions but
are in fact amalgamations of various regions with historically different
identities.
But those currency unions evolved over time and did not simply turn
up one bright New Year’s day, as the Eurozone did on January 1, 1999, an
ostensible union among countries with very disparate economies and wealth.
The
euro works like a gold standard. Obviously the euro isn’t exchangeable for
gold, but like the gold standard, the euro forces adjustments in real prices
and wages instead of exchange rates. And, much like the gold standard, it has a
recessionary bias. Under a gold standard or the euro regime, the burden of
adjustment is always placed on the “weak-currency” countries, not on the strong
countries.
Under
a classical gold standard, countries that experience downward pressure on the
value of their currency are forced to contract their economies, which typically
raises unemployment because wages don’t fall fast enough to deal with reduced
demand.
Interestingly, the gold standard doesn’t work the other way. It doesn’t
impose any adjustment burden on countries seeing upward market pressure on
currency values.
This one-way adjustment mechanism creates a deflationary bias
for countries in recession. The deflationary bias also makes it likely, at
least by historical measures, that a gold-standard regime will see a higher
average unemployment rate than will a freely floating currency regime.
In
the Eurozone, Greece can’t simply devalue its currency, or even let the markets
do it. So it suffers 25% unemployment (50% youth unemployment) as it tries to
bring its trade balance back into equilibrium. The same thing is happening in
Spain and the other peripheral countries. To receive the fiscal help they need,
they must turn to Germany and the other Eurozone core countries, which
impose draconian austerity on the countries receiving help. As I wrote four
years ago, the necessary rebalancing process will take at least a decade.
Greece’s debt will be larger and more unsustainable at the conclusion of that
process than it is today. The question is not whether Greece will default on
its debt, but when and at what cost.
It
is ironic that during the first ten years after the creation of the euro, the
European periphery experienced large increases in wages and prices compared to
the core.
While prices and wages were stagnant in Germany, they grew rapidly at
the periphery. This dynamic made the periphery very uncompetitive relative to
Germany and the rest of the core. The result? Peripheral countries imported a
lot more than they exported and ran large current account deficits. The only
way to turn this trend around is through real cuts in wages and prices,
resulting in internal devaluations and deflation. This approach is hugely
contractionary and has clearly created tremendous problems in the European
periphery, starting with massive unemployment. Because there was no available
“quick fix” of actual currency devaluations, the process has been long and
ugly, especially if you are a worker in a peripheral country.
All
these pressures have created an intense political debate over the policies that
should be adopted. In numerous countries we are seeing rising political parties
on both the right and the left begin to take “market share” from the more
centrist parties that have been in control for decades. Portugal seems to be in
outright revolt, as was Greece for a period of time.
My
friend and geopolitical expert George Friedman is pessimistic about the
viability of the Eurozone and has said for a long time that he thinks
immigration issues will be the final wedge that splits the union. I have been
somewhat more sanguine, because the political leadership of Europe, both left
and right, is very committed to the idea of a political union.
They will do, as
Mario Draghi has said, “whatever it takes.” I think the European Union still
has a chance, if only a small and expensive one, to be viable.
The
European Union is a wonderful political idea but not a good economic idea. It
was politics that created Europe, and it is politics that holds Europe
together. The EU’s political leaders and other elites are committed to holding
it together. Understand, the idea of a United Europe is an article of faith,
imbued with all the ferocity and fervor of any religious belief with which I’m
acquainted.
There
are many True Believers in a vision of a United Europe. I believe that, to hold
their union together, the leaders at the core will ultimately be willing to
absorb all the debts of all the various member nations and put them on the
balance sheet of the European Central Bank, basically nationalizing all the
debt. They will then be willing to sacrifice their individual countries’ fiscal
autonomy on the altar of the European Union.
All
of the problems I mentioned above can be solved by political decision making,
but it must be understood that the solutions will come at an unimaginably high
cost, running to many trillions of euros. The longer Europe puts off the day of
reckoning, the bigger the bill will be.
Whatever the ultimate bill is, the
euros to pay for the transition will not exist, so they will have to be
manufactured; and ultimately the value of the euro itself will be considerably
reduced on world markets, just as the current manufacturing of Japanese yen is
diminishing that currency’s value. If you are a True Believer, you might be
willing to pay the price.
Either
the Eurozone will be re-forged as a true political union, or it will break up.
When you come to the end game, there is really no middle ground. Oh, I suppose
that Mario and his successors can print and monetize for another decade, but
they can’t do so without the euro’s suffering a large reduction in value. There
are going to have to be major reforms, or the euro will continue to “adjust.”
Right now, Europe seems quite comfortable with the idea that the euro will
eventually fall to parity with the US dollar. But what happens when the euro is
at $.80 to the dollar? Does Europe want to go down that rabbit hole another
25%?
Into
that volatile mix of politics and economics, let’s now throw in terrorism,
immigration, and the refugee crisis.
I
saw a report referenced on Bloomberg last week that said 2014 was the costliest
year for terrorism since 2001, in both financial terms and human lives lost.
That assertion seemed remarkable, so I went to the source. The Institute for
Economics and Peace is an Australian nonprofit think tank. I can’t vouch for
their expertise, but their “Global
Terrorism Index” is still interesting.
Their
report calculates that the worldwide economic cost of terrorism was $52.9
billion in 2014, an all-time peak. That’s the GDP of a small country, gone up
in smoke (literally).
IEP
arrives at that number by adding up property damage along with medical costs
and lost income for victims. They do not include the indirect costs of
preventing or responding to terrorist acts.
How
much money does the world spend to cope with the mere possibility of terror
attacks? The US Transportation Security Administration’s 2014 budget was $7.4
billion. TSA is only one of several agencies focused on terrorism, and the US
is only one country.
Think
about all the private security guards, construction costs of hardening office
buildings, executive and staff time spent dealing with the inevitable headaches
and delays, and much more. Pick a very large number. Whatever that number is,
you can bet the cost will go much higher after what happened last week. For
instance, how much did it cost to shut down Paris for a weekend?
Looking
back at my past newsletters is always interesting (and frequently humbling).
It’s a bit like entering a time machine. Reading what I said in the past
underlines how the world has changed in the meantime.
Only
two months ago (Sept. 20), in “Merkel
Opens the Gates,”a I looked at Europe’s refugee crisis. Germany’s Angela
Merkel had just promised to accept 800,000 refugees this year, and was pushing
other countries to help.
I
don’t often quote myself, but the following excerpt from that letter helps set
the stage for what we will discuss below.
And
while Merkel says Germany can take 800,000 immigrants, notice that they are
instituting border controls to stem the flow. It’s is all well and good to say
you can absorb nearly a million immigrants, but where you going to put them?
How will you feed them or school them? That effort takes planning and time,
planning and time that have not been much in evidence the past few years in
Europe.
Just
as the Grexit crisis showed us the underbelly of European monetary integration,
the refugee crisis highlights the huge difficulty of political integration.
Hungarians, Slovaks, and Czechs do not want Brussels telling them how many
Syrians they must admit and support. I don’t blame them.
Ambrose
astutely points out that Europe must now deal with an east-west split on immigration
along with the still-unbridged north-south economic chasm. Yet EU leaders push
blithely on, thinking they can roll right over their opposition. To them each
crisis presents another opportunity to impose structure and an artificial unity
from the top down.
Read
that last sentence again. Have we seen EU leaders pushing top-down solutions to
the ISIS-inspired attacks? No. We see the opposite. Countries all pledge
cooperation, but they want it on their terms. The EU central command all but
disappeared in the aftermath of the Paris attacks. I think this is significant,
like “the dog that didn’t bark” in the venerable Sherlock Holmes story.
European
unity was already wearing thin before last week. Just two months ago, Merkel’s
German government, along with the EU authorities, thought they could impose
their desire to accept more immigrants on the entire union. Eastern European
states (and many individuals all over Europe) didn’t like that idea at all.
They refused to cooperate.
Look
what happened next. The German public’s initial generosity faded quickly as
people grasped the magnitude of the task. Merkel’s political allies began
peeling away. Her grip on power started looking shaky.
Elsewhere
in Europe…
- Protests
again erupted in Greece over EU-imposed austerity measures.
- A
left-wing coalition brought down a euro-friendly Portuguese government
just two weeks after it took power.
- Spain’s
Catalan region moved forward with its secession effort.
- “Brexit”
sentiment grew in the UK.
The
“European problem” was not improving even before Paris. Then the shooting
started.
You
might think all the minor issues would fall by the wayside in a true crisis.
Francoise Hollande’s first impulse was to reach out to his EU neighbors for
help, right?
Wrong.
Within hours, he issued orders to close France’s borders with its EU neighbors.
There was real fear that more attacks would follow, and Hollande essentially
decided that France would stand alone. And indeed, there are reports from the
hacker group Anonymous that ISIS plans to strike all over the world today
[Sunday].) Yes, Hollande subsequently relaxed, but his initial reaction tells
us something important. So does the way Merkel and her EU friends blended into
the woodwork when Paris was hit.
This isn’t what you expect to see in a healthy
alliance.
That’s
because the EU is not a healthy alliance. Different countries have radically
different views of national sovereignty and responsibilities. If they can’t put
their heads together on handling refugees and fighting terrorism, how can they
possibly cooperate on fiscal policy?
How can they maintain a common currency?
Or maintain enough political support from very nervous voters?
On
Monday, Hollande formally invoked the European Union Treaty’s “mutual defense”
clause, which says member states must help any other member facing armed
aggression.
What does this mean? No
one knows. This is the first time any EU member asked for aid.
It
does not sound as though EU leaders are anywhere near a united European response.
They have simply agreed to talk about the problems. Meanwhile, ISIS is planning
its next attack. This is why Hollande acted alone that first chaotic night –
and why the euro currency is now several steps further down the path wending
toward oblivion.
George
Friedman sent around some private thoughts last week. I convinced him to let me
share them as an issue of Outside
the Box, which you can read here.
I think George’s assessment of European unity, or lack thereof, is right on the
money. The immigration crisis was already coming to a boil ahead of the Paris
attack. Here’s George:
Had
Europe been functioning as an integrated entity, a European security force
would have been dispatched to Greece at the beginning of the migration, to
impose whatever policy on which the EU had decided.
Instead,
there was no European policy, nor was there any force to support the Greeks,
who clearly lacked the resources to handle the situation themselves. Instead,
the major countries first condemned the Greeks for their failure, then the
Macedonians, as the crisis went north, then the Hungarians for building a
fence, but not the Austrians who announced they would build a fence after the
migrants left Hungary.
Between
the financial crisis and the refugee crisis, Europe had become increasingly
fragmented. Decisions were being made by nation-states themselves, with no one
being in a position to speak for Europe, let alone decide for it.
Exactly.
This is Europe’s core financial problem as well as its political barrier. The
EU nominally speaks for the whole alliance, but it never says much because it
takes forever for all the members to decide anything. All it takes is one
holdout to bring the whole apparatus to a halt – and someone always holds out.
ISIS
is not, as Obama said, the JV team. They are the real deal. All the talk I’ve
read about dislodging ISIS is just that – talk. They have 100,000
battle-hardened soldiers, are relatively well-financed, and are remarkably
adept at utilizing social media. Paul Kagan estimates that it would take 50,000
troops to create a safe zone for Syrian refugees in Syria and simply to contain
ISIS to the territory it holds today.
I
think that estimate significantly underestimates the zealotry and ambition of
ISIS. They are intent upon establishing a caliphate. They recruit additional
psychopathic soldiers every week. They have a functioning government, albeit
one that we don’t like and one as barbarous and backward as any government the
world has seen for centuries. Seriously, they have published manuals explaining
that it is perfectly within their religious law to have sex with pre-pubescent
girl slaves. And to stone women for offenses against Sharia law, etc. etc.
That
Obama said we have contained ISIS is now almost laughable. They may not be
growing their territory, but they are not ceding any, either. Twenty thousand
pairs of US boots on the ground would not even come close to being enough. And
the ability of ISIS to strike deep into the heart of Europe has not been
contained at all.
Let’s
turn to the US for a moment. The exchange between Senators Rand Paul and Marco
Rubio in the last Republican debate was illuminating. There is a very clear
divide on what military budget priorities in this country should be. There are
lots of ideas, but none of them are palatable.
Let’s
examine just one notion. There are several Republican candidates who would like
to arm the Kurds. Okay, let’s say we create an army of 250,000 Kurds that is as
well-armed as any group in the Middle East. They would be a formidable force;
and with US intelligence and airpower, along with that of the rest of our
allies in the Middle East, they could lead the attack to roll back ISIS. Seems
like a simple enough plan, right?
Well,
not exactly. Turkey and Iran would be extremely uncomfortable if not outright
hostile to such a scheme. Iraq, such as it is, would be rendered completely
incapable of keeping the Kurds from forming their own country and then
beginning to absorb more of what we now think of as Iraq. At that point, what’s
to keep them from absorbing the part of Syria that is Kurdish? Can we even
assume that the Kurds would give up any of the territory they took from ISIS?
There are large parts of Turkey and Iran that are heavily Kurdish. How would
those countries be affected? In addition, there are severe divisions among the
Kurds themselves. Arming the Kurds sounds good in theory, but in practice it
could be like arming the Taliban in the 1980s to fight the Russians. Then
again, it might be a brilliant idea. No one really knows.
Donald
Trump wants to stand off and bomb the hell out of ISIS. Okay, that doesn’t cost
a great deal of US blood, but how many videos of women and children being
killed along with ISIS troops are this country and the world willing to
stomach? How much blood and treasure are we willing to spend to go back into
the Middle East? The free world was willing to go along with massive bombing of
mostly civilian cities in World War II, but I doubt there is anywhere near that
much resolve today. Most of the cities occupied by ISIS – they are sometimes
characterized as “strongholds” – are actually heavily civilian, and the
citizens have no option to relocate.
There
are no good solutions, or at least no attractive ones, for dealing with ISIS.
And that reality means they and their terrorist cohorts around the world will
continue to be free to operate. Hollande can talk about massive reprisals, but
I’m not sure reprisals will solve France’s problem of homegrown terrorists.
We
should recognize that the “terrorists” in the recent Paris attacks were
basically French citizens growing up in the Muslim ghettos (let’s call them
what they are), where youth unemployment is 40 to 50%.
The
reality is that there are going to be more terrorist attacks in Europe, and
every one of them is going to make more European voters increasingly
uncomfortable. With each terrorist act, voters are going to grow increasingly
restless and increasingly willing to listen to politicians who will promise to
control borders and make people safe.
There
is already a great deal of economic distress in Europe, and a great deal of
political unrest as a result. Throw in a few more terrorist acts, which are
almost a certainty given homegrown terrorists and the porous nature of European
borders, not to mention the refugee issue (which is going to be massively
expensive in the short term), and we may see the centrist parties lose control
of the political process. It is no longer outside the realm of probability that
anti-EU political parties will take control of major countries in Europe.
Marine Le Pen is riding high in the French polls.
If
Marine Le Pen is the answer, France is asking the wrong question. I wonder what
kind of working partner she would be with Angela Merkel. And that’s assuming
that Angela Merkel can stay in power. I have to wonder where the political
leader who will take the EU forward is going to come from.
Please
understand that I am actually pro-immigration, for economic reasons, leaning
against the grain of many of my political friends. Europe actually needs
immigration, but the kind of immigration they are getting is making their
citizens very uncomfortable.
The
problems in the Eurozone are already massive and can be managed only with
considerable political coordination. There has been precious little political
coordination and agreement in the European Union lately. Toss into the mix the
current refugee and terrorist crises, and it becomes significantly more
difficult, if not impossible, to achieve positive outcomes in Europe. I have no
particular love for any of the centrist parties in Europe. And they may well
deserve to be voted out. Then again, look how well that turned out for Greece.
And the center-right doesn’t appear to be doing all that well in Portugal,
either.
I
don’t see how the situation in Europe ends well. And that is sad, because
Europe, the Europe I know and love, deserves better.
Islands
The
schedule in the subhead above sounds hectic, but it’s not really. I’m not
scheduled to fly until early January, when I will spend five days in Hong Kong.
More on that in future letters. In late January I will be the keynote speaker
at the big ETF conference (ETF.com), where a few thousand people will gather to
talk about portfolio design in the world of ETFs. I’m really looking forward to
that. Then I’ll return to the Cayman Islands for a speech in early February. I
know I have to get to New York and maybe Washington DC sometime betwixt and
between; but for me that is a rather sedate travel schedule, which is good,
because I need to be spending most of my time researching and writing.
The
letter is coming to you a little later than usual because I was able to spend
more time than I had originally planned with my friend and Hall of Fame science
fiction writer David Brin. David is a fount of knowledge and ideas and a true
expert on the issue of privacy in the future. He does a great deal of
consulting with various national security agencies on the topics of
cybersecurity and privacy. It turns out science fiction writers can actually
come up with plausible scenarios that government agencies tend not to come up
with.
David
and I spent quite a bit of time talking about the nature of privacy. We both
expect that what my fellow Baby Boomers think of as their right to privacy will
be continually eroded in the future. The recent terrorist attacks will only
accelerate that trend. David points out that to think that major government
agencies don’t already have all the encryption-decoding ability they need is
laughable. The whole privacy debate is basically for show.
His
solution? Recognize that we are losing our privacy and that the government will
have more information about us than any of us are comfortable with. What we
have to do is pass very firm laws regarding what they can do with that
information and then create far more strict oversight of the various government
agencies involved to make sure they don’t breach those laws. A few
congressional committees will not be not enough.
I
saw a poll today that said that 40% of Millennials are actually okay with
limiting free speech if it is racist. And we think that our kids are going to
be worried about a little invasion of privacy? David says it’s almost as though
there is a conspiracy among all the Millennials to post everything they do on
Facebook so that in the future everybody will agree to ignore what’s on
Facebook when evaluating people. Maybe that is indeed their rationale, because
they all do it, though I still get on my kids about what they post on Facebook,
even if it’s generally down the middle.
It’s
time to hit the send button. In a short while I will be going to the theater to
watch the fourth and final movie in the Hunger
Games series. I have found the acting of Jennifer Lawrence to be
absolutely captivating, as well as that of Donald Sutherland and others in the
cast. The films are a stark reminder of what can happen when security becomes
more important than liberty. And with that thought, I’ll wish you a very good
week. We all have much to be thankful for.
Your
thinking about how the future will unfold analyst,
John Mauldin
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