Fi­nanc­ing Europe’s soaring de­fense costs

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

Fran­cois Hol­lande has rightly made it clear that France is at war. And wars cost a lot of money, as keep­ing an army in the field and air­planes in the air is ex­pen­sive. There is a rea­son for the mil­i­tary adage “am­a­teurs talk strat­egy; pro­fes­sion­als talk lo­gis­tics”.

More­over, fight­ing a ter­ror­ist or­gan­i­sa­tion in­volves both mil­i­tary costs and large do­mes­tic se­cu­rity costs. As such, the in­crease in se­cu­rity spend­ing for the war against ISIS guar­an­tees that France will fail to meet its Euro­pean Union bud­get re­quire­ments for a long time to come; an in­crease in deficit spend­ing that will rightly be mostly fi­nanced by Euro­pean Cen­tral Bank money print­ing. The im­pli­ca­tion is that the fi­nan­cial cost of the in­crease in France’s de­fense spend­ing will be shared across the eu­ro­zone.

But at this junc­ture, it looks like this is about all that will be shared. The events of the past ten days re­mind us that Europe’s in­sti­tu­tions can­not cope with a cri­sis. Hence, the de­fault mode of pol­i­cy­mak­ers in such a sit­u­a­tion is to fall back on in­di­vid­ual na­tion-states. Hol­lande’s im­me­di­ate re­ac­tion to the Paris at­tacks was to fire up the French jets be­fore talk­ing with any other Euro­pean lead­ers (he met David Cameron on Mon­day and will see An­gela Merkel on Wed­nes­day). He also called for a clos­ing of bor­ders even though re­stric­tions on travel within the Schen­gen Area ended 16 years ago.

This mat­ters be­cause eco­nomic growth de­rives from one of two sources. Ei­ther it comes from a ra­tio­nal­i­sa­tion of tal­ent (Ri­car­dian growth), or it comes from new in­ven­tions (Schum­pete­rian growth). Of the two, Ri­car­dian growth is eas­ier to achieve. As bar­ri­ers to trade, to the move­ment of peo­ple, or to the free flow of cap­i­tal are dis­man­tled, in­ef­fi­cien­cies get squeezed out and growth can soar. Bear­ing this in mind, it is ob­vi­ous that the pri­mary en­gine of growth across Europe over the past few decades has been the con­stant drive to­wards uni­fi­ca­tion.

In fact, we would go as far as to ar­gue that be­tween 1980 and 2010, one of the most prom­i­nent macro-trends glob­ally was the in­ces­sant growth of what we came to call the “Euro­pean Em­pire”. This search for em­pire took on many forms, from ter­ri­to­rial ex­pan­sion ( mostly into East­ern Europe fol­low­ing the fall of the Berlin Wall), through ef­forts to es­tab­lish com­mon reg­u­la­tions for the tele­com, fi­nan­cial, health­care in­dus­tries and other sec­tors, to the de­sire to forge an ever closer po­lit­i­cal union.

But build­ing an em­pire is a costly busi­ness, which is why im­pe­rial projects al­ways need their own cur­ren­cies; no em­pire was ever built on some­one else’s dime. The dream of Euro­pean Em­pire there­fore gave birth to the eco­nomic fal­lacy of the euro. As long as the Euro­pean Em­pire re­mained in ex­pan­sion mode, the euro it­self — even though loaded with in­ter­nal con­tra­dic­tions — was a struc­turally strong cur­rency. As each new coun­try was ab­sorbed into the Em­pire, more com­pa­nies needed eu­ros for work­ing cap­i­tal, more in­di­vid­u­als saved in eu­ros, and more cen­tral banks padded their re­serves with the com­mon cur­rency. In short, for 30 years the struc­tural trend was to­wards in­creas­ing Euro­pean in­te­gra­tion, with Ri­car­dian growth and greater euro use, as a con­se­quence.

This past sum­mer we ar­gued that the best the Euro­pean Em­pire could now hope for was to stall at its present bor­ders (east­ern ex­pan­sion be­ing blocked by Vladimir Putin and southern ex­pan­sion to­wards Mus­lim lands be­ing too com­pli­cated and con­tro­ver­sial). How­ever, with ev­ery cri­sis that hits Europe, it seems in­creas­ingly clear that “stalling” is the best-case sce­nario. In­deed, the grow­ing Euro­pean re­al­ity is the re­turn of bor­ders, of na­tional pref­er­ences and of optouts. As such, one ques­tion we need to con­front is whether the con­tin­ued “shrink­ing” of the Euro­pean em­pire will jeop­ar­dise Ri­car­dian growth across the old con­ti­nent.

Which brings us to the euro ex­change rate. Af­ter all, as the con­ser­va­tive French econ­o­mist Jac­ques Rueff used to ex­plain, a given ex­change rate is the “gut­ter where a coun­try’s un­pro­duc­tive spend­ing ends up”. And with that in mind, ev­ery­thing that has occurred in the past few weeks has been ex­tremely bear­ish for the Euro­pean cur­rency. In­deed: 1) Wars cost money and wars fi­nanced by mon­e­tary print­ing, as the ECB is promis­ing to do, sel­dom lead to a higher ex­change rate.

2) The scal­ing back of Europe’s em­pire and the re­turn of na­tion-states un­der­mines the foun­da­tional prin­ci­ples of the euro and raises ba­sic ques­tions about its abil­ity to gen­er­ate pro­duc­tiv­ity gains. And with­out pro­duc­tiv­ity gains, an ex­change rate sel­dom thrives struc­turally.

3) The re­cent di­ver­gence be­tween the Fed­eral Re­serve’s promised tight­en­ing and the ECB’s promised eas­ing should cap gains in the euro.

And yet, in spite of all this, the euro has held up de­cently well in re­cent weeks: it has yet to make a new low against the US dol­lar for the year (that hap­pened in March) and in the last quar­ter it is ac­tu­ally up against most emerg­ing mar­ket cur­ren­cies. In other words, the euro is al­most be­hav­ing like a stock that no longer falls on bad news. This may re­flect ex­haus­tion among sell­ers, or the fact that non-Euro­pean firms have al­ready hedged euro sales re­ceipts, while ev­ery Euro­pean pro­ducer is con­comi­tantly hedg­ing their US dol­lar costs. In other words, it may be that the mar­ket is qui­etly ex­haust­ing its pool of nat­u­ral euro sell­ers. Ei­ther this or the unit is be­ing held up by the cap­i­tal flows of global in­vestors for whom, ac­cord­ing to all sur­veys, Euro­pean eq­ui­ties are now the favourite over­weight.

In any case, as was high­lighted last week, on the ba­sis of logic the euro should be weak. Worse still, the struc­tural case for the cur­rency con­tin­ues to de­te­ri­o­rate. Now it could be that the euro’s in­abil­ity to make new lows sim­ply re­flects its ex­treme weak­ness over the last year and ex­ist­ing mar­ket po­si­tion­ing. Al­ter­na­tively, it could be that the cur­rency mar­kets are buy­ing nei­ther the Fed’s hawk­ish­ness, or the ECB’s dovish­ness. What­ever the rea­son, we are left with the un­com­fort­able quandary of a mar­ket price that is not be­hav­ing “as it should”.

In­deed, there is lit­tle doubt in our mind that fun­da­men­tals point to­ward a weak euro for a long time to come ( Nonethe­less, does re­cent mar­ket be­hav­iour, along with val­u­a­tions, sug­gest that press­ing bets on the euro-US dol­lar may no longer be opportune?

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