The Macro Strategist

David P. Goldman

+1 917 915 2985

dgoldman@macrostrategy.com

Flight Forward in Europe

Monday, November 14, 2011
SUMMARY
"Never was the Christian Democratic Union so powerless," writes the German daily
Die Welt about the ruling party's annual conference yesterday. The beleaguered
Chancellor Angela Merkel offered a utopian vision of Europe's future.
Italy's new Prime Minister Mario Monti is a Eurocratic lifer for whom European
unification is a tenet of faith. His prospects for success are dim.
The viable sections of the European Union should take measures to ring-fence their
economies against southern European bankruptcy, and force an auction of Italian
national assets to foreign investors. Instead, they have doubled down on a busted
bet on European unification. That will lead to further loss of confidence.

Exhibit 1: Informal Economy as % of GDP

With nearly a
third of economic
activity
underground,
Greece and Italy
are incompatible
with Germany and
France

Source: World Bank

The Macro Strategist

Kleptocracies, Corruptacracies, Statists and Capitalists

A negotiation, not
a crisis

Europe is in a negotiation, not a crisis. The amounts of European debt outstanding, the
derivative exposure against that debt, and the identity of the creditors is not only
known, but dissected exhaustively in the financial press almost daily. Unlike the
subprime disaster, when derivative exposure (at AIG for example) was extremely
large in relation to the cash exposure outstanding, net notional exposure in the credit
default swaps market is in the range of 5% to 10% of sovereign debt outstanding.
When all the exposures are known, the question is who suffers and who benefits.
Globalizing Europe's major institutions is the answer, for two reasons. First, Europe
needs new capital. Secondand more importantis that a banking system operated
by foreigners for profit will act more honestly than the politically-tainted financial
institutions of southern Europe.

Merkel has
brought a crack
pipe to a gunfight

Sadly, Europe's leaders are still smoking the crack of European unification. "It is time
for a breakthrough to a new Europe," Chancellor Angela Merkel told the CDU party
conference yesterday, adding, "this Europe is a community of destiny in the globalized
world," which is now "in its most difficult moment since the Second World War,"
concluding, The task of our generation now is to complete the economic and currency
union in Europe and, step by step, create a political union." This is ridiculous. Europe
contains two radically different kinds of polity with incompatible modes of economic
life.
Exhibit 1 on page one shows the World Bank's estimate of "informal" (that is, untaxed)
economy as a percentage of total. Broadly speaking the world groups into four
categories.

The USA, Canada

and Australia are
among the few
free markets in
the world

1) The outright kleptocracies like sub-Saharan Africa or Russia, where the

government functions as a family office for a handful of oligarchs. "Informal" activity is
close to half of the total economy;
2) Countries where corruption pervades the state, such as Turkey, Italy, and Greece,
and roughly a third of the economy is underground;
3) Statist economies like France and Germany, where high tax rates drive a
substantial part of economic underground (in the 15% to 20% range), but most
economic activity is visible; and
4) The USA, Canada, Switzerland, and Australia, where informal activity forms less
than a tenth of the total.
We know that the World Bank estimates are roughly reliable, because there is a close
correlation between labor force participation rates and informal economy. The workers
who fail to participate in the measured economy presumably work in the informal
economy. It is easy to hide transactions but rather more difficult to hide workers.

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The Macro Strategist

Exhibit 2: Labor Force Participation vs. Informal Economy

Why austerity
alone won't work

Source: World Bank, OECD

Although the World Bank's estimates for informal economy activity may be wrong
(they probably underestimate the extent of tax evasion), the relative ranking of
countries by extent of informal economy probably is accurate.
This observation leads to two conclusions:
1) The short-term problems of southern Europe are easy to solve in principle, and
2) The short-term problems of southern Europe are impossible to solve in practice
within the framework of the existing political structure.
Where informal activity comprises a quarter or more of total activity, all the major
institutions of commerce and government become contaminated. Corruption trickles
down to the capillary level of the economy. Market participants protect themselves
against enforcement by keeping transactions and a great deal of their wealth offshore.
Their first response to a prospective tax increase (or harsher enforcement) is to move
more wealth and more transactions offshore. In the case of Greece and perhaps Italy,
the threat of an exit from the Euro and a return to a national currency creates a
powerful incentive for companies with access to foreign exchange to keep it offshore.
Trade financing for Greek oil importers already has dried up, Reuters reported Nov.
11, and Greece has turned to Iran instead of its traditional suppliers like Russia,
Azerbaijan and Kazakhstan. It seems likely that a vast migration of wealth is
underway out of southern Europe to safer venues. The attempt to extract more
revenues from existing sources probably will lead to the worst possible outcome,
namely a collapse of economic activity and flight of wealth.

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The Macro Strategist

There are two ways to put the economies of southern Europe into bankruptcy. One is
to allow conditions to deteriorate until the market refuses to roll over their existing
debt, a condition we approached last week in Italy. The other is to arrange a de facto
outside takeover of the bankrupt entity with an injection of new money. That might
involve selling the national energy economies ENI and ENEL to China, selling the
Italian banks to North Americans, and offering a one-time exemption from the 27.5%
corporate capital gains tax to private Italian firms who sell a participation to outside
investors. Most of Italy's wealth and talent is locked into undercapitalized familyowned companies (with names like Beretta, Vespa, and Ducati) that necessarily
operate under the radar to escape the predatory clutches of the Italian state. The
trouble with this second (rational) alternative is that it would destroy Italy's political
class in perpetuity.

Europe is the
wrong concept
altogether

The solution, in short, lies in globalizing Europe's financial institutions and productive
industries, not in "Europeanizing" them. Instead of the Eurocrats in Brussels, Europe
wants to bring in America, Chinese, and other corporations who will run businesses for
the stockholders rather than for the benefit of political predators.
Exhibit 3: Germany Export Growth is to the East, not the South

Why should
Germany care
about Europe?

Source: Bundesbank

Germany's economy is the poster-boy for globalization: in the past ten years, its
exports to the core of the European Community (in nominal terms) have risen by
40%, but its exports to the east have risen by 240%.

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The Macro Strategist

Why, then is Chancellor Merkel so ebullient about European political unification at the
precise moment that economic logic militates against the idea of Europe as a distinct
economic entity? That is a matter for psychiatrists, not economists. Twice in the past
century Germany risked its national life on the proposition of its own superiority. Now
it is risking its national economy on the proposition that its German identity has
dissolved into a broader European identity. The latter may be a reaction to the former.

On the record,
Monti is the worst
possible president
of Italy

What do we know about Italy's new president, Mario Monti? An academic economist
and former European Commissioner for Competition, his most notable act in office was
to block the proposed merger of GE and Honeywell in 2001. As the Economist reported
at the time, "President George Bush and several senators have grumbled publicly at
what they see as unwarranted interference in an all-American deal, and have hinted
that Mr Montis true aim was to protect European companies. That has politicized the
whole question of antitrust policy and opened a new front for transatlantic tensions."
Monti made his career, that is, by blocking precisely the sort of corporate opening that
today might give Italy a chance for recovery. He is a creature of Europe's selfinsulating political elite.
Monti set forth a utopian vision of a united Europe on the eve of the crisis in a May
2010 report to the European Commission entitled, "A New Strategy for the Single
Market." The report drew on extensive consultations with constituencies, and offers
this disturbing comment:
An uncomfortable feature of the single market today emerges prominently
from the consultations, although it is seldom brought out explicitly: the single
market is less popular than ever, yet it is more needed than ever. Highlighting
this contrast will perhaps be considered political incorrect. But only by
addressing it openly will it be possible to work for a genuine and sustainable
relaunch of the single market.
Prof. Monti, in short, believes in pressing impractical schemes even when no-one
wants them. In this, he and Chancellor Merkel are united in a Folie Deux (mutual
delusion, but somehow it seems more appropriate to say it in French). Their chances
success range between tiny and nil.

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