05/29/2019 - The Roundtable Insight: Daniel Lacalle and Yra Harris on the Eurozone’s Monetary, Fiscal and Bond Nightmare

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FRA: Hi, welcome to FRA’s Roundtable Insight .. today we have Yra Harris and Daniel Lacalle. Yra is an independent trader, successful hedge fund manager, global macro-consultant trading foreign currencies, bonds, commodities for over 40 years. He was also CME director from 1997-2003. And Daniel is an investment manager and has been a professor of economics. He has a PhD in economics, author of “Escape from the Central Bank Trap”, “Life in the Financial Markets” and “The Energy World is Flat”. He writes frequently at the Mises Institute. Welcome Gentlemen!

Daniel: Thank you so much! Always a pleasure.

FRA: Great, today I thought we would do a focus on Europe, what’s happening in Europe, the parliamentary elections and tying that in to some recent writings that both of you have done. We can also touch upon the Chinese-US trade frictions. So maybe to begin with, we get your views on all of the elections that have been happening this past week. Looking like a strong move to nationalist based parties and what your thoughts are on the effects of what this means towards the economies in Europe as well as the financial markets. Yra, would you like to begin?

Yra: Well, in discussing the elections, I think the biggest part of the election story now comes of course, you know I’ll talk about the horse trading. But from my perspective, most important element should be and I’m not sure how Daniel, whether he will agree with this or not, but Jens Weidmann should become the ECB president and my view on that hasn’t changed in several years. But I believe the same back in 2011 that Merkel succumbed to the charms of Sarkozy and settled. It was a mistake because I think it’s important for Europe that a German were to head the ECB now. Because you have to get the German populace to buy in full force into everything that the European Union wants to accomplish. And if you don’t have a German I think running the bank, it will be bad for German domestic political politics. So better to have somebody, especially of the caliber of Jens Weidmann and that will be a very important element because if we look at the flawed of how this all ends, Mario Draghi has built with Angela Merkel’s blessings and others, a massive balance sheet is whatever it takes scenario. What happens to that balance sheet? I think the highest probability is going to be that it gets folded into a euro bond which is what the main stage of the European project want anyway so you may as well have the German at the head, and I will stop there.

Daniel: I actually quite agree with what you are saying. I think that what these elections have shown is two things I believe.

One is that there is an important rise in the number of seats taken by euro-skeptic or nationalistic parties and that is I think very evident in countries that have seen very, very weak growth and the constant erosion of purchasing power from the monetary policy. You see there in Italy, you see it in France, you seen it also in Germany, even in Spain. So, I think that the first take is obviously that there has been a very significant rise in the populace. I don’t like to call it populace- the nationalistic parties.

The second point is that these elections have been about everything except monetary policy. There has been varying interests in the debates that there has been very few comments in the debates about monetary policy, about the role of the European central bank. And you’re very right, looking at the central balance sheet right now is about 40% of the GDP of the Eurozone at the peak of the QE. The US, the federal reserve, central bank was less than 26% of the GDP of the US.

So, it is very important that as you very well said, that the next president of the European Central Bank is a German official. And the reason for it is because the European central bank is already moving to some form of monetization or Euro bond. Because it cannot buy more sovereign debt but it’s buying every maturity and therefore it’s putting a lot of pressure on sovereign bond yields and on spreads. As such, if the Germans who are not very keen on full monetization of debt etc. See (6:14-6:16 Inaudible) European Central Bank under somebody that is not a German it can definitely create some tension in the euro and Europe.

FRA: And you’ve recently written an article called “ECB’s Monetary Trap” Daniel. In which you describe what’s happening in Europe in general and as far as what the objective is, you see that the ECB is looking to make public spending cheap to finance in a sort of financial repression. Can you elaborate on that?

Daniel: Yes, the ECB launched the quantitative (7:03 Inaudible) program as a tool to improve the possibilities of a government going to take structural reforms. However, in this process what has happened is that governments have grown accustomed to very low interest rates and cheap debt. What they have done is the opposite. If you look at the general results of the European elections, with the main parties that have won are demanding is more deficit and then more government spending. So, the ECB funds themselves monetary prep (7:42-7:45 Inaudible) it’s policy, it stops the low rate purchasing of maturities program that they have right now. What ends up happening is that you see massive rise of spread yields in the eurozone that could rock the economy very quickly. On the other hand, if it doesn’t stop and it continues to do what it is doing, instead of buying or telling the governments to undertake structural reform, what it is actually doing is whitewashing the populist agenda. Which is that government spending should be fully monetized and that there is no problem with massive deficit spending.

FRA: And you mention a lot of this basis is that there is no apparent inflation. As you point out, there has been a lot of inflation since 2000. Can you elaborate?

Daniel: This is actually quite humorous, because if you think about it the European Central Bank, most of the economists, most of the censuses is telling us that there is no inflation in the eurozone. As such, monetary policy can be as (8:59-9:01 Inaudible) as needed for as long as it’s needed. However, at the same time, you have every (9:06 Inaudible) France, demonstrations of the Yellow Vests. And what are they demonstrating against? The rise in prices. The rise in consumer prices, the cost of labor and in the polls undertaken by the eurozone, the second biggest concern of households after unemployment is the cost of living. It is a complete fallacy that there is no inflation in the eurozone. And more importantly there is quite a substantial amount of inflation. Prices has risen as I mentioned in my article, 40% since 2000 whilst productivity and salaries have barely risen.

FRA: And your thoughts Yra on ECB’s monetary trap and the perspective of Daniel?

Yra: I couldn’t agree more, and that’s my point about why they need a German to head up the bank. And I see that Daniel seems to have come out of it the same way. I had a conversation yesterday, first time I ever talked to him but I respected him for 40 years, 35 years, Mr. Zulauf. We had a nice long conversation and I raised the same issue with him and we’re having this discussion and I said “Look, if you follow the work of Carmen Reinhart, which I think is very important on financial oppression, which of course is who sponsors this podcast; Financial Repression Authority, nobody in the world has been as financially repressed as the German citizen because of their culture of saving”. That’s just the way it is, they really don’t. When the Germans did step up to speculate in stock markets, they ran right headfirst into the (11:19 Inaudible) market back in 1999, 2000, 2001. They had the lowest housing purchasing ownership because they don’t borrow. They don’t borrow to buy houses.

It’s just not as common so here you have: If I’m a German saver, and let’s say I’m in short money. I’m getting negative 50 basis points, 40 basis points, 30 basis- whatever, it’s negative. And inflation in Germany, I don’t care what it is in the rest of Europe, I live in Germany and we know that’s where it manifested itself and with Merkel’s ridiculous energy program which has driven up energy costs. I have suffered tremendously in order to bail out everybody else. So, the fact that I’ve been so financially oppressed as I feel as a Bavarian burgher and I’ve not been able to vote for any of this. Nobody has ever asked me even (12:27 Inaudible) received piece in the Financial Times talking about taxation, we got representation and of course financial oppression is certainly a form of taxation. So I need to see Jens Weidmann, I want Jens Weidmann because I have to feel that somebody is actually looking out for me. Right now, nobody is looking out for me. Yes, I know Germany has benefited from a weaker currency to the Deutschmark would have been very, very strong. But that’s an asset as well as a liability.

So, this is- Daniel, 100% and I can’t agree with it more; it’s a monetary trap and Draghi following more importantly Bernanke and the Japanese, whether it’s Kuroda or Shirakawa, has walked into this and he has no exit. So, the exit has to be to create the folding of the entire ECB balance sheet into a euro bond. I’ve looked at this and I’m sure Daniel there’s no other way out of this and it builds every day and now of course they’re buying corporate bonds which who Jim Grant did a wonderful piece in Barron’s over the weekend about it. That the ECB has been an enabler of French corporate takeovers because money’s so cheap and that is exactly right. And I will end on that because one thing the Brits are not doing intelligently is they can get the ECB to fund the entire Hinkley Point nuclear project and basically zero interest rates by just selling the damn bonds to the ECB, you know the French would never get it because the EDF would love for that to happen and the Brits ought to do that before they leave and saddle them with the entire cost of it.

FRA: Your thoughts on that, Daniel?

Daniel: That is actually a very, very good point. You mentioned this concept of German benefiting from a weaker euro which has been used quite extensively by consensus as a main benefit for Germany in the monetary union. However, you’re absolutely right. Who has been the other side of the trade and who has (15:08-15:09 Inaudible). And one side, the German savers have been massively and negatively impacted by a weaker currency and the low interest rates. But also, the household consumers have seen a very important rise in consumer prices, the energy (15:31-15:34 Inaudible) power prices more than double for households and as you already said they don’t (15:44 Inaudible) massively like the Spaniards or like the Italians to buy property and what ended up happening as well is that you have riots- well not riots but demonstrations in Berlin because rental prices are going through the roof.

So, the way out for the ECB is evidently some form of rolling the balance sheet into an euro bond, absolutely it is. There is very little else that can be done. However, how do you sell this to a European Union in which the level of its trust between nations has increased when you have the peripheral countries trying to go back to 2008 and have large deficits, even break the European Union. You have had even as recently as a year ago you had the president of the- current vice president of (16:50 Inaudible) talking about the possibility of breaking of the Euro. A euro bond on one side is a solution and the other side is a massive time bomb because if it is successfully launched, what would happen would be that peripheral countries would be screaming for that euro bond to be extended to current deficit. And on the other hand, if it doesn’t it would be entirely a liability for the German household. It is not an option and I think that is why you need to find a way in which with the new president of the ECB, you implement some sort of process in which responsibility and shared responsibility comes also with some form of guarantee that’s going to be effectively implemented.

FRA: You mention also Daniel, that there are 16, ten-year sovereign bonds in Europe now showing negative real yields. Do you see that condition as persisting or maybe getting worse?

Daniel: I think it will get worse, I personally think it will get worse because as we were mentioning before, the problem is it’s very easy to enter into progressive (18:27 Inaudible) monetary policy, very easy to print money. It’s very difficult to get out. And it’s very difficult to get out when you have three factors in the eurozone that differentiate real economy, for example the US. Now in the eurozone, 80% of the real economy is financed by the banking system. In the US it’s 20%. Therefore, shocks in banking system have massive impact on unemployment, on growth, on credit for SMEs, you name it.

The second factor is the level of government spending at a country in the European Union level. Government spending and government liabilities is very, very high and the reason why it’s so very high is also because you have a massive and growing liability on the pension side. So, one side you have the banking system which is still very fragile and financing a large part of the real economy. On the other side, you have very high levels of government spending and governments that- basically, a 1% increase in government debt expense in the eurozone would mean that deficits would balloon in (20:00 Inaudible) 16, 17 countries.

But the third factor is also very important, is that 80% of gross capital formation in the eurozone is recycling of capital. Therefore, you’re not having a dynamic capital expenditure that is driving new technologies, new (20:20-20:23 Inaudible) etc. Productivity growth is very poor, and overcapacity remains very high. That third factor that leads to a very, let’s say perverse incentive from both governments and the ECB to Japanize the economy, to sort of keep it stagnant but let’s say, painless.

FRA: And your thoughts Yra, on negative real yields in Europe?

Yra: Well, I think that’s absolutely right. You see how it’s crushing the banking industry in Europe. The worst performing stocks for 30 years have been the Japanese banks. And that’s been with a lot of the banks being destroyed in Japan, so you think based on the concept of an oligopoly at least, that the profit margins would be great. But of course, the central banks have destroyed that and as Daniel points out, of course Europe has a much more banking sensitive base economy. Not corporate bonds although the issue being is to their benevolent actions creating more corporate bonds causing the incentives of corporations to entertain that.

But you look at the banks, listen. The crown jewel of European banking was Deutsche Bank, that doesn’t even bring a laugh, the Spanish banks have recovered somewhat from the terrible situation they were in, the Italian banks we will never know what the real story is there because especially under Fazio. This is one of the great feedback loops of all time is because Fazio rules sovereign debt is zero-risk weighted. So, unit credit or Sienna whatever I’m loading up on Italian sovereign debt because I earn a decent return relative to everything else. And I don’t have to reserve (22:42 Inaudible) so it’s a beautiful relationship Bob. In fact, I actually asked (22:48 Inaudible) that question. I say when he was at the Bank of Spain, of course he was in favor of zero-risk weightings, but I ask, well I said “now that you’re at the BIS do you have a different viewpoint on that” and he started laughing, the answer of course is self-evident.

This is a giant, giant mistake but it’s more part of what Daniel calls “the money trap” and it is a money trap. And of course, Draghi can’t really get out of there fast enough. You know, October 31st can’t come quick enough because it’s going to be very difficult just like it was for Yellen and now certainly for Jerome Powell in trying to exit from the strategy that is very difficult to exit and then they really had no exit plan. So, I think it’s really worse for Europe and that what’s they’re caught in and if you look at Europe, nothing says it better than of course the stock valuations of European debt.

FRA: And Yra, you frequently made reference to the book by Bernard Connolly called “The Rotten Heart of Europe”. Bernard Connolly used to be a senior economist with the Brussels Commission. How do you see what he foresaw in that book to what’s happening now in Europe?

Yra: As I say, all you have to do is read the fore, he wrote the book in 1995, he updated it with a new foreword in 2012, 2013. If you read that you have to go, get a nice scotch and sit back and think about this through because everything he has talked about has come to fruition. Unfortunately, he is not proud of it, by the way because I know Bernard well. So, he’s not proud of that and it’s always worried him, and this is where it sits. And you know everybody points out ridiculous things. What they worry about, ridiculous things because the Financial Times which used to be a good newspaper has become a joke because they just sit there and nod in agreement with whatever comes out of Brussels and don’t challenge it. The fact that this election is the biggest issue, of course what they wanted to make the biggest issue was nationalism and anti-immigration. I would vehemently at rise of the Alternative for Deutschland and it’s actually at its beginning in 2013 in response to what the ECB actions were.

And this is going to get worse because these are pocket book issues, and nobody has an answer for it. And fiscal, you know as long as the Germans remain (25:59 Inaudible) about fiscal austerity or at least fiscal- I’m going to say more importantly fiscal responsibility. I mean, you see it as we’re sitting here right now Rome and Brussels are going back and forth and I’m willing to bet that as much you know, people think that Brussels is going to place a fine upon Rome, it’ll never happen. It can’t happen because the Italians, you got to give Salvini his due cause he understands. He gives power to the old saying: If you owe the bank a hundred dollars, they own you. If you owe the bank a billion dollars, you own the bank. So that’s exactly what’s going on there and the Italians are not foolish. They understand. And I really think that Salvini must meet all the time with Yanis Varoufakis. He explains to him because he was very upset when Alexis Tsipras sold out the entire movement to get whatever he could out of Brussels but Salvini is going “There is nothing you can do to us” and they’re going to run a much bigger deficit, they have to. They’ve got no choice. So that’s where it lies and going back to Bernard Connolly “The Rotten Heart of Europe” which is still the most important book, I’m sorry if I hurt anybody’s feelings about Europe, it still has relevance and the players he talks about 20 years ago, 25 years ago, are still heavily involved in this now. So the book still has great relevance.

FRA: And your thoughts Daniel?

Daniel: I completely agree with what Salvini is doing. I was in Italy recently, there was a TV debate about this whole to and fro between Brussels and Italian government and one of the members in the league was saying “Hold on a second, you mean that we’re going to get a 4 billion euro fine for having the same deficit as Spain?” It’s become a system of perverse incentives because on one side is (28:25 Inaudible) we cannot exceed the deficit and we cannot break the rules agreed at (28:32 Inaudible) etc. However France has missed those same targets 11 times, Germany itself as well and France for example has not had a balanced budget since the late 70s.

The problem of the eurozone has nothing to do with the lack of government spending. The problem of the eurozone’s very poor productivity, very undynamic growth and very weak levels of employment, comes from the excess of government spending. And obviously yes, they will run larger deficits as you very well said there is no other option because Italy has been stagnant for two decades, France as well. But ultimately the issue here is, is that going to solve anything? And the Germans will finance that deficit at the end of the day, it’s a bit of, sort of a bender-financing type of situation. But if you think about it, from the perspective of whether that is going to help the eurozone countries economies improve in productivity and therefore salaries improve in competitiveness and improve in growth, unfortunately it won’t. Yes you will have deficit spending, more current spending in subsidies and in malinvestment but fortunately that is not the solution. The point that you mentioned before, is at least you will sort of hide the risk of European banks under the rug of the ECB, that is as much as you do. But unfortunately, I don’t think that it’s (30:37 Inaudible) large deficit is going to move the country into growth because it’s been running a massive deficit for many, many years and it hasn’t.

FRA: And finally, a question on the global trade. How do you see the US-China trade frictions and their effects on the financial markets and the global economy and also do you see intensifying US-European trade frictions as well… Daniel?

Daniel: How do I see, I was explaining this to my students the other day. If you have a company and you have the biggest supplier of your company, how do you treat your supplier? You treat your biggest supplier with a little bit of tightening. You demand discounts, and if somebody is your biggest client, you take them for dinner, you treat them nice, you send them presents for Christmas and so what is happening right now is exactly that, is the negotiation between the largest customer and the largest supplier. And what I see is that the rhetoric of consensus is blaming the global slowdown and the problems of the eurozone, the problems of different economies on something that has absolutely nothing to do with it. Which is this trade dispute between the US and China.

The first reason is because people perceive that the trade dispute the US and China is something that is hindering the growth of the rest of the world, and it is not. There is absolutely zero evidence that China is importing less than the rest of the world than what it needs. Actually, there is all the evidence that it is importing a lot more. China has a trade deficit with most of the rest of the world.

The second thing is that there is this perception if there was this agreement with the US and China, it would be an agreement that would sort of kick back growth and the growth mode in the global economy. We tend to forget that if there is an agreement between the US and China, it is a zero-sum game. If China starts importing more soda from the US, it means importing less from Argentina, because there is no evidence that China is importing less than what they need. Actually, there is all the evidence that they’re importing more than what they need in order to boost GDP and it’s evident in the (33:26 Inaudible) bill.  The same with natural gas, if China imports more natural gas from the US, that will mean less natural gas imported from Qatar.

So, what I’m trying to get to is that this dispute is a negotiation, and that this negotiation, there will be an agreement reached. However, a lot of Europe, a lot of the excess valuations in the market, excess risk taken of the market etc. Was predicated on the idea that an agreement between the US and China would sort of change the global trend of growth. I think it’s not going to do it. The impact on it right now, we are seeing right now is obviously, you get (34:16 Inaudible) you get very low 10-year sovereign yields. So, you have flight to safety and I think that basically just the trade war has been use as a subterfuge because either we have been in a trade war since the early 2000s. Remember all of us here remember for example, the aluminum war between the Bush administration and what Obama did with for example, solar panels, all these things. Either we have been in a trade war since 2000 or we are not in a trade war now. What we have now is let’s say a less diplomatic negotiation. Will the US go after some of the imbalance afterwards, after reaching an agreement with (35:10 Inaudible), you bet they will, you bet it will. And the reason for it is the reason I always explain to everyone. You go down the street here in Madrid or in London or in Germany, any city in Germany, any city in France, tell me how many US cars you see.

FRA: And your thoughts Yra?

Yra: We are very much in agreement. You know I think this issue is far more of course than trade and it’s long overdue. You have to let the (35:47 Inaudible) whose been screaming about China’s entry into WTO which of course was all laid out by the Clinton administration and the way they were done and the rules that were crafted. In the way that China has skirted around what the WTO’s true intentions were on certain issues and it’s been long overdue. But American corporations and American businesses are not just like European businesses by the way, is not without some liability in this because they are willing to quote-on-quote sell their souls for access to a billion .3 consumers. Anything to get into that market.

So, they knew what the rules were going in, they just didn’t believe them. And I always harken back to 2009 when Jeffrey Immelt was then CEO and Chairman of GE. You know GE started pulling out of some business because they realized they couldn’t make any money in China. It was very difficult, you have to give a lot in the partnerships. So, they realized then it was not working out. These are things that some have been corrected but everybody went into China knowing what the rules were or not, what the rules were not. And the Chinese has been very astute so let me pick up more Daniel, which is I keep saying to people. If you’re right about the outcomes of China, then you should be buying Mexico. And as bad as Mexico can be with all it’s corruption, the whole concept of NAFTA which we are revisiting too was that they were going to build a North American behemoth of Canada, US and Mexico, big population and it would ensure that there would be wage pressure on US unions to keep America somewhat competitive on that basis and the Chinese disrupted it because January 1st in 1994 when NAFTA began, that’s the Chinese devalued the yuan from 5.8 to 8.7. They knew full well what the intentions were and of course that’s created the Asian contagion because you had all this capacity built in Thailand, in Malaysia, Indonesia, Hong Kong, Taiwan. Massive amounts of capacity and now the Chinese were doing their best to disrupt the whole thing anyway, which they did.

And they created what came four years later and of course Mexico suffered immediately with the- what do they call it, the tequila crisis. But if you believe that this has staying power and you’re a large global corporation, a multi-national corporation if we still use that word. When I was in school, the essence of my research was multi-national corporations, that was the 70s. Then it’s time for NAFTA investments into Mexico and actually AMLO, who is from the political left, he understands what’s going on. Can you get the corruption under control? Hopefully he can because he has a huge popular mandate, but I would look to Mexico, Mexico would tell me more about what people really think than anything else. Because there it is, (39:41 Inaudible) that sit on the northern border of Mexico, southern border of the US were built to be the key focal point of the global supply chains which China basically uprooted by design.

So, there are things we don’t have to guess at this, if we watch to see what is going on, we will have a pretty good idea. Right now, it’s not telling me. I look at the peso, I look at what’s going on in Mexico, it wants to happen. But you’re not seeing it yet. I think some people are pulling out of China because they’re fearful so they’re moving some factories across to Vietnam and Thailand and Malaysia again, but we’ll see what happens. But if you look at the value of the peso relative to when the yuan was devalued by 50%, the peso then was I think about 3.3 to the dollar is of course is 19 to the dollar so all kinds of advantages. But let’s see if they work out. I think it’s a little early to make that decision, but it is worth watching and it will tell us more about global trade because Daniel’s point about (40:53-40:56 Inaudible) so what it means is if you don’t buy soybeans from the US, you buy from Argentina, someone will buy the US soybeans. But it’s the same again with LNG but of course in the LNG issue a lot of those long-term contrasts there’s a lot of Asian financing that went to building those huge complexes down on the gulf coast. So, with that comes contractual agreements, a lot of that LNG has to go to Asia, it’s not like Trump will say we are going to sell it to Europe, no you’re not. There are long term structural agreements you will have to adhere to. There’s a lot of things going on and they’re really worth watching and now I have to go and read Daniel’s work because I’m not familiar with it, but this conversation has really elevated that for me so thank you.

Daniel: And thank you!

FRA: Great, this has been great insight and fascinating discussion, how can our listeners learn more about your work, Daniel?

Daniel:  Well, the easiest way is to go to my website DLacalle.com. And obviously you can find my books on Amazon and you can also follow me on Twitter at DLacalle_IA.

FRA: Great, and Yra?

Yra: Where I’m writing as usual is at “Notes from Underground” but you can go to YraHarris.com and register for, it’s free. There’s a lot of great discussion that comes from people all over the world, it’s all about discourse and ideas and of course we’re, Daniel in the classroom, I’m in the training arena and investment arena so we try to beat the concepts around and try to create very profitable opportunities for training and investing and that’s what our goal is, again there’s no political agenda, there’s nothing else but trying to generate profitable trades and if that’s what your designs are then it’s the right place for you to come and join the discussion.

FRA: Great, thank you very much gentlemen.

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.