Against EFSF? Really?

Estonia's parliament will vote on expanding the powers of EFSF tomorrow together with Germany. As always media and politics have managed to develop a circus out of the discussion preceeding the vote. Polls show that Estonian people are mostly against expanding EFSF (also those supporting our current right-liberal government). Some of the people shout out arguments like "Greece should go bankrupt" or "Why do we have to feed banks". This was followed by a statement from our centre (populist) opposition party that they also don't support joining the EFSF probably hoping to get some votes. Since people are getting very emotional on this subject I will lay out some most important facts about EFSF. (Check these out yourself HERE)

1) First and foremost - EFSF was created with an intention to preserve financial stability in the eurozone by providing temporary financial assistance to governments or banks in difficulty. In other words it is supposed to AVOID crises like we are in now.
2) EFSF finances itself by issuing bonds that are guaranteed by all 17 eurozone countries up to 440 billion euros. Countries participating in EFSF do not pay any additional funds to EFSF, it is backed by guarantees.
3) EFSF is only a temporary measure to handle the current crisis and its permanent follower will be ESM or European Stabilisation Mechanism.

Q: What happens if a country doesn't participate in the EFSF?
A: There's a risk that other countries don't want to particpate as well, who will finance the EFSF then?

Q: Why do we need EFSF at all?
A: To avoid uncontrolled bankruptcies of banks and countries

Q: Why do we need to avoid their bankruptcies if they have overspent?
A: Since if we don't borrowing costs for countries like Italy, Spain, France, Belgium etc will rise significantly leading to other bankruptcies. Banking system as we know it might fall because of the losses that these banks will have (the banks are holding the bonds that are worthless after a bankruptcy of a country). There will be no more euro.

Q: What happens if euro goes?
A: Countries like Germany, Estonia, Finland, Netherlands etc that are financially sound will get currencies that will rise significantly in value causing our exports to fall greatly (it is then more expensive for other countries to buy our products). This will bring massive unemployment and loss in economic welfare. It has been estimated that the effects of such an event would lead to 20-40% fall in GDP in first year. For countries like Spain, Italy and Greece this might even leed to civil war since their currency would devalue so greatly that the people of these countries are unable to pay off their loans. There would be massive unemployment since there is no funding for investments (who would borrow to a bankrupt country in civil war?). GDP of these countries could even fall 50% or more. (Analysis is done by UBS).

The total loss of these events will surpass trillions of euros (if you look at European GDP of about 12 trillion EUR). The countries going through tough austerity measures including budget cuts and reforms will hopefully turn to growth in a couple of years. It is not like regular people of these countries aren't suffering enough already. Hasn't Europe learned anything from its history just 70 years ago? It's not like we are not on the edge of a cliff..

Operation Twist not impressive, fiscal stimulus needed

Fed announced yesterday that it would change the average maturity of its bond holdings towards longer term bonds. This is carried out by selling short term government bonds (2-3 years) and buying long term bonds (6-30 years). The idea of this operation is to lower long term yields thus making mortgages cheaper and stimulating economic growth through housing market. This isn't something that markets liked to hear, unfortunately. S&P500 was down more than 2% yesterday in addition to -3% already at pixel time. Not to mention DAX that is down more than 5% in trading today.

There has been a lot of talk of decreasing effect of more quantitative easing. Since yields are on record lows already the effect of manipulations performed by Fed have just marginal effect. The problem is not that long term yields are too high. Interest rates are near 0% already. The problem is economic outlook. Companies aren't investing as much as they used to hence not supporting employment, the future of individual persons is everything but certain. There's only so much that Fed can do about it. They have done everything they can.

Unfortunately Fed is one of few institutions that realizes the importance of financial markets in modern economy and their importance in supporting economic growth. Unfortunately Fed is also one of few institutions that is willing to act quick. What is needed today, is economic stimulus by fiscal expansion.

We need governments of the biggest countries to step in, initiate infrastructure projects thus directly subsidising employment. We need them to expand not contract. Even though we have a debt crisis in our hands we need to borrow (and grow) are way out of this mess. Governments tend to overspend during good times and underspend during bad times. This is not the fiscal policy we signed up for! That's the basic idea of fiscal policy - to level out economic cycles.

Debt crisis has to be handled by bold guarantees by central banks (for example unlimited purchase of government bonds) or by issuance of eurobonds for example (in the eurozone). Instead of this we are crossing our fingers and hoping that we will somehow get out of this mess, dealing with consequences.

Unfortunately things have to get really tough for this to happen. Stocks are cheap around the world. We need bold action by governments to get the stocks rising again. Watch out for these weekend meetings of countries. I wouldn't want to be short ahead of some bold plans when these would be announced at some point.

Europe needs a vision, not just doing something

Imagine a football match without goals and goalkeepers, everybody are just trotting around anxiously. Imagine a ship on the sea without a compass or any other navigation system. Imagine a doctor treating you for symptoms even though you haven't agreed that you want to get better. This is what Europe is doing right now with the eurozone crisis.

In strategic management a vision is defined as the way an organization should look like in the future, what is the state of things. In the same manner we could (and most definitely should!) have a vision for Europe. What is the future of Europe? Do we want an economic union, a political union or even more integrated Europe? If we knew that it would be awfully easy to find a solution for the crisis.

If we wanted tight economic cooperation amongst countries we should let Greece suffer for their own overspending and throw them out of the euro. If we wanted United States of Europe we should introduce bazookas like eurobonds or unlimited supply of liquidity, bond buying and loans from ECB.

A clear vision of Europe is making it so difficult to find a solution to the crisis since everybody has their own vision for Europe. Again - imagine a football match where everybody would have their own rules for the game.. It is not too late yet. Even though the project of Europe should have began with a common understanding of the ultimate goal, it is not too late to agree upon one right now. The markets don't need a bazooka per se, they need a clear understanding of how Europe is going to tackle the crisis.

Please welcome Google flights

Google has just launched their travel planning initiative (see website here HERE). Currently site unfortunately supports only US flights. All the major travel sites were down yesterday in the beginning of the trading day following the announcement.

I ran a quick test and compared the site with Expedia. I set up a travel route from LA to NY departing on 1st of Oct and returning on 8th of Oct. Expedia found me a flight that cost 258 USD (Continental), Google 289 USD (American). So I guess Google might not have so many deals with different airlines yet.

However the best feature that Google has is displaying the cost of flying from a selected destination to other cities. Just look at the following map (click to enlarge). So for example from LA to Denver it costs 159 USD to fly on these dates. Can't wait for this feature to be available in Europe since planning multiple destinations can be a real headache.

Windows 8 in action

MarketWatch has posted a video of Windows 8 in action on a tablet. Looks cool doesn't it?

Are German stocks getting cheap?

Frankfurt blue chip stock index DAX is one of the biggest fallers during the recent financial turmoil. Just look at the 5 year graph of the DAX index (click the chart to enlarge).

DAX has declined more than 25% already this year compared to S&P500 (9%) in the States or FTSE100 (13%) in UK. So the question is whether German stocks are getting cheap? On the following chart P/E ratios (stock price to earnings per share) of all the companies included in the DAX index are presented (click to enlarge).

While European banks are suffering a possible liquidity crisis (hence the low valuation) Commerzbank's stocks are good for gambling. The low valuation of most stocks seem to price in a double dip recession in Europe. We could see a nice rally with cheapest stocks from manufacturing industry once economic data gets more positive. Upside of 30% from current levels would not be anything extraordinary. One of my favourites from these stocks is BMW. Even though Europe and US might be slowing we have a major consumer boom in China and companies with big Chinese exposure might still do well this year and the following year. Hence my sympathy for BMW as well.

We'll see how much downside the DAX index still has and whether we're entering a double dip recession. Those who believe in a slow recovery rather than a recession might just start shopping, me included.

In memoriam

Today is the anniversary of 9/11. The world changed that day, 10 years ago. War on terror officially began that day. But is the world safer today?

I think it is not. Terrorism comes in many forms, as we saw recently in Norway. The bombings in Russia or UK were also a proof of that. Al-Qaeda has lost their leader and their network is not the same it was 10 years ago which makes me to believe that operation similar to 9/11 would be hard to carry out. There just might not be organisations with such capabilities anymore.

Still, lack of such attacks is not a proof that such capabilities don't exist. As long as there are different ideologies there are those who are willing to fight. We just have to hope that initiations like the Arab spring will carry the power of words further than the power of weapons.

What about Maastricht criteria?

Every country part of the eurozone has to fulfill certain economic conditions (referred to as Maastricht criteria). The country that is not obeying these criteria can be punished by the ECB. The criteria go as follows:

1. Price stability. The inflation rate should be no more than 1.5 percentage points above the rate for the three EU countries with the lowest inflation over the previous year; 
2. Budget deficit. This must generally be below 3% of gross domestic product (GDP);
3. Government debt. The national debt should not exceed 60% of GDP, but a country with a higher level of debt can still adopt the euro provided its debt level are falling steadily;
4. Exchange rate. The national currency's exchange rate should have stayed within certain pre-set margins of fluctuation for two years (no re- or devaluation of currency);
5. Interest rates. The long-term rate should be no more than two percentage points above the rate in the three EU countries with the lowest inflation over the previous year;

Maastricht criteria were the reason why my home country Estonia didn't join the euro in 2007 as planned because of the inflation criteria was not fulfilled even though Estonia is fiscally the toughest and best performing country in Europe (Estonia is part of the eurozone from 2011). That's OK because rules are rules... or are they? Greece, Italy and Belgium (the heart of EU - really?) joined the euro even though their debt was exceeding 100% of GDP. Greece was running the biggest budget deficit with one of the highest inflation rates. Check the following graphs.

So far the criteria have been important for countries willing to adopt euro since it's a precondition for joining (this statement is conditional itself as seen from history). For joining countries it is a good motivational exercise to get their finances in order. Once already in the eurozone motivation quickly disappears.

So how should we deal with that? Shall we fine the countries that are not capable of cut their spending (read: living within their means)? That's like asking for money from a beggar so it probably wouldn't work. There are still couple of things that could be tried.

Make it political! The main reason for not cutting spending or increasing spending for politicians is the support of their voters. Political promises can often lead to overspending so there is motivation for politicians to spend more than possible. So why couldn't it be possible to force the government step down if two out of five criteria are broken for example?

Another idea is to keep away the cookies. Today a lot of countries are receiving structural funds and richer countries are participating in other mechanisms like Framework Programme. Would it make sense to cut funding for countries that aren't fulfilling their duties? Since all of the EU countries aren't in the eurozone it would be impossible, but approach as such would serve its course (as can be seen in Greece today).

I would prefer stabilizing the eurozone with political measures which reduces populism, the mother of all wrongdoings. We should remove the motivation to behave badly, fines and nagging doesn't work here!

What happens to a country after leaving the euro?

Who hasn't heard of a populist politician arguing that a country should leave the eurozone and be better off? I've had many discussions on this subject but as long as we don't have a precedent we really don't know what will happen. Anyway we have some calculations by UBS Securities (LINK) and I quote:

Ahead of the German constitutional court ruling on bail outs, we have assessed the cost of countries leaving the Euro. For a weak country the cost is 40%-50% of GDP in the first year. For a strong country like Germany the cost is around 20-25% of GDP.

Economic costs of break-up dramatically exceed the costs of bailing out weaker states. Political costs also need to be considered. Virtually no monetary union has broken up in modern times without some trend to authoritarian or military government, or civil war.

The cause for such a major crash is loss of credibility, default, collapse of banking system etc. I wonder whether the same people arguing against war in Iraq for example are arguing against bailing out countries like Greece which could turn into civil war? I wonder how the protesters below expect governments to fund basic needs of people with a scenario described above?

It is easy to be populist because it is good to be popular. Next time you hear somebody arguing their case about Greece, Italy or Iraq ask them about alternative theories - what should we do then (and don't settle with an answer "don't bail-out a country") - because that's what we usually see and hear - populist thoughts without a credible alternative.

Cat and mouse play by the ECB

I'm back from a nice holiday and sad to see that Greece is making the headlines again together with Italy. Two interesting things have happened that caught my attention.

First, Greece has caused representatives of the IMF (International Monetary Fund), EU (European Union) and the ECB (European Central Bank) to walk away from a progress monitoring event which was suspended for 10 days causing the bond yields of Greek 2-year bonds to rise to more than 50% today! The price of the bond has fallen lower than 50% of its initial value. This means that investors are getting more confident over a Greek default. Greek finance minister Evangelos Venizelos claims that Greece is not willing to make any more budget cuts this year.

The second interesting thing is that at the same time the ECB has not commented on whether they are continuing to buy Italian government bonds or not. This has caused yields of Italian 10-year bonds to rise above 5% again which is considered to be not-sustainable.

The ECB doesn't have too many instruments to put some pressure on Italy and Greece carrying out their austerity programmes. While couple of weeks ago we could see worrying statements by Papandreou, Berlusconi and Tremonti (Italian finance minister) then suddenly we're seeing both governments dropping some of their austerity plans. So right now we might just be seeing the ECB taking a more straightforward line with the two governments.

Even though both sides want to find a solution to the crisis it is not so easy to find it. The economies of both countries aren't doing so well and extra austerity measures might temporarily lower the growth even more. At the same time the ECB has to stand against Germany who opposes bond buying programme. Who will be the cat and who will be the mouse in the end?