two important developments in the EU yesterday

short-term interest rates cut

In post-WWII Europe, monetary policy has been dominated by institutional memories of the hyperinflation that plagued the Weimar Republic in the first quarter of the last century.  The hard lesson learned then, and being applied now?–eliminate any whiff of inflation, even at the expense of economic growth.

That’s been the mantra of the German Bundesbank and of its intellectual successor, the European Central Bank.  It’s why the ECB raised short-term interest rates in the wake of the subprime mortgage crisis rather than follow the lead of the Federal Reserve in the US and lower them to try to stimulate economic growth.

…until now, that is.

Two days after assuming his position as president of the ECB, Mario Draghi cut rates by .25% to 1.25%.  He cited the risks of recession and he played down any threat from inflation, which is currently running above the central bank’s target of 2%.

This is good news.  The positive stock market response to this move seems to me mostly a reading that the torch has been passed from the Bundesbank to a new generation of policymakers who will act more in the American mold–rather than to the rate decrease itself.  Again good news.

an ultimatum to Greece

It’s over a year since the Papandreou administration announced that the former Athens government had been falsifying the national accounts for years and that the country was in effect broke.  Bailout talks have dragged on almost interminably.

The Greek negotiating style, as I see it (sitting here in on the east coast of the US), is real hardball stuff and not designed to win either friends or continuing business relationships.  It consists of repeatedly leaving the table after giving the EU the impression that the parties have reached a “final” agreement–and then reopening talks to ask for further concessions a week or two later.

Many companies have told me that it’s commonplace in China to haggle even after formal contracts have been printed up.  I worked for someone who did this all the time.  The idea is to use the fact that the other side has already reported to its bosses that they have a deal as leverage to extract slightly better terms.  But like the death of a thousand cuts, this process goes through many iterations.  So the multiple “slightly betters” can add up to a lot.

In this case, there’s also the issue that a real default by Greece would hurt the EU more seriously than is commonly realized.  The EU wants a restructuring of Greek debt that won’t trigger many billions of euros of credit default swaps its banks have entered into.  To avoid punching another wide hole in the banks’ capital, the EU needs Greece to cooperate.  Greece has used this to its advantage.

Yesterday, however, the EU said enough is enough.  It halted negotiations once and for all.  It says that Greece must accept the latest restructuring package and implement the economic austerity measures that entails.  The EU also says it is starting to make preparations to expel Greece from the EU if it does not.

(In other words, it is figuring out how to prop up any EU banks that become insolvent, either from holding Greek sovereign debt or from foolish credit default swaps.)

This doesn’t mean Greece will finally accept the bailout package.  It may opt to default and be tossed out of the EU.  I doubt it, but I don’t know. At any rate, however, the EU has finally drawn a line in the sand and set a time limit.

The issue will be decided before yearend.  Uncertainty will be over.  Investors will be able to see and deal with the implications of what Greece elects to do.  That in itself is a positive.

investment implications

The one-day read by Wall Street is that both developments are plusses for world economic growth.  I agree.

In addition, investors appear to be thinking that the primary beneficiaries will be the most highly cyclical firms, like capital goods or basic materials companies.  I’m not sure that’s right.  I prefer consumer discretionary and IT stocks.  But I’ve got to keep an open mind, since the business cycle message is being delivered so strongly so far.

more problems from Greece

Last week, the new Greek finance minister tried to renegotiate the bailout plan the country had agreed to with the rest of the EU, by suggesting weaker austerity.  After that overture was rebuffed, the Greek government–the one that revealed the prior administration had been falsifying the national accounts for years, triggering the current crisis–was found to be preparing legislation for a necessary parliamentary vote that incorporated the weaker austerity measures the EU had rejected.  Apparently, Greece was planning to ratify the weaker terms and then present the rest of the Eu with a fait accompli.

Now it appears the Greek government may not have the votes to pass any austerity plan.

It’s hard to know which side to have sympathy for–Greece, which merrily used its EU membership to run up bills it knew it never could pay, or the rest of the EU, which fudged its membership criteria to get  Greece in and which seems to have known what Greece was up to, but just underestimated the extent of the fraud.

I think the EU has two objectives:

–it wants to avoid having its banks forced to write down the Greek government bonds they’re stuffed to the gills with; and

–it wants to avoid setting a precedent that Ireland and Portugal, if not Italy and Spain, could reasonably expect to follow.

Greece, on the other hand, seems to fully appreciate the maxim that if you owe $20,000 to the bank you’re in trouble; if you owe $200 million, the bank is in trouble.

Today’s development is that large French banks have “voluntarily” proposed to roll over much of their Greek debt for thirty years, while reducing interest and reinvesting a large part of the coupon payments into new Greek sovereign debt.

A wildcard in these proceedings is credit default swaps–how large, who owns them and what are the precise terms.  History tells us that Continental European banks tend to be the ultimate “dumb money,”  which would lead to the surmise that there are a lot of CDSs and European banks are on the losing side in case of default.

The burning question, then, would be about the terms.  Let’s say the EU as a whole reaches an internal agreement about Greek debt that it believes solves the problem without requiring the banks to write down any of their Greek bondholdings.  What happens if the rating agencies declare that despite this legal paper shuffling, the solution is in fact a default.  Does this trigger the credit default swaps?  My experience says “Yes” is probably the correct answer, but I don’t know.

It seems to me we’re entering the final innings of the game.  The outcome is still in doubt, and no one is leaving the ballpark.

From an equity investing point of view, I think the negative effects of an ugly outcome to the Greek situation will be felt mainly in European financial companies and in firms doing most of their business in Europe.  A good portion of the ugliness has to already be discounted in global stock prices.  Still, this is an issue to watch carefully to make sure the ripples don’t spread far wider than one might expect.