Investment contagion

Insanity and austerity

Amid the sound and fury of the Greek debt negotiations, it is easy to forget how the problem was created. Idiotic bankers throughout the world find it easy to believe that ‘sovereign debt’ – that is, government bonds – is risk-free, regardless of practical history.

In the happy times before the banking crisis, German and French banks overdosed on Greek debt, and then faced bankruptcy. Rather than punishing their shareholders and managers for their stupidity, and embarrassing themselves,

the EU authorities chose to rescue them. They did this by buying out their Greek loans, and taking them onto the EU’s books via the ECB and IMF.

Insanity has been defined as doing the same thing time after time, though always hoping for a different outcome. This has been the policy of the assembled brains of the EU Commission, the ECB, and the IMF [the so-called Troika], and the whole German economic establishment since the banking crashes of eight years ago.

Eurozone as high risk venture

The eurozone was always a risky venture. It had a predecessor in the 1865 Latin Monetary Union. This was based around France, Italy and Switzerland, and designed to facilitate trade; but without any political linkages, member countries played fast and loose with the rules. The LMU was finally destroyed by the outbreak of war in 1914, although it lasted de jure until 1927.

This lack of political union was accepted as a necessary disadvantage of the eurozone, especially as the banking crisis identified the problems of monetary unification without political agreement. All attempts to solve this issue through ‘ever closer union’ and a unified European banking industry have been stymied by the reluctance of politicians to give up control of their national banking systems. Current thinking is that no major progress on this will be made without treaty change, and that is not on the cards.

It also means that there is no way that the imbalances created by the trading success of Germany, the Netherlands and other northern European states can be recycled to the benefit of ‘Club Med’ counties, even if the Germans were to accept that the problems are as much their own making as that of anyone else.

Another failed State.

Financial orthodoxy has destroyed the Greek economy – a fall of 25 per cent in GDP over the past five years, unemployment of over 30 per cent, with 60 businesses going bankrupt every day this year – and has shown that the eurozone is not a monetary union but a fixed exchange rate club. If Greece can leave, so can anyone else.

The Greeks are not easy partners – the Venetians were complaining about them half a millennium ago. But if no government in Athens has been able to carry out the reforms demanded by the troika – over five years, two bailouts and a debt write-down – it suggests that such reforms are easier defined in Brussels than implemented in Athens. Another approach is needed.

Indeed there are other EU counties that suffered Ottoman domination for centuries, and with political weaknesses not unlike those of Greece. But whether bank reform and unification, or changes to British membership, the signs

are that the EU is now so unwieldy and bureaucratic that nothing can change, lest the whole edifice comes tumbling down.

Investors should be cautious of arguments that Greece is such a tiny part of the EU GDP [less than 3 per cent] that there will be no contagion effect. Much the same was said of the Lehman Brothers collapse, and the optimists were wrong. With Greece, there are some significant political threats. The chance that the country will fall into economic chaos — and then political extremism — is high.

Political risks in the Med

All Mediterranean countries of the EU have similar problems to Greece. These are weak economies unable to throw off the legacy of slow or no growth, sclerotic labour markets, some corruption and clientelism preventing necessary supply-side reforms, and 40 to 50 per cent youth unemployment. Italy and France have maintained such economic growth as they have through public sector spending and high borrowing.

Secondly, Italy and Greece face the additional problem of North African migration, and a marked refusal of other EU countries to help them. As Italy’s prime minister asked at a recent Heads of State summit, what is the point of the EU club if members do not help each other?

This year Greece has received the same number of refugees as Italy. The escape route for these – through Serbia, to Hungary and so the EU – has now been blocked by the Hungarians fencing off their border with Serbia.

The threat of Isis

European attention has been focused on the Russian threat, rather than the increasing appeal of Isis within the Arab world. Indeed, the idea of the ‘caliphate’ is seen as ludicrous by mainstream politicians, who at the same time talk of the need to appeal to the disaffected Arab minorities within their states with ‘ideas’.

But the caliphate is that idea, and one for which it is perceived to be worth dying.

It is a dream of reinventing a glorious past, of a powerful, cultured and expansionist Muslim civilisation that once held the West in thrall.

The countries of the Levant and North Africa, carved out of the Ottoman Empire in the aftermath of the First World War, never developed much legitimacy; now these are dead in the wreckage of Sunni and Shia civil war. Isis and jihadism bring hope and promise to a young, unemployed and discontented population.

And the leaders of that movement, however barbaric and murderous, are clever strategists. Only Tunisia of the Arab Spring countries succeeded in establishing some sort of economic and political fairness.

But Tunisian tourism has now been targeted by Isis, for they know that economic failure leads to political extremism, and another failed state on the southern shores of the Mediterranean is yet another knife aimed at the heart of Europe.

Low-risk investment

Between Waterloo and August 1914, there was little need for monetary policy, since only the discovery of new gold and silver mines could increase the world’s supply of paper money. But there were plenty of stock market crashes, driven by investors’ greed and bankers’ imagination.

Today, lack of demand and quantitative easing have downgraded monetary policy to keeping interest rates low and investment markets high. Investors are blithely unaware of the political and economic monsters that lurk beneath the stagnant waters of the world economy. These are real enough — although they may take time to surface — but the threat has upended most investment verities.

The only safety now is in equity investment, and the ability of a committed long-term manager to find companies that are growing, are sensibly valued, and have a better than average return on assets. These are more likely to be found amongst investment trusts, and with managers like Terry Smith of Fundsmith, than among the marketing driven generality of unit trusts.

Above all, debt and credit-based products should be avoided. This is partly because monetary policy has driven returns down to ludicrously low levels, but also because those low returns have forced money managers into developing highly leveraged and complex products. What those levels are, no one knows, but the record level of margin finance in New York suggests that illiquidity will worsen political and economic fears.