Google reported fourth-quarter revenue and profit that missed analysts’ estimates as an economic slowdown in Europe crimped international sales. Bloomberg News. January 20th, 2012.
Does it mean Google will take a little longer to occupy the 2,900,000 square feet of office space they leased or purchased in Sunnyvale and Mountain View in 2011?
And does it mean that after two years in the making, the effects of the European Debt Crises are being seen in Silicon Valley?
As an observer of the commercial real estate finance world and a commenter on the Northern California real estate markets, Greece and the whole Eurozone financial crises can seem very far away. Yet Newmark’s institutional investor clients and correspondent lenders tell me the consequences of this impending slow-motion train wreck in Europe is the biggest threat to the current relative stability in our financial world, and a force that could push a recession onto the entire developed world and seriously slow down the growth of the exporting nations of the developing world.
Some form of disintegration of the Eurozone is inevitable
Creating a united currency without a united government controlling fiscal policy may seem in hindsight to have been a really dumb idea. Countries hid their financial picture to be admitted to the Eurozone then almost immediately violated the guidelines; even on their own reported numbers that turned out in the case of Greece and likely other nations to be fraudulent. The solution being floated: We will now be serious about the guidelines that almost every country (including Germany) violated. We will centralize economic monitoring in Brussels and create penalties if countries violate the guidelines.
This solution is destined for failure, due to three reasons:
1. Unless there is a single European treasury, no one can trust the numbers. You have to listen to this investigation from NPR’s Planet Money. It details how a European Union (EU) accountant was sent from Brussels to Greece to calculate the true amount of the Greek deficit. The prior administration had claimed the deficit was 6% of GDP, the new administration claimed it was 12%. The EU accountant thinks this should be a one day task. He ends up being Mao-Maoed by the union leaders for the Greek Statistical Agency workers. He brings in reinforcements from Brussels and eventually estimates the deficit at 16% of GDP. His private email communications with his personal lawyer are illegally hacked. He faces strikes from the Statistical Workers Union and office occupations. He ends up being investigated by Greece’s Prosecutor for Economic Crimes for the charge of treason and faces a potential sentence of life imprisonment.
You can find the podcast here: http://www.npr.org/blogs/money/2011/12/16/143846133/the-friday-podcast-how-office-politics-could-take-down-europe.
2. Democracy is a process that is almost impossible to reverse. To achieve a common fiscal policy throughout Europe, the EU needs to take away a great deal of sovereignty from the member nations. Without free powers to set spending, to create tax policies, to set pension and retirement policies, member countries will feel like occupied nations; especially, if they face truly punitive sanctions.
3. Una faccia, una razza, as the Italians say, or mia fatsa, mia ratsa in the Greek equivalent, meaning one face, one race. There is a great cultural divide between Northern Europe and the Mediterranean region. The Mediterranean is a culture rooted in out-smarting its occupiers. For thousands of years, Greek and Roman history tells of small city-states dominating their neighbors and sometimes occupying whole regions. Areas like Sicily spent much of its history under foreign control by Greece, Roman, Vandel, Byzentine, Moores, Normans, Catalonians and Bourbon occupiers. Italy was not “united” until Garibaldi accomplished this by force, defeating the final holdout, Rome, in the 1860’s. If you talk to “Spaniards” from Catalonia or the Basque region, Spain is not united today. The Mediterranean culture is set up to use whatever leverage or subterfuge is available to benefit family first, village second and cultural sub-region third. National identity is far down the list. The idea of sacrificing for the cause of “Greater-Europe” might ring true in the North but not in the Mediterranean.
So if the Eurozone breaks apart, what are the consequences?
The threat of a Eurozone meltdown is real if not inevitable, but what are the consequences? Here things get murky. We face three negative outcomes that could happen in various combinations:
1. European Recession: This slowdown has started and will intensify: due to the need for governments to rein in spending, cut benefits, and raise taxes. On top of the headwind from this fiscal austerity will be increased austerity in the private sector as we see a need to deleverage in the European household, corporate and financial sectors.
2. Banking Crises: Last year, prior to the falling value of their sovereign debt holdings, European banks were estimated to need to raise 25% to 50% more capital to be properly margined. Those banks that did stock offerings in 2011 faced major reductions in stock prices in the last six months, now making it hard for the laggards to tap the equity markets. So if a bank’s equity is fixed, the main tool to improve capital ratios is to shrink assets; a bank’s portfolio of loans and investments. To meet most minimal of current guidelines, European banks will need to trim their loan portfolios by $3 trillion. The easiest way to do this is to stop making new loans. This credit crunch will cripple the European economy. To ease the process, European Banks need bail-outs, mergers and accounting gimmicks. But far worse than any lending constipation that results from the lack of bank equity capital is the potential of a financial panic caused by bank runs, or the modern equivalent – banks being cut-off from credit by other banks. To stem this contagion, the lender of last resort, the European Central Bank, ECB, is helping troubled banks with a European version of TARP (aka cash-for-trash). And, the Fed is helping the ECB. Without any approval from the American people or Congress, the Federal Reserve is helping to finance this effort under the guise of “a temporary U.S. dollar liquidity swap arrangement”, announced in December. This program will further balloon the Fed’s balance sheet and create a further flood of dollars in the world economy: Some are referring to this program as QE3. Let’s hope it works. In spite of these efforts, huge amounts of capital are moving within and also fleeing Europe.
3. Countries leaving or being thrown out of the Eurozone: There are many versions of how this could or should happen. The developed world has seen three fairly recent downturns caused by deregulation of financial sectors that turned into credit bubbles that popped. Two in Scandinavia, Finland and Sweden in the early 1990’s and the third in South Korea in the late 1990’s. In these cases devaluations of the currency were major factors helping these economies recover. Sweden devalued its currency by 34% and South Korea by 50%. The weak Eurozone countries could use this stimulus today but can’t because they share a common currency. I have heard it said that if Germany really wants to help Europe, they should be the one to leave the Eurozone not Greece. If Germany went back to the Deutschmark the rest of Europe can benefit from a devaluation of the Euro: Imagine the inflow of money created by cheap prime beachfront property in Greece and cheap labor throughout the Mediterranean.
Preparing for the consequences of a Eurozone breakup?
Here things are even less clear. One of the best analyses I found is “What Next? Where Next?” by David Rhodes and Daniel Stelter of the Boston Consulting Group. In a nutshell, these experts say the European outcome is so cloudy you need to prepare for both deflation and hyperinflation scenarios.