Free Spirit Magazine, January 2012 – Europe is the world’s biggest economy. It is threatened, however, by bank and government debt defaults. It is growing old and has far more social spending obligations than it can afford. And, if Europe goes into a deep or prolonged economic slump, the rest of the world follows because Europe is a big market, not only for Asia but also for America.

After a marathon meeting that started on December 8, 2011, the European Union (EU) member states agreed to create an intergovernmental treaty to forge stricter budgetary controls. Britain has opted to remain out of the treaty. Markets were up the following day. Before the meeting, so we are told, Europeans were in disarray. But the day after, apparently, they have got things all sorted out – again.

Before the adoption of the euro by the core EU countries 10 years ago, the detractors of the wisdom to create a monetary union made the case that a monetary union without a political union would not work. They warned of the need for a central Euro-government – to control national budgets and taxation.
And, look now: it was not the hedge fund managers and bond traders who caused the trouble in the eurozone; they merely exposed the fundamental problems with the currency. It was the utter failure of the eurozone countries to observe the rules of the 1992 Maastricht Treaty. It was the refusal of Greeks and the PIIGS – Portugal, Italy, Ireland, Greece and Spain – economies to control their spending or to reform their social security systems.

How was the creation of the euro the reason for the current problems in sovereign PIIGS bond markets? Why have the European banks put so much money into buying the Greek bonds and not into some other shaky country’s bonds? After all, there are plenty of other countries that spend above their means, where the banks could have invested their funds. What is the difference between Greece and any other risky country?
There are two big risks to consider while investing anywhere. The first thing to consider is the fiscal and political situation. If the country starts regulating the market to death and spending like there is no tomorrow, then that is a problem. The second big risk is the central bank. If the currency goes out of control due to unrelenting expansion of the money supply, the bonds it issues will not be worth much.
But with a European monetary union, investors did not have to worry about Greece’s central bank any longer. As a result, one major risk was completely off the table. Furthermore, the banks understood that being a part of the eurozone meant an implied bailout and assistance for the country. As it turned out, they were correct. So, as a result, the European banks, particularly those in Germany and France, loaded up on Greek debt.
This crisis is directly related to the eurozone – the above factors all encouraged investment into the weaker EU member states. If Greece would have had its own central bank, its own currency, and there were no implied bailouts, the European banks would never have put that much money into the country. Sure, they would have invested some, but not to the level where default could mean a worldwide financial crisis. There are plenty of countries with terrible finances. But, it is no accident that we are discussing the debts of Italy and Greece rather than Madagascar or Jamaica.
Finally, we were told the truth at the EU meeting on December 8 – further centralisation of powers at the EU level is necessary and individual European nations have to relinquish control of tax and spending decisions in order to save the euro. In other words, what Europe needs is a fiscal union. What could not be sold to Europeans 10 years ago is now – as a matter of urgency – necessary to solve the financial crisis, so we are told. Deceptively, ‘saving the euro’ is conflated with ‘averting impending financial disaster’. However, the two are not synonymous. It is exactly further centralisationthat makes it possible to kick the can further down the road. It opens the doors to further delay dealing with problems in the near-term, by not having to face the wrath of markets, just yet.

There was an outcry over the fact that European Central Bank (ECB) did not announce that it would monetise trillions of euros worth of the PIIGS debt by the end of 2011. It did not commit to a preannounced amount of the PIIGS debt purchases, as the US Fed did with its quantitative easing programmes. However, this does not mean that ECB will just stop supporting this market. No, ECB is not a ‘tight’ central bank. On the day before the meeting, the largest central banks in the world announced a coordinated easing programme. This will involve printing more of their home currencies and lending these currencies to other central banks, which in turn will re-lend these currencies to local banks. We saw ECB lend to International Monetary Fund (IMF), which will then re-lend the cash to PIIGS, in a cynical move to circumvent the prohibition for ECB to lend directly to PIIGS. ECB will do whatever it deems necessary to support the EU banking system, and that includes supporting bank liabilities with easier and easier lending terms, and supporting the market value of bank assets by continuing to buy the PIIGS bonds.
Many European banks have essentially been cut off from borrowing in the private credit markets, which means that most of these banks are insolvent. If left to their devises, they would have to wind down, as any normal businesses would do. But central banks ignore this and offer them easier and easier access to long-term funding to keep them from failing. The entirely predictable result will be similar to what we see in the US – banks whose assets will feature fewer and fewer private-sector loans and more and more government bonds. How is this supposed to foster anything but simultaneous recession and inflation (also called stagflation)? Economic recovery can only be driven by the private sector. The world will have plenty of consumers, financed by government spending and printing money, financed by banks kept afloat by the central banks. But will there be sufficient producers?

ECB and most of the other central banks, for that matter, believe the main problem the western economies are suffering from is the ‘deficient demand’ and the risk of deflation. But I disagree. Bad credit needs to default and corporations need to go out of business if the western economies are to have any chance of beginning a new phase of renewal and growth.
But, that is not the plan that is on the table. The plan of the central banks is to artificially support asset prices and to bail out sickly too- big-to-fail banks. And, as a result to prevent liquidation of investments that should have not been made in the first place because they were not economically feasible. Once central banks start lending to insolvent banks, there can be no orderly exit. When sovereign defaults occur – and they will, in Greece and Portugal, and probably Italy and Spain – there will be more money printing to keep the system going for a while.
The plan is driven by elected politicians to avoid short-term negative consequences. The EU and ECB will get more and more radical in their tactics to protect the core EU banking system from collapsing under the weight of credit exposure to PIIGS. But how long can the can be kicked further down the road? In the end, savers of government fiat money will be the ones to pick up the tab for all of these government- created disasters. Once again, the responsible shall be forced to bail out the irresponsible.

However, there is light on the horizon! Britain refused to sign away its sovereignty to the EU and IMF at the December 8 EU meeting. It is the only country that could have dared to get away with this, and its refusal to participate in the next round of the EU centralisation was long overdue. But the move is unprecedented. This opens the prospect of a Europe of two speeds – where the core countries will continue on their path of further centralisation and the other countries offer an alternative option. The very fact that there will be European alternatives to the centrally-organised core EU states will place limits on the powers of the EU to regulate, tax, uniformise and print money. These limits will be more effective than any self-imposed mechanisms to limit the powers of the EU, which are cast aside anyway when push comes to shove. The fact that there are competing systems with alternative sets of policies on, say social benefits, will mean that governments will have to be more in tune with what is affordable because they have to still appeal to the producers and entrepreneurs who areexpected to cough up the money to finance the grand plan. It will be more difficult to implement grand societal designs financed at the expense of taxpayers. It will also mean that the attempt to keep the financial system and its banks and governments afloat will fail sooner than it otherwise would.
And that is a good thing. Bad debts need to be written off, and companies that cannot survive need to go out of business in order to make place for new ones. That is the essence of capitalism. The sooner this happens, the better. That is exactly what happened in Iceland, which had the luck to have leaders who did not listen to or did not understand what Keynesian economists were recommending, or maybe they were just paralysed when the crisis hit. But in any case, banks failed because of the lack of decisive governmental action. The country went through a deep but short depression, but is now all set for a period of new economic growth with bad investments liquidated and unsustainable debts written off.

Although it is hard to imagine how the UAE would not be affected by a prolonged period of stagflation in Europe since that is its mainmarket, the UAE is better positioned than many other countries to weather the coming storm. A small, sovereign and agile country with no income taxes and VAT (value added tax), light regulation, labour unions, which are kept in check, and unrestricted access to the world’s labour market, offers a welcome reprieve for businesses and entrepreneurs to operate away from the world’s overregulated economies. Although dependent on the European markets, at least here, these businesses will not be producing in order to pay for the next round of bailouts and keep the euro afloat a bit longer.
In addition, the UAE, and in particular Dubai, could make the most out of its traditional status as a haven for gold trading as holders of fiat currencies like euro and dollar continue to seek refuge into gold since its value cannot be deflated by printing more of it. Gold has kept a steady value in terms of purchasing power over thousands of years and was one of the best investments of the past decade and will probably continue to perform well for the next decade, given the trouble with the world’s major fiat currencies.

Adriaan Strujik is the Managing Director of Freemont Group. Previously engaged with one of the Big Four professional services firms, he holds a master’s degree in business, and is a qualified Trust and Estate Practitioner (TEP). This article was published January 2012 in ‘Free Spririt‘ the bi-monthly publication of the Ras Al Khaimah Free Trade Zone. Y