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The Euro Crisis: Some Observations

Professor Brendan McSweeney,School of Management,Royal Holloway College,

University of London

24 January 2013

“Euro Crisis” ?

Can mean:

the severe challenges to the Euro – possibility of complete break-up; country exits with range of dire consequences; and/or significant decline in value of the Euro

AND/OR the comparative decline in the economic performances of many EU countries

AND/OR more narrowly the bursting of property bubbles in some EU countries or parts of some countries

One source: Greek, Irish, Spanish, and other banks borrow from largely

German and French financial institutions – fuel construction bubbles – governments (i.e. the public) take

over debts

Need to distinguish between product/service markets (so-called real-economy) and financial markets (currencies, bonds, equities)

They are interrelated – the on-going financial 2007/8 crisis contaminated the ‘real’ economy

Problems not unique to Euro 17 or just some of those

countries

The bulk of media ‘crisis’ coverage has been on “peripheral” Euro Zone countries such as Greece, Spain and Ireland because they have been forced to adopt severe austerity programmes BUT the real economy and currency challenges are much more widespread and also involve many non-Euro EU countries.

Real Economy ExamplesFord shut its Genk plant

General Motors shut its Bochum plant

Dow Chemicals announced closure of operations in Belgium, the Netherlands, Spain and the UK

HP has axed 8,000 jobs in Europe

Kimberly-Clark has closed most of its European factories

Between 2007 and 2001, annual investment in the 27 EU countries dropped by more than Euro 350 billion.

Government Debt

Diversity not Uniformity

There is diversity within the 17 + 3 Eurozone countries and also within the wider European Union, for example:

German government and personal debt, and the scale and performance of its manufacturing industry, are not the same as those in the UK.

Manufacturing output in Eurozone Ireland has grown whilst it has fallen in most other Eurozone countries

Tax evasion is rare in Sweden, it’s extensive in Greece

So, generalizations are problematic.

VARIETIES OF CAPITALISM

Notwithstanding the increased financialization of Europe: varieties of capitalism – not a uniform capitalism – exit.

Varieties of capitalism

... systematic differences in the formulation, content, focus, and effectiveness of national or regional economic, political and corporate policies and practices across nations – caused by the institutional (or cultural) characteristics of each country (or region).

• Whitley• Anglo-Saxon (GB, IRL)• Nordic (SF, Sweden, N, DK)• Rhenish (D, F, CH, A, NL, LUX, B, I, ES, P)• Eastern European (PL, H, CZ, SK, SLO etc.)

•Hall & Soskice Liberal market (USA, UK, Austral, NZ, Irl) Coordinated market economies (Sweden, D, Jap., CH, N,

DK, Fin, Austria) More ambigeous (Fr, Esp, Port, Greece, Turkey.)

In short, capitalism is a context within which variations exist.

Liberal Market Economies (e.g. UK)

Strong emphasis on primacy of shareholders - less equal income distribution

Powerful role of financial markets in relation to ‘real’ economy firms

‘Light-touch’ regulation

Typically poorer health

Longer working hours, shorter holidays

Few restrictions on hostile takeovers

Less state funding of the arts

Coordinated Market Economies (e.g. Germany)

Depend more heavily on non-market relationships, networks, incomplete contracts, trust

More plural view of stakeholders – esp. employees

More protection for employees

More active role by the state (incl. greater funding of the arts)

Financial markets less influential

Typically better health

Restrictions on hostile takeovers

Shorter working hours, longer holidays

Greater state funding of the arts

Not all EU Coordinated Market Economies are in the Euro Zone (e.g. Sweden) but most are.

The Euro Currency Crisis is pushing the Euro Zone countries even closer

Multiple explanations of the Euro real economy and/or currency crisis, for example:

Production migration

Migration of production from parts of Europe

(and US)

Social security burden on employers

But does not fit the facts.

Data does not support: ‘it’s all because of public expenditure’

Religion

UK: Protestant

Poland: Catholic

Austria: Catholic

Germany: 34% Protestant; 34% Catholic

Need for greater transnational control within Euro 17 (and EU as a whole) conflicts with

increased nationalism

Identification with national ‘imagined communities’ is a powerful force

Too much 'red-tape’

2007/8 Crisis: De-emphasis on regulation

An anti-regulating regulator

Regulators across Europe – to a greater or lesser extent - eulogized or were pressurized into ‘light touch’ regulation

Bill Clinton ‘modernizes’ US financial markets by revoking the 1933 Glass-Steagall Act

Too much regulation, or the wrong regulation

Ineffective regulation

There’s no such thing as a ’free market’

The notion of a "free market" society is unreal. It is a non-existing utopia.

History in fact has shown us again and again that market-based societies only work because markets are embedded within legal and political rules.

There has to be regulation, but how much and of what type?

Underlying many of the opposing views about the performance and prospects for the Euro (and of the economies of the European Union) are suppositions about the appropriate roles for financial markets and of regulation. In short, how ‘free’ should financial markets be?

My main contribution today is some commentary on that debate/shouting!

FINANCIAL MARKETSWithin a generation, there’s been a revolutionary expansion in the size and rate of financial transactions across the globe.

1. The volume of foreign currency trading has increased by an immense amount (average daily turnover in excess of US$4 trillion –vastly more than required for real world trade and tourism)

2. In the main, companies have become much more focused on and are more controlled by financial markets

3. Cross national share ownership has ballooned (for example, about 45% of the shares of French listed companies are foreign owned).

Let me try to ‘unpack’ the notion of Financial Markets

A financial market is conceived of as an optimally efficient and effective discovery procedure for processing, concentrating, and concisely transmitting (via price signals) correct valuations of assets (Allen, 1981; Benston, 1989, 1990; Citanna and Villanacci, 2000; Grossman and Stiglitz, 1980; Malkiel, 2005; Mossin,1966).

The Efficient Market Hypothesis [Dogma] rests on three assumptions

(Shleifer, 2000)1. Share, bond, and currency traders (aka ‘investors’)

are assumed to be rational and hence to value currencies and securities rationally

2. To the extent that some traders are not rational, their trades are random and therefore cancel each other out without affecting prices.

3. To the extent that traders are irrational in similar ways, they are met in the market(s) by rational arbitrageurs who eliminate their influence and thus the price of a security/currency can never get far away from its fundamental value.

In short, financial markets never get it wrong – their valuations are the true valuations (of currencies, shares, etc.)

But financial market valuations cannot eliminate uncertainties; and their valuations are influenced by:

1.Cognitive biases

2. Irrationalities, and

3.Emotions

An Example of Financial Market Failure (Misvaluation)

The board of directors of the newly formed Anglo-Dutch company Corus decided to sell its aluminum division. By far the largest part of the company was the carbon steel division.

Product Market Data:

Carbon steel EBIT (£m.) (422) (96) 567 751 457

Aluminium EBIT (£m.) 29 30 54 40 40

 

10/02/03 8,223,035 26.75 25.00 26.00

19 February Works Council rejects sale;

11 March 2003 Supervisory Board vetoes sale;

14 March Decision Upheld; CEO resigns.

An external analyst’s view – a widely held view

On 14 March following Judge Huub Willems’ support of the Supervisory Board block on the sale of the aluminium business an analyst from BNP Paribas stated that:

"Even at 4p, Corus shares are not worth buying.”

10/02/03 8,223,035 26.75 25.00 26.00

11/02/03 19,316,532 27.50 26.00 26.75

12/02/03 23,171,652 27.00 25.75 26.00

13/02/03 34,126,740 26.00 24.25 24.50

14/02/03 37,650,816 25.00 23.25 23.25

17/02/03 35,683,580 24.50 22.25 22.50

18/02/03 39,032,444 23.50 22.25 22.50

19/02/03 127,027,704 22.50 18.00 18.00

20/02/03 87,170,896 19.75 16.00 17.00

21/02/03 110,316,224 17.50 15.50 16.25

24/02/03 40,620,776 17.00 15.00 16.00

25/02/03 99,662,096 16.00 12.00 15.50

26/02/03 61,267,036 15.00 12.50 12.50

27/02/03 82,282,784 15.00 12.25 15.00

28/02/03 51,884,348 17.50 14.75 17.50

03/03/03 46,290,664 17.99 16.25 16.75

04/03/03 15,663,103 17.25 15.50 16.00

05/03/03 23,487,760 16.25 14.50 15.00

06/03/03 21,601,648 15.75 15.00 15.00

07/03/03 18,911,344 15.50 13.25 14.00

10/03/03 17,196,756 14.00 13.00 14.00

11/03/03 514,877,792 9.00 4.75 5.00

12/03/03 248,482,768 6.45 5.60 6.10

13/03/03 482,560,576 7.50 3.75 4.00

14/03/03 316,145,952 5.85 3.90 5.50

17/03/03 165,015,744 8.00 5.15 8.00

18/03/03 255,996,400 9.80 8.00 8.80

19/03/03 75,294,384 9.50 8.30 9.25

20/03/03 49,234,708 9.50 4.50 8.89

21/03/03 61,754,112 9.35 8.90 9.15

24/03/03 49,583,496 9.25 7.50 8.25

25/03/03 91,113,864 8.20 6.70 6.90

26/03/03 53,949,764 8.63 6.78 6.85

27/03/03 93,797,672 7.25 5.81 6.40

28/03/03 60,380,576 7.28 6.01 7.00

31/03/03 25,255,404 8.50 6.36 6.53

01/04/03 37,013,408 7.00 6.40 6.99

02/04/03 106,241,640 8.98 7.50 8.71

03/04/03 72,064,384 9.35 8.00 8.50

04/04/03 50,705,960 9.00 6.50 8.88

07/04/03 33,016,416 9.25 8.50 8.79

In short, panic led to the share price falling to less than 4p.

January 2007 Tata Steel buys Corus for 608p per share beating an offer of 606p by Companhia Siderurgica Nacional

Other evidence of cognitive biases, irrationalities, and emotions in financial markets

Bubbles and crashes (Rashes, 2001)

Over-reaction; to prospects of losses or gains (Kahneman and Tversky, 2000).

and to

result announcements – positive and negative– new information is overweighed whilst prior and longer-term information is underweighted (Liu et al. 2001)

Dominance of short-term horizon “Myopia” (Benzarti and Thaler, 1995).

Herd mentality: Irrational exuberance” (Shiller, 2000); Hypes and Panics (e.g. dot.cons); Flight (MacKenzie, 2003)

What day is it?Valuations are influenced by the day of

the week, the location of the day within a month, and by the season e.g.

Monday Effect (French, 1980; Pettengill, 2003) Highest proportion of suicides

Tuesday Effect in some Far Eastern Countries Friday Effect (Keim & Stambaugh, 1985) January Effect (Das & Rao, 2011)

Identical securities and currencies sell at different prices in different markets.

Whilst we can think of reasonable explanation for this, the price diversity is inconsistent with the claim that a market price reflects/measures fundamental value – there can not be more than one fundamental value.

Price divergences between fundamentally identical securities

In efficient markets fundamentally identical securities should sell at identical prices because of the workings of arbitrage. The record of trading in ‘twin-securities’ demonstrate that this is not so.

Example 1: Unilever N.V. vs Unilever plc (50:50 profit split) but shares have often radically departed from the parity – even in the same market.

Example 2: Royal Dutch and Shell split cash-flows are split on a 60/40 basis. If their stock prices were equal to the net present value of future cash flows, the value of Royal Dutch equity should be equal to 1.5 times the value of Shell equity. This is far from the case (see next slide)

Stock price of Royal Dutch relative to Shell (deviation from 60/40 value) (Froot & Dabora, 1988)

Gender, Marital Status, Age, Education

1. Gender: Male financial market traders tend to be more risk seeking than women.

2. Marital status: Single individuals tend to make riskier decisions than married persons. Single men trade 45% more than women and have poorer results (Braber & Odean, 2001)

4. Age: Younger persons are inclined to be more risk seeking than older individuals.

5. Level of education: A person with higher levels of education display a greater risk propensity or tendency to take risks.

Instead of offering warning signals of the underlying weakness and deterioration of a number of Eurozone countries’ financial position and performance, financial markets were excessively optimistic and showed little differentiation amongst countries in the Eurozone. Thus weakening rather than strengthening discipline in countries such as Greece.

Market sentiment swung from excessive optimism to excessive pessimism.

The substantial revision produced by the new Greek Government of prior official estimates of its fiscal deficits was the immediate trigger which led to a swing from one extreme to another.

“The markets are very fickle, they’re very happy to lend money under conditions which seem slightly absurd for long periods of time and then they're like a herd of cattle: they suddenly go into the feeling that this is now unstable and so they move off in a completely different direction.

And the politicians always have difficulty in comprehending these mood swings … And then they tend to blame the cattle for being irrational when in fact the cattle are irrational.” A Banker

Excessive power of irrational financial markets can create problems at the micro level

Emphasis on Financial Markets leads to the evaluation by such markets being the primary or exclusive focus of business

activitiesDespite the influence of cognitive biases, irrationalities, and emotions and the history of bubbles it became widely held that financial market orientation should be the primary corporate focus.

Much more so in Liberal-Market economies but growth of influence on so-called Co-Ordinated Market Economies esp. in the banking and related sectors.

Two key claimed advantages of the primacy of financial market orientations

1. Companies whose central focus is financial markets are the most economic/efficient/effective;

2. Such companies also have better social welfare effects (‘everyone’s a winner’);

THE MAIN JUSTIFICATIONS FOR THIS ORIENTATION AS THE PRIMARY OR EXCLUSIVE CORPORATE PURPOSE

SELF-EVIDENT OR REQUIRED

1. Shareholders own the firm

2. Shareholders are the main suppliers of investment funds

3. Shareholders bear the residual risk – (in contrast with other stakeholders, they “invest for the life of the firm” (Oliver Williamson).

4. It’s a legal requirement

EFFICIENCY/EFFECTIVENESS (bad risk diminishing – good risk enhancing)

5. It eliminates top management shirking

6. It allows a company to focus on one key matter which is the best way to maximize

7. MSW oriented countries are the most successful

8. MSW orientated firms are the most successful

Underlying 5-8 is the assumption that financial markets are the optimum information processing and resource allocating processes

Each justification is contested;

In my opinion, all of the justifications are flawed.

I only have time to briefly comment on three of the justifications

1. OWNERSHIP: A FIRM IS THE PROPERTY OF FINANCIAL MARKETS VIA ITS SHAREHOLDERS

“It’s our company and we’ll do what we want, do what we want …”

“What using business resources for non-business purposes is, is theft: an unjustified appropriation of the owner’s property” (Sternberg, 1997: 82).

Ownership: a firm is the property of its shareholders

A view of property as having rights – which it has, or certainly should have - but not having any responsibilities.

I own my car – I can paint it whatever colour I like.

But I have a responsibility to ensure that its brakes and lights work and that I do not drive it recklessly.

Financial markets are not the only parties with an interest in the activities of a company.

AND shareholders/financial markets do not own companies, they own the shares of those companies.

2. FINANCIAL MARKETS ARE THE KEY SUPPLIERS OF FINANCE

Finance is a crucial resources, but not the only necessary corporate resource.

Isn’t the supply of knowledge, work, etc. by employees also essential?

Financial markets are not the only source of finance.

In fact, those markets are at best suppliers of a comparatively small amount of finance

Claim: SHAREHOLDERS ARE THE KEY SUPPLIERS OF FINANCE

Net Sources of Finance – 1970-94 (Percentages)

Germany Japan United Kingdom United States

Internal 78.9 69.9 93.3 96.1

Bank Finance 11.9 26.7 14.6 11.1

Bonds -1.0 4.0 4.2 15.4

New Shares 0.1 3.5 -4.6 -7.6

Other 10.1 -4.0 -7.6 -15.1

Data source: Corbett and Jenkinson, 1997:74

Claim: SHAREHOLDERS ARE THE KEY SUPPLIERS OF FINANCE

Net Sources of Finance – 1970-94 (Percentages)

Germany Japan United Kingdom United States

Internal 78.9 69.9 93.3 96.1

Bank Finance 11.9 26.7 14.6 11.1

Bonds -1.0 4.0 4.2 15.4

New Shares 0.1 3.5 -4.6 -7.6

Other 10.1 -4.0 -7.6 -15.1

Data source: Corbett and Jenkinson, 1997:74

Conclusion

Finance is but one of a number of vital resources.

Financial markets contribute only a small fraction of that resource.

3. Financial Markets invest for the life of the

firmRoughly 70% of all U.S. equities trading is now done by “hyper- speed” traders (usually robots) — some of whom hold stock for only a few seconds (Barton, D. 2011, Capitalism for the Long Term, Harvard Business Review, March).

THIS IS NOT INVESTING, IT’S GAMBLING

ICI• ICI was one of Europe’s largest and most successful

manufacturing companies.

It defined its purpose as aiming to be:

“The world’s leading chemical company, serving customers internationally through the innovative and responsible use of chemistry and related science [Through achievement of our aim, we will enhance the wealth and well-being of our shareholders, our employees, our customers and the communities we serve and in which we operate]”

• Around 1997 changed its purpose to “Our objective is to maximize value for our shareholders”.

• The decline (including of shareholder value) was relentless. In 2007 it ceased to exist as an independent company.6

9

I rest my case

More emphasis of financial market steering and deregulation than even in the US

Some greater influence of financial markets than heretofore, but still comparatively small

For further discussion of this issue see my video: http://www.youtube.com/watch?v=XnYY9rsn7SY

But is there a Euro Currency Crisis?

By Tuesday this week, Europe’s single currency had risen almost 7 per cent on a trade-weighted basis since late July. It is up more than 25 per cent against the yen and 10 per cent against the dollar.

On the other hand, Sterling is weakening and I predict: i. the UK will lose its triple-A credit rating this year; and ii. there will be further weakening in Sterling.

By next January we are much more likely to be talking about a Sterling rather than a Euro crisis. Why?

Sterling fell 20% at the beginning of the crisis but before the slide turned into a crash, the Euro took up the position as the worst in the storm – in part because of fear of a break up.

The UK has one of the worst trade deficits in the world. When this College was founded, the UK was ‘the workshop of the world’; 80% of world trade was carried in UK ships. Even as late as the 1960s, UK motor bikes dominated global markets. Now!

Decades of expanding banking; giving many people welfare rather than jobs; generating housing bubbles; and privatized Keynesianism.

Last year especially, massive quantities of ‘hot money’ flowed into the UK because of fears about the Euro. This is unlikely to be sustained at nearly the same levels.

If as is likely, Sterling becomes the object of negative attention, the tendencies of financial markets is extremism – to be overoptimistic sometimes and then swing to the other: an excess of pessimism could mean a sharp devaluation.

Textbook economists suppose that a significant devaluation of Sterling will enhance growth, but that supposes (i) that price is the crucial determinant of sales, and (ii) that the UK has the capability of making much for export.

But “forecasting is difficult when it really is about the future” – what would happen if Greece exited the Euro? But I don’t believe it will.

The Golden Rule

Thank you for listening!