March 2012 - Richard 'Jerry' Haworth: Who said pigs can’t fly?

We understand that when building a house in Spain a substantial part of the cost now involves paying people “off-grid” or “under the table”. This seems endemic and we imagine is partially historic but IF it is increasing in extent as a result of the GFC it is an important trend. Extrapolating this trend out to the whole population, one suddenly realizes that the private sector could be slowly going “off-grid”, further starving governments of revenue and thus the means of the economy’s and therefore the government’s recovery.

As more and more private transactions go “off-grid”, which will inevitably happen as taxes go up or the cost of living goes up, less revenue will flow to the governments in question, which will force them in turn to borrow to make up the shortfall or make more bureaucrats redundant. The latter will further stress the economies in question which will make private investors even keener on moving their business “off-grid”.

As the question of leaving the Euro pops up again in the country in question, all reasonable investors will start moving their money off-shore which will hollow out that country’s financial institutions. This money can only be replaced by ECB funding of which there is some logical limit. Banks in turn will reinvest the money in said government bonds because it offers: a) a high rate of interest; b) matching the duration of the three year loan with three year investment.

It WON’T lend to the real sector whose interest rates are artificially low and the sector looks comparatively risky.

Thus credit creation, GDP growth etc. will dwindle…..

The downward spiral will continue until eventually social unrest will rise to the point where there will be a “European spring”. One country will ditch the Euro and/or their cumulative debt holdings and/or move back to their own currency. The pain of action will be less than the pain of in-action.

If the country in question defaults on their debt but stays in the Euro this raises an interesting question about how they can run their respective governments?

Well, firstly they now have no debt so they no longer have to make interest payments which had become a large part of the government budget! They can issue unsecured bonds at “junk” rates and still pay much less in total interest payments than before.

The ECB could step in to prevent a default and convert all current debt into Eurobonds with the understanding that no further Eurobonds will be created if the country in question has a debt to GDP ratio that is unsustainable e.g. 60% plus. In this way, European banks will be saved from massive haircuts on what they already own and respective governments who fail the debt-to-GDP test could issue more debt at “junk” rates as per the first option.

Lastly, the respective countries could ditch the Euro altogether.

Counter-intuitively, money will start to flow back into the country via the new devalued currency as money gets repatriated and investors sense opportunity. Other PIGS will look on and realise that maybe this path has less peril than first thought.  There is an irrational bias towards herding behaviour and others will follow as soon as they see that it offers a faint glimpse of hope.

Others will follow and the ECB and Brussels will be powerless to stop it.

So here we sit watching a couple of PIGS not trying consciously to fly but flapping their baby wings anyway. We watch on, content in the knowledge that PIGS can’t fly…

Until, that is, the first one takes flight.