Wednesday, April 09, 2008

The End of the Euro?

Jim from The Depression of 2006 has started a very interesting conversation on the return of the Deutsche Mark. I have been arguing that the Euro is here to stay and that it has benefitted Europe in many ways, not least, through higher efficiency and by making cross border consolidation of industries easier, since currency arbitrage is no longer necessary, at least within Europe.

But this article is another piece of "evidence" that there is dissastifaction with the project. So I wanted to address it.

Jim and others have taken the view that the Euro is a real drag on competitiveness, particularly for Germany, a country that is heavily dependendent on exports. Germans often complain about prices under the Euro, calling it der Teuro, which is a pun on the German word for expensive, which is teuer (pronouced toi´-er). The German pronunciation of Euro is Oi´-ro, so it rhymes.

I countered that the actual influence of the higher Euro on finished goods prices was not that large, because a stronger Euro was making raw materials relatively less expensive. Raw materials are a major factor in the price of automobiles and other high-end export products. The higher Euro primarily creates a price disadvantage in labor costs - this is not nothing, but a 50% increase in the value of the Euro does not translate into a 50% cost change, more like 15-20%.

This, of course, is still an issue, but there are other positives that offset some of this decline. First, Europeans are experiencing higher purchasing power - energy costs, food costs and other basic materials, not to mention imports of equipment like computers and software from the US have become less expensive. The higher purchasing power allows Europeans to increase aggregate consumption, meaning that more economic growth can be driven by the home market. Overall, I argue (and most economists and business leaders would agree) that the Euro has been a net positive.

Politics, of course, is something else. Focused on Germany, I largely neglected the other side of the coin - the Mediterranean economies, Italy, France, Spain, Portugal and Greece. An article in Forbes argues that they desire to pull out of the Euro, because they are prevented from using their traditional strategy for restoring economic balance: currency devaluation.

Andre Sapir, a major insider at the EU, has published a paper on the European Social Models, which argues that there are really four different economic models offered in Europe. Each model offers certain strengths and weaknesses, though some more strengths and some more weaknesses. A key factor is that the Mediterraneans have traditionally resorted to devaluation to escape structural problems in their economies, such as demands for high wages from relatively unproductive union workers. Because it enforces a consistent monetary policy (and one that reflects the desires of the "Continentals" - Germany, Belgium, Luxembourg as well as Austria and France) it essentially runs counter to the political situation in Spain, Italy and Greece, and that they may chose to leave. (Note that the Nordics and Anglo-Saxons largely avoided joining the Euro altogether).

The argument in Forbes essentially says that if they were to leave (certainly if France were to pull out) the Euro as a currency would collapse, and Jim would be right, we would have a new Deutsche Mark. (Though, were this to happen, I believe the Germans would still engage in policies such as fiscal displine an a positive balance of payments that would ensure the Mark would be strong, not weak).

I still think this outcome unlikely, in spite of the glacial progress of European integration. More and more, that integration is leading to substantial gains. Moreover, many of the countries, particularly Germany and Austria and to a much lesser extent France, have made real strides in improving the productivity of their economies. A collapse of the Euro would invite many other changes which are generally well received in Europe. It would ask whether the common market should really be maintained, or whether the Schengen system (which allows for free movement of people, i.e. the ability to work outside of one's home country) should be continued and on what scale. All of which would lead to reduced, not enhanced, opportunity for Europeans.

Economic nationalism is rearing its ugly head in many places, the US presidential election, particularly in places like Pennsylvania, which has seen a decline in manufacturing employment (much of which has moved South, not offshore, or simply been automated out of existence).

Globalization is not an inexorable trend. Largely global markets in the late 19th century, which coincided with massive gains in labor productivity and also purchasing power, were undone in the period 1915-1935, especially 1930-1935, when international trade declined by over 30%. The outcome was predictable. With the loss of global markets, local surpluses of goods, services and commodities could not reach needed customers and prices, employment and investment fell precipitiously. At the same time, consumers could no longer tap global sources of supply, so local shortages resulted in higher prices and lower consumption.

I remain optimistic that Europeans will keep the Euro. I find it much better than changing currencies all the time (how many Austrian shillings to the dollar again?) and it creates a sense of a broader European market, rather than a series of small national ones - a sense which is slowly becoming a reality. I am even getting used to the 1 and 2 Euro coins, though, as an American, I still believe change should be for amounts smaller than a basic currency unit.

The article has some advice on what to do if you want to speculate on a disintegration of the Eurozone. I have no better suggestions, but I will point out that the devaluation that is anticipated would be bad for commodity prices (in US dollar terms). But it is a bit early to go short on commodities over anticipation of the demise of the Euro.

Posting Delay

Sorry all, I have been unable to post due to some technical difficulties.

But I have found an interim solution, so I will return to normal posting now.

Tuesday, April 01, 2008

Housing Analysis: You read it here first

I relgiously read two of John Mauldin's weekly newsletters, Thoughts from the Frontline and the Outside the Box E-Letter. Last Friday, in FrontLine, he mentioned two deep analyses of the housing market, both Powerpoint presentations. Based on his recommendation I read them both. One slide, from John Burns Real Estate Consulting made me particularly proud, because of this chart:

A few weeks ago, in my own reading of the housing tea leaves I produced and published this chart:

When I published this analysis, readers of this blog were quick to comment on my view that it is necessary to see a significant overshoot to the downside in order to offset the long and excessive overshoot to the upside. This follows from the very definition of a trend line. A trend line is defined using a statistical process known as ordinary least squares (OLS). What this does is draw a line through the data set such that minimizes the total distance between the square of the actual data (the Y-value) and the trend line, for every X-value in the data set. Squares are used to eliminate negative values. In other words, we try to find the line that has the least “error” – that one which does the best job of estimating what the Y -should be for any X-value.

In a good data series with a strong trend, we can often “free-hand draw” a trend line through a data series because visually we see that the line must be roughly “in the middle” that is – that error of underestimation (where the actual data is above the trend line) must roughly equal the amount of overestimation (where the actual data fall below the trend line). That is, the point at which there is the least “error” in estimation.

Drawing a trend line through a data set is easy (actually, we can draw multiple trend “lines” as many trends are better described by curves, such as compound interest projections). The question is – does the trend line matter: that is, is the relationship a significant one.

In the case of home sales and their growth over time, the answer is yes. Home sales volume, over the long term, is driven by household formation which itself is remarkably stable, though it certainly has gone through periods of faster and slower expansion, thus residential real estate sales growth over time is remarkably stable (note that the growth rate is the slope of the trend line). Home sales growth is a geometric series with respect to time, however, so there should be a curve sloping upwards, the problem is, the growth rate itself is so small (At less than 1% per year) that even over long periods of time the series may appear to be linear.

Nevertheless, not to get carried away, what is important to realize is in order for housing to bottom, sales must remain below trend for some time. This is not what policymakers are suggesting. Rather, they are trying to find ways to support bubble-era prices in a post-bubble environment.

One suggestion has been for the Federal Government to purchase and demolish undesired homes so as to reduce inventory. Incidentally, this policy is not without precedent in major cities that have fallen on hard times. Philly and Buffalo both have crews who perform demolitions, though sadly, there are so many homes that the crews have multi-year backlogs.

While I think this to be a good idea in cities that clearly have far too many homes to support the population that actually wants to live there, I think it should be done at the local level, since it was local planning boards who approved the building of the homes in the first place. Local taxpayers will suffer the demolition costs, but they are also the ones who will benefit from the presumably higher prices that derive from having fewer homes for sale (and fewer abandoned homes in the neighbourhood). I see no reason to make residents of Omaha pay for demolition to support home prices in Las Vegas.

But attempts to manage inventory is trying to fix the wrong problem. The issue with sales (and ultimately prices) is that there are relatively few buyers. Very few people have anything like an incentive to purchase a home, given that buying a home represents a huge premium to renting. Moreover, very few people can come up with a substantial down payment required to purchase a home in the absence of home price appreciation. But reducing inventory will likely make the problem worse.

Reducing inventory is an attempt to maintain artificially high prices – but who would or could pay those prices? Even the people who “purchased” the homes, using questionable financing let us not forget, could not afford those homes. At best we will exacerbate the problem of poor affordability at worst we could reignite bubble lending and more building.

Do you see, as our politicians do not, that keeping prices high means that the only option for purchasing is to continue to rely on low-down payment financing and hope for future appreciation (i.e. bubble thinking)? The higher prices remain, the larger the down payment required to obtain a conventional mortgage. Why do we want to make it harder for people to purchase a home?

The best option is to see a reduction in prices. Only a revaluation of owned real estate with respect to rented real estate can encourage buyers to make the switch from renting to owning or to purchase an additional property with the intent of renting it. This could, begin to help us lift that trend line.


Housing sales will be down for years. The fundamentals are against home purchase, though there is some potential in trade up now, if you can sell your own home. First time buyers are still priced out of the market and will be discouraged by falling prices to risk hard-saved equity. Moreover, lenders will be insistent on having lower LTV so as to ensure adequate protection for their own loans. The lack of buyers cannot be materially improved by policy moves, though it can be materially impaired by them.

I also recommend that you sign up for John Mauldin’s newsletters here and that you read the presentations here and here.

Just remember, you read it at the Strategic Investor first.