Europe's recovery faces dilemma

Europe could address its long-term debt problems by hiking retirement ages, according to Baring Asset Management, but lacks the ability to make the right choices.

Greece’s fiscal profligacy has increased uncertainty in financial markets worldwide and the eurozone sovereign debt crisis has only heightened concerns for investors. Commentators and economists are busy airing their views on what has caused the situation to escalate so quickly and how it can be resolved. Last week it was the turn of Baring Asset Management.

“The problem has been leverage,” said Marino Valensise, chief investment officer at Baring Asset Management. The reason for this, he explained, is that the extra leverage needed to generate an additional $1 million in profit has increased from $1.37 million in the 1950s to $5 million in 2007, due to fewer arbitrage opportunities. In other words, the diminishing returns from leverage during the past 60 years has driven up the amount of debt required to maintain the same amount of profit.

“For some countries in the West, levels of debt in relation to GDP have passed the point of no return,” said Valensise. “The equity value of these governments is negative; if [they] were private companies, they would all be bankrupt.”

Greece’s equity value, according to Barings, is -1,600% of its GDP. Three-quarters of this is derived from the cost of pension promises that politicians have made to their citizens. Germany and France fare somewhat better in comparison, but on an absolute basis they also have an equity-to-GDP value of around -500% and -650% respectively, partly due to huge pension burdens.

“They are not in a position to pay for the promises they have made in the past,” said Valensise, adding that European countries need to change.

Barings said that the full economic crisis could actually be solved very quickly by raising the retirement age by three years. However, politicians will never consider this, it said.

Instead, Barings discusses three common proposals to cut Europe’s debt: growth, default or inflation. Significant growth in Europe during the next few years is unlikely, and a default is both unthinkable and unpalatable for any major economy. The last option, inflation, may be the only feasible option.

However, printing money to pay off the debt will lead to a reduction in living standards, assuming that low growth persists, and citizens in Germany are clearly unwilling to make such a sacrifice to pay for their neighbours’ mistakes.

“Central banks are fighting inflation but I think they are fighting yesterday’s enemy and yesterday’s war,” said Valensise. “The problem in Europe is deflation.”

Citing the low birth rates across the region, Valensise was pessimistic about the chances of recovery. Barings research has shown that price-to-earnings (P/E) ratios show a positive correlation to demographic trends in a country. Put simply, ageing populations have lower P/E ratios thanks to the fact that there are fewer youngsters to work and pay taxes, making it harder to gear up the economy.

Globalisation does not just mean cutting production costs to gain competitive advantages, but also sending jobs overseas. “Politicians 40 years ago underestimated the damage that this would do to Western economies,” said Valensise. “This means people in Detroit lose their jobs.”

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