Political risk has come home, and we must combat it

The past decade has upended my profession almost entirely. I work in political risk, and my job is to advise companies how to manage political and economic instability. A coup in Turkey, sanctions against Russia, unrest in Venezuela, debt default in Argentina – such risk events are the bread and butter of political risk analysts such as myself, and of political risk underwriters who offer insurance policies against such perils. Until recently, these risks occurred almost exclusively in emerging markets such as Turkey and Russia. No one ever asked us to analyze the politics of the Netherlands. No one ever tried to buy political risk insurance against civil war in Canada. To have done so would have been preposterous. Indeed, the absence of political risks from the “advanced economies” of North America, Western Europe and Japan was almost definitional. The certainty that politics would not impact business operations was what made these countries safe havens for investment; it was part of the formula that enabled these countries to become, and remain, rich. The Eurozone crisis changed all that. Greece’s sovereign default in 2012 was the first default by a rich, industrialized country since World War II. (And even during World War II, defaults were rare.) It was an event that most people had considered inconceivable. For Greece, the economic costs of political uncertainty turned out to be enormous. Perhaps hoping to stave off cognitive dissonance, in 2013 Morgan Stanley Capital International duly reclassified Greece as an “emerging market.” Such risks are not limited to Europe. In 2011, the US lost its AAA debt rating from Standard & Poor’s, in...

The Greek crisis explained, in pictures

Between 2007 and 2012 several Eurozone countries — Portugal, Ireland, Greece, Spain — needed bailouts. In each case, the recipient countries threatened that they would leave the Eurozone if the bailout terms were too harsh. Germany and the other AAA-rated European countries countered with threats to withhold the bailouts if the recipients did not agree to austerity and economic reforms as part of the bailout terms. The threats were treated by financial markets as credible (the price of gold, for instance, soared, as each bailout deadline approached). Hence both sides gained leverage and the bailout packages, though harsh, conformed to the desires of the recipients. This was a classic game of chicken, illustrated here with tractors in honor of the American movie Footloose. In 2013, Cyprus attempted the same strategy. Eurozone financial markets did not react. Probably, Cyprus was seen as small enough that if it exited the Euro there would be little impact on other Eurozone economies. As a result, Cyprus had no leverage. The brinkmanship strategy was a failure. The terms of the bailout Cyprus received were exceptionally harsh – much harsher than those currently offered to the Greeks. Money was taken from Cypriot bank accounts to pay for the bailout, for instance. Cyprus accepted the bailout nonetheless. This was the last time a Eurozone member employed a brinkmanship strategy… …until 2015. Greece, under a Syriza-led government, made another attempt. Rather than threatening to leave the Euro, though, they threatened to default on debts from prior bailouts. The financial markets once again did not react, even as negotiations went to the brink and Greece defaulted on IMF debt. Greek negotiators tried everything, including good-cop-bad-cop and...

The Eurozone’s (and Japan’s) deflation problem

I tend to be bullish on Europe – partly as a corrective to the mass of commentators who too early wrote off the crisis in the Eurozone as irresolvable. This optimism has been justified by the recent run-up in European equities, with developed European countries (Germany, Ireland, Finland…) constituting four of the five best-performing stock markets of 2013, when measured in US dollar terms. That said, a spectre is now haunting Europe – the spectre of deflation. The problem with deflation is that it makes the value of savings grow, which encourages people to spend less. If prices are falling, a penny saved is more than a penny earned, because, if you do not buy that TV set (for instance), not only will you have saved your penny, but the TV set will be cheaper in a few months, so you are actually getting a return on your patience. Hence deflation encourages people to save, which reduces demand. The TV shops in response reduce the prices of TVs even further, in an effort to get you to buy. Which implies yet more deflation. A few rounds of this, and you have the dreaded “deflationary spiral”, producing not only deflation but a serious contraction in consumer spending and hence real economic activity. Scenarios run by Oxford Economics on the potential impact of sustained deflation in the Eurozone are not pretty, suggesting the economic bloc would be pushed back into recession. In response to such concerns, Germany’s Bundesbank has recently softened its opposition to quantitative easing, suggesting that radical measures to combat the threat of deflation may be forthcoming. This announcement has widely...

The German Constitutional Court leads by example

The differences in interpretation of the recent German Constitutional Court ruling on the legality of “bailouts” by the ECB have been extraordinary. In part this is understandable: the court, in effect, ruled that bailouts via OMT are illegal under German law, but then nullified its own decision by – for the first time ever – referring the question “upstairs” to the European Court of Justice (ECJ). On the one side is the immediate reaction of some pundits (and financial markets) who appear to believe that this ruling removes a major obstacle to crisis recovery. In this view, since the ECJ would be unlikely to rule against OMT (as it is presumably less obsessed with issues of German constitutionality), the ruling effectively resolves the matter. On the other side are various degrees of panic. Some commentators have argued that until the ECJ actually rules one way or the other, an OMT bailout would be impossible. Perhaps the most extreme reaction comes from Wolfgang Munchau of the Financial Times, who initially argued that the Eurozone would break up, then argued that it would stay together, and now, on the basis of this ruling, has gone back to arguing that the Eurozone’s institutional problems are unfixable. On the face of it, this reaction is particularly odd. Whatever else one might think about the ruling, Germany’s Constitutional Court is leading by example. It is generally agreed that a lasting resolution to the Eurozone crisis will come when Eurozone economic institutions are created that stand above national governments – i.e., a banking union, fiscal union, and perhaps a common debt. In declaring that the...