As a former political science professor, I have a unique approach to analyzing ongoing global events such as the debt crisis in the Eurozone. Unlike the pundits, I'm more concerned about predicting the final outcome than advocating my ideal solution.
To illustrate this point, in a post from June of 2012 I posed a thought experiment in which pundits and traders would have to play along with the kind of simulation I used when I taught at UW Madison.
"Each player would be given a role. The success in the game would be determined by how well the national objectives were met. For Germany, it would be preserving the Euro, which has led to great financial success, while exacting concessions from others on changes in labor rules, agreement with debt limits, etc.
For the ECB the rules would stipulate not going too far until various governments had made commitments.
For the Chinese, it would mean not committing funds until the Europeans had done their part. Ditto for the US. If you acted too soon, you could not get an 'A' for the simulation.
For Greece, it would mean exacting debt concessions, stimulus, and whatever else you could get. Ditto for Italy.
For Spain and France, it would be a little more nuanced.
The rules of the game do not optimize the global result. If you and I were dictators, we would have 'solved' this long ago, although our ideas of the best solution might differ."
The idea behind this thought experiment is that by putting the pundits in the shoes of the relevant political actors, they would quickly gain an appreciation for the competing interests that accompany the public negotiations. The real investment edge with regard to Europe is being able to understand the reality of the political situation, not to pontificate on what solution you would personally prefer.
While the pundits have been advertising doom and gloom, the situation has been steadily improving. Entering this summer, it appears as though an end may be in sight. I don't claim to know all the answers, but my forecast includes three factors:
- The eventual outcome will include a bit less austerity because of recent election results;
- European leaders will manage to avoid the very worst outcomes; and
- The nature of the political process leads to eleventh-hour solutions, permitting everyone to fear the worst as long as possible.
Apart from that, anyone who claims to have all the answers is probably not factoring in all the relevant information. In particular, investors and traders alike should remain wary of the pundits whose predictions fall in line conveniently with their political agendas. In a matter of months, this issue will be sufficiently addressed to such a degree that we will no longer hear about it daily. When the perma-bears move on to hyping up the next doomsday crisis, will you have profited from their advice?
Over the last several months I have written extensively on the European debt crisis. Here is a list of articles I have written on the subject in the last year, followed by additional analysis below.
Finding the Best Information About Europe (September 14, 2011)
Investors: Prepare to be Deceived on the Europe Story (September 26, 2011)
Profiting From the Confusion Over Europe (October 4, 2011)
Predicting the Europe Outcome: What it Means for us (November 16, 2011)
How Investors Should Think About Europe (December 15, 2011)
How to Predict Policy Decisions - Focusing on Europe (December 16, 2011)
Why not to Panic about Europe (May 8, 2012)
The Investor Edge from Europe (May 15, 2012)
Possible Endings for the Greek Drama (May 16, 2012)
Europe: Get Ready For a Surprise Endgame (June 6, 2012)
There has been a lot of panic and misinformation out there, mostly stemming from the fact that the pundits on financial television and blogs have a very simplistic view of the policy process.
In September of 2011, I advised my readers to remain skeptical of claims by mainstream media sources.
"Here are a few thoughts on each of the sources you might consider.
- Markets. Should we accept the verdict of the market on Europe --- the high credit default swap rates, etc? Is Greece definitely going to default? Here is the dilemma. Everyone pointing to the market as the ultimate source on this is a liar! If you asked them if they believed markets were efficient, they would say 'no.' Otherwise they would have no job. All of us get edge by finding market mistakes. So pointing to the markets on this one occasion is hypocritical, self-serving and inaccurate. It is confirmation bias in action.
- Political Leaders. Should we accept the statements of political leaders? We all know that they are trying to maintain confidence. We also know that there are no guarantees. When the Geithner news came out this morning, CNBC reported from both Rick Santelli and Bob Pisani -- veteran floor observers. No one on either floor believed Geithner! Here is the dilemma. We all know that it pays to be contrarian. Maybe everyone is too skeptical...Most people just accept the Wall Street Truthiness. When it comes to this subject, no one is a contrarian. It is 'smart' to dis the politicians.
- Bank Executives. In 2008 we saw a number of statements from executives that proved to be inaccurate. They could have been lying, mistaken, or inaccurate in their expectations about upcoming behavior. Most of them did not see the collapse of short-term lending and the aggressive impact of FASB 157. Is there a lesson? What I do is to listen carefully -- very carefully -- for specifics...Most traders reject corporate executives because they have 'learned the lesson of 2008.' This is a gross oversimplification. There is a legitimate concern that this is a crisis of confidence, so we need to evaluate each statement on the merits."
Then, in December of 2011, I provided my readers with a framework for analyzing the situation in Europe.
"The right way to approach macro investment themes depends upon your time frame. For traders, you need to find the rhythm of the current market. What do the active participants expect? When do they expect it?
The problem for investors is much different. The investor should hope for wild gyrations and mispricing of asset classes. That is the source of opportunity."
Later in that same post, I addressed some of the major problems I had with the way the European debt crisis has been portrayed by pundits on television and in the blogosphere.
"...the many critics suggest that the leadership is stupid, ill-informed, and made up of people who 'just don't get it.'
My perspective is quite different. Any blogger who thinks that he or she knows more than Merkel or Sarkozy or Braghi (or Bernanke) is posturing for an audience. World leaders are intelligent, well-informed, and aware of the market implications. Market pundits are wrong to underestimate their abilities.
As one who has moved freely in both the government leadership and trading groups, I want to sharpen the focus: Ask not what some pundit thinks should happen. Ask instead what is most likely to happen."
Later that month, I discussed the best ways to see through the hazy fog of lackluster media coverage in order to anticipate important public policy decisions.
"For investors to get an edge, you need to have information or analysis that is not widely known. The European problems and attendant stories occupy hundreds of columns each week in the financial press and even more blog posts. There is a general consensus about what will happen if there are no policy changes.
You need to think not about the problem, but about the solution. To do this, let us look for the best source on solutions in 2008. Who accurately predicted the alphabet collection of programs? The determination to avoid disaster? The willingness of doctrinaire Republicans to intervene? The willingness of the Fed and the Bush Administration to stretch the law to aid financial institutions? The extension of this by the Obama Administration to non-banks?"
Pundits are looking for "the answer" - some magical silver bullet that will end the crisis and fix all the problems. My own hypothesis is far more complex and far more realistic.
"...there will be a messy negotiated compromise to the European problem. It will include many participants and some leverage. Austerity. Sale of public assets. Haircuts on debt. Eurobonds. ECB bond buying. It will include everything that has already been mentioned and some things we have not yet heard about.
European bank capital will increase. Confidence will gradually be improved and interest rates on sovereign debt will fall. It may take years to accomplish in full.
There will be no single meeting with a final plan announcement. Each incremental step will be met with skepticism from the usual suspects, beginning with the fact that it is not comprehensive."
Again, much of this misinformation comes from the fact that pundits don't understand incremental policymaking. In public policy, there is a well established principle known as constructive postponement. I discussed how this term could have implications in the investment world back in May 2011.
"There is a dangerous idea making the rounds, the notion that delay is inherently bad. Adherents of this viewpoint are winning the sound bite war with 'extend and pretend' and 'kick the can down the road.' Using these phrases seems to have the effect of trying to end discussion. To me it seems more like an impatient toddler insisting, 'I want this! I want it right now!'
Here are some easy examples of when delay is (or might have been) wise.
- The surgeon recommends shrinking the tumor before operating.
- You decide to make sure of your current job situation before buying a new house.
- President Bush delays attacking Iraq to get a little more evidence about weapons of mass destruction.
- You negotiate a new repayment schedule of loans to reflect your changed employment status.
- You decide to do some graduate study instead of taking a job that you do not really like.
- You decide to travel abroad for a year, delaying your college studies.
- You delay an investment in a local business, waiting for more clarity about conditions.
- You postpone your plan to quit smoking until you are through a period of stress.
In most of these cases an aggressive adovcate for the "other side" could invoke slogans."
The market predicts these countries will go broke unless some fast action is taken, but the leaders in Europe are operating on a different timeline. After the most recent European elections earlier in the spring, I again emphasized the nature of this kind of collaborative policymaking.
"The European story is an ongoing process of bargaining and compromise. US observers are far too ready to impose their own value judgments on other countries and cultures. The exact trade off of austerity, bank recapitalization, central bank intervention, and rescue funds is a work in progress. The exact nature will change and I still expect new entrants...I want to emphasize my most important point:
Policymakers have been responsive and flexible. Skeptics have consistently underestimated the willingness and resourcefulness of the relevant institutions."
Most recently, this May I examined the ways in which this gradual proccess of compromise and renegotiation has garnered a better deal for all of those involved.
In the best case, things are much better than a year ago. Banks have more capital. They have lending from the ECB, with the chance to profit on the spread.
In the worst case, things are also much better. The original Greek debt with the threat of CDS payoffs was a major systemic threat a year ago. Those debts were negotiated, and things are a bit different. There are various current paths for Greece. Whether it is an exit from the EZ or another discount on debt, the stakes are lower than a year ago.
This is a continuing story of compromise and negotiation. Each party is benefiting from the delay. So far, it has also helped the collective.
Those complaining about "kicking the can" have been wrong. Those criticizing European officials have been wrong. Those predicting disaster have been wrong. Do you see a pattern?
Naturally, I will continue to monitor the most recent developments in Europe very closely.