Counter Argument……David Kotok: A Euro Bull Waiting For Storm To Pass

Posted By on February 27, 2010

David Kotok: A Euro Bull Waiting For Storm To Pass
Written by Lara Crigger  -  February 26, 2010 11:56 AM
 David Kotok is the co-founder, chairman and chief investment officer of Cumberland Advisors, a New Jersey-based money management firm. His thoughts on the financial markets have appeared in various media outlets, including CNBC, the Wall Street Journal and the New York Times. Kotok also currently serves as the director and program chairman of the Global Interdependence Center, a Pennsylvania-based global trade and monetary policy think tank.

On the heels of our interview with Dennis Gartman, IU Associate Editor Lara Crigger sat down with Kotok to discuss the fate of the euro, including how the euro will survive, why Spain doesn’t need a bailout and why more bad times are ahead for the U.S.

Crigger: The situation over in Greece looks pretty bleak at the moment. Is the euro doomed?

Kotok: No. The euro is a new currency. It was only officially agreed upon in 1991, and was launched as a virtual currency on Jan. 1, 1999, with 11 countries. Greece was not one of them.

Greece came in later. It has been subsequently revealed that the data Greece used to qualify and obtain entry into the eurozone was flawed. The polite way is to say it had errors. An impolite way is to say that it was miscomputed as an act of deviousness.

Crigger: Are you saying that Greece miscalculated its data on purpose, so it could get into the eurozone?

Kotok: I don’t know. I wasn’t there. But there are many people who believe it was purposefully misstated. And we have evidence now, from the use of currency swaps, that the data was certainly massaged to obtain qualification. Subsequently, it was revealed to be inaccurate.

But if Greece were to default, or to withdraw from the eurozone or the European Union tomorrow, the biggest damage would be done to Greece: the Greek economy, Greek citizens, Greek businesses and banks. Others might suffer small losses, but Greece would render itself economically to a status that might be rivaled by a poor country like Albania. The Greeks know it, which is why Greece has yet to threaten departure from the eurozone or the EU.

Crigger: But it doesn’t look like France or Germany, the two biggest members of the eurozone, have any intention of bailing Greece out.

Kotok: They don’t; not until Greece imposes an austerity budget and alters its present, sovereign fiscal policy. So what you have now is a dance with saber-rattling.

Something to keep in mind is that 51 percent of the Greek budget is wages and benefits for public sector workers. The public sector workers do not want to give up this free lunch. But they only have one political tool: They can go out, strike and demonstrate. And they’re doing that. We should expect it, really, because that’s the form that negotiations take in European social-democratic countries. This is a classic negotiating structure in Europe, where the unions demonstrate on the street.

Crigger: So you think the European Union and the euro can recover from their present troubles?

Kotok: Right. I don’t think this dooms the EU, and I don’t think it dooms the euro. I expect the European Union to stand the ground defined in the Lisbon Treaty, which means Greece will not be able to vote or participate in EU matters.

After all, this needs to be put in context. Greece is only about 3 percent of the eurozone economy. It’s a very small portion of the capitalization of the European central banks, and any assistance package would be prorated by capitalization in the European central banks.

The euro and the European Union now confront their first grand crisis. In my view, they will resolve the crisis. There will be controversy and hullabaloo for several months, and more labor demonstrations and negotiations. But eventually, there will be resolutions. The sovereign debt will roll and refinance. It usually does, when there is the capacity to service the debt and pay it. That is true in Greece, and in Portugal and Spain and everywhere else.

Crigger: That’s contrary to what some have said, that if the EU—namely, France and Germany—have to bail out Greece, then won’t they have to bail out Spain, and Portugal and so on, which are of course much bigger economies?

Kotok: I don’t think France and Germany have to bail out Spain. Spain has adequate resources to service its debt. Its debt schedule is not as severe at all as Greece’s. It does have to deal with a very high unemployment rate, though, and government-sponsored labor out on the streets, protesting the change in the retirement age. But my experience in Spain indicates to me that there’s ample opportunity to tighten their budget. They have the resources, and they are high-grade credit. In fact, their creditworthiness has been reaffirmed by one of the rating agencies in one of the past few weeks.

So Spain is quite capable of handling its debt load. So is Portugal. The whole idea that we have a mass contagion, and all these sovereign countries are going to default and the currency is going to be destroyed—it’s bizarre.

Here we are in America, arrogantly disparaging the eurozone’s member countries, including Greece, which is the worst case, because they have deficits of about 10-11 percent of their GDP. But we never say our deficit is about 10-11 percent of our GDP. We criticize the members in the euro currency zone, while we have to deal with the members of the U.S. currency zone.

Crigger: How do you mean?

Kotok: One of them is California, which is 13 percent of our GDP. It defaulted, and had to use scrip for a couple of days. It didn’t change the structure of U.S dollar-denominated federal debt, or of the currency, one bit. If Rhode Island in the U.S. were to default tomorrow, it wouldn’t change the U.S. dollar standing.

What is different here, however, is that the U.S. dollar has been in place for a relatively long time, and the euro is relatively new. For a new currency in its first 10 years, it hasn’t done very badly.

Crigger: But is Greece really an accurate comparison to Rhode Island, considering how different the United States is politically and economically than the countries in the eurozone?

Kotok: No, I think a better comparison might have been New Jersey, although New Jersey is a larger state. We have a new governor in NJ, with a budget crisis very similar to what Greece has. He has a very large public sector with embedded high pension costs and wages. He has issued an executive order to stop the spending, cut the spending. And the teachers unions and the workers unions in New Jersey are not happy, as they don’t want to go through that. There are going to be strikes, demonstrations in New Jersey. We will have pickets outside the Statehouse, just as we do in Greece.

In the end, New Jersey has to confront a huge accrued liability that is unfunded. And they cannot raise taxes higher. At this point, they’ve raised taxes so much that the more that they raise in tax, the more people flee to another jurisdiction, and net revenue to the government goes down.

And let’s look at the issue of transparency and clarity vs. dishonesty and deceitful budgetary mechanisms. Greece has been accused—in my view, rightfully—of deception. In the U.S., Fannie Mae and Freddie Mac, our housing agencies, practiced budgetary deception. To this day, they still do not appear on the federal balance sheet. So are we doing anything different than Greece?

Crigger: Does that mean we’re setting ourselves up for the same problems as Greece?

Kotok: We may have a more severe problem. We too have accrued liabilities that we don’t count in our budget mechanics. We have agencies that don’t participate in our national budget, and it’s the U.S. taxpayer that ultimately has to pay the bill. So I would say we’re no better than the Europeans. And in many ways, we are worse.

The financial crisis was the American Made crisis. We melted down Lehman Brothers. We had AIG fail. We didn’t supervise the securities industry and let in a Bernie Madoff. We defaulted on the Fannie/Freddie preferreds, $30 billion, half of it held by institutions and foreigners. Our hands are unclean. We are less transparent, and yet we act holier than thou.

In my new book (“Invest in Europe Now! Why Europe’s Markets Will Outperform the U.S. in the Coming Years” (Wiley, 2010)), one of my arguments is this: Today, Europe is confronting its crisis head-on, because it has to. The forces are in place to ensure resolution. And when this is all over, the euro will emerge stronger than ever. The European Union will survive this test, whether Greece is in or out.

Crigger: Yet in the short term, you believe the euro will weaken, correct?

Kotok: Right. Our investment strategy today is “strong dollar, weak euro.” Underweight the European stock markets, and let this crisis run its course over the next several months.

We are coming up on a key date: March 16. That’s when the Greeks have to either pay their debt or they roll it. If they can’t pay it, they default. So I would say that the uncertainties are high now, and the public debate, the strikes and other activities intensify it. Therefore, this is not the period to bottom-fish in the eurozone or European markets.

I believe the euro will get weaker, and I will wait patiently for the buying opportunity. My suspicion is that when the buying opportunity comes, it will come in the face of the worst news; that time when markets will be in a fall.

Crigger: One last question: Do you see deflation or inflation on the horizon?

Kotok: The risk is deflation, and it has been for several years. Inflation requires two things. It requires an expanding private-sector credit multiplier. We don’t have it. And it requires rising labor income. We don’t have it. Show me one case of inflation anywhere in the world that doesn’t have those two elements and you’ll pick the first one. You just can’t have inflation when the credit multiplier is contracting, and when labor income is stagnant or falling. It’s not going to happen.

Crigger: Thank you for your time.

 David Kotok’s market commentary is available at

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