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Jackson Hole Preview: Draghi's Plan Should Net Positive for Markets

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Draghi has done the math, knows the formula, and understands the channels through which a devaluation needs to work. He knows it's not just about trade, it's about real wealth and income and effects on capital investment.

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MINYANVILLE ORIGINAL When I first learned that ECB President Mario Draghi would be speaking at this year's Jackson Hole symposium after an already much anticipated speech from Fed Chairman Ben Bernanke I immediately thought there must be some coordination between the two central bankers who both earned their respective PhDs from MIT in the 1970s. I sought to find a connection between their respective influences to see if I could find a common theme. I did find an interesting link to MIT, but it was not what I expected.

I first learned about what would become the European crisis in 2006 when on vacation with my wife on the Croatian island of Hvar in the Adriatic. We were enjoying a nice dinner in the harbor town of Sucuraj discussing politics with my wife's very vivacious family friend named Ranka (R is rolled). The discussion was on whether Croatia should enter the EU and adopt the euro common currency. Ranka was adamant that it would be bad for Croatia, namely because it would increase the cost of living and potentially reduce tourism which was so vital to Croatia's economy. She was comparing what happened to their neighbor Italy across the Adriatic and how expensive it was now to visit relative to pre-monetary union. I remember thinking to myself, this isn't going to work. The euro is flawed. Italians aren't Germans.

Then a few years later in early 2009 I was catching up with an old college friend, discussing the mortgage meltdown that was unfolding. We had a mutual friend that worked at a hedge fund that had accurately positioned for and was profiting from the chaos that had taken down the financial system. He asked if I was aware of their new fund strategy and I was not.

The Hedge Fund that Called the Euro Crisis

The most legendary hedge fund manager you've probably never heard of (and I think he likes it that way) is Mark Hart of Corriente Advisors in Ft. Worth, TX. In late 2007 Corriente began marketing the European Divergence Fund co-managed with macro research gurus GaveKal sporting the subtle subtitle, The Next Shoe to Drop. To my knowledge this was the first hedge fund that was positioning for what would become the European debt crisis.

I was able to obtain a copy of their presentation and it was truly mind-blowing. It was like reading a suspense novel. It seemed each page presented a stunning new conclusion with statistics, data, and charts. With sovereign spreads of what are now referred to as the PIIGS all converging with Germany juxtaposed with the respective countries' fiscal situations it became obvious. They simply asked: How Do Countries Go Bust? They Issue Debt in a Currency They Can't Print. I thought back to my conversation with Ranka. This is genius. This thing is going to unwind.

The rest is history and five years later the European debt crisis still consumes us every day. However upon further investigation, it's much more complicated than what the financial media typically portrays as simply a problem of too much debt. What started as a re-pricing of sovereign credit risk premiums has evolved into something much more serious. It's not just a sovereign debt crisis; it's a balance of payments crisis born out of the fixed exchange rate regime.

Balance of Payments

The balance of payments is the sum of the current account (trade balance) and the capital account (investment balance). Essentially it's the sum of domestic vs. foreign consumption and domestic vs. foreign investment.

I first began exploring this notion of a balance of payments imbalance in the eurozone last year upon stumbling across this FT Alphaville post. That led me to the Financial Times piece cited by Deutsche Bank economist Thomas Mayer titled, Euroland's Hidden Balance-of-Payments Crisis that further defined the issues and offered potential solutions:

Below the surface of the euro area's public debt and banking crisis lies a balance-of-payments crisis caused by a misalignment of internal real exchange rates.

In a fixed exchange rate system, however balance-of-payments imbalances can emerge when the exchange rate is above or below its equilibrium value.

The path of least resistance seems to be an appreciation in creditor countries through the inflation of goods, services and asset prices...

What Mayer is alluding to is an internal devaluation. Since the individual currencies aren't allowed to re-price against trading partners to adjust the imbalance externally, the devaluation needs to occur internally in prices of goods and services to realign purchasing power parity in order to bring it back into equilibrium.

Internal Devaluation

Mayer cites the work of University of Munich Economist Hans-Werner Sinn who has been at the forefront of taking on and solving the issue of the balance of payment imbalance.

The truth is that the cheap flow of credit for private and public purposes made possible by the euro until 2007 had fed an inflationary bubble that pushed prices for property, government bonds, goods and labor above the market-clearing levels and resulted in huge current-account deficits and foreign-debt levels that private investors have not been willing to finance or refinance since 2008.

The eurozone suffers from a severe balance-of-payment crisis of the kind that ended the Bretton Woods system. Instead of merely lacking credibility, the stricken economies have lost their competitiveness. Instead of growing out of their problems, they need to shrink out of them (in nominal terms, to reduce their imports and boost their exports).

Ironically the US credit bubble, which was on the back of a weak USD, was at the core of the European crisis. The resulting stronger EUR currency helped fuel the consumption bubbles in Southern Europe because they were given more purchasing power than their local currencies would have otherwise provided.

At the heart of the balance of payments crisis are the concepts of equilibrium, purchasing power parity, and clearing prices of goods and assets. It appears Sinn has done a lot of work on and is no slouch when it comes to equilibrium theory and recently wrote a paper titled, Taxation, growth, and resource extraction: A general equilibrium approach.

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