There’s no guarantee all these countries will get into trouble in the ensuing global economic turmoil that would follow a Eurozone-collapse. However…
Interview with Dr. Markus Krall:
When it comes to identifying and evaluating the key vulnerabilities and inherent risks of the banking and financial system, there are few who have the insights and practical experience that is required to truly understand the scale of the issue and its investing implications. This is precisely why Claudio Grass turned to Dr. Markus Krall, who graciously agreed to share his thoughts and observations, as well as his outlook on the future of the financial system and the economy.
Dr. Markus Krall, managing director of the consulting firm goetzpartners, has worked in the financial industry for over 25 years. Over the span of his successful career, he has amassed extensive global experience working with leading international corporations, regulatory bodies, governments and supranational institutions, from a consulting as well as from a line role perspective, mainly in banking, primary insurance and reinsurance, and regulatory affairs.
He is also the author of two bestselling books on economics, monetary policy and geopolitics: “The Draghi-Crash” and “When Black Swans Multiply”. Additionally, he is a regular columnist for several of Germany’s leading print and online publications where he focuses on monetary policy and European affairs. Finally, as a knight of the papal order of the Holy Sepulchre, he is engaged in humanitarian work and foundations in the Middle East.
CG: You weren’t always as opposed to the current financial system, to the modus operandi of central banks or to the idea of a common currency in Europe as you are today. Why did you decide to seek ideas beyond the “received economic wisdom” and what made you change your mind?
MK: Yes, that is correct. When the Euro was introduced and for a number of years, I did not perceive the common currency to be the problem and time bomb it later turned out to be. When the Euro was introduced in 1999, I mainly perceived it as an opportunity to reduce the transaction costs of intra-European trade and therefore a good thing. My awareness of the inescapable tensions a fixed exchange rate regime would introduce to a severely suboptimal currency area, which the Eurozone resembles, was underdeveloped to put it mildly. Also, back in the 90’s, I did view the EU and the integration it was driving as a force of free trade and thus believed it to be a good thing.
Two main developments changed my mind on this matter: The EU retreated from the ideas of free trade, free markets and competition and turned its attention, resources and intentions towards developing a bureaucratic, regulatory, planning economy approach which gave more and more economic decisions to bureaucrats, regulators and advocates of redistribution and forced equalization. Today’s EU is the embodiment of bureaucratic hubris.
The second element was the mind-boggling mishandling of the Euro-crisis, as it was born out of the global financial crisis which laid bare the intrinsic tensions, weaknesses and governance deficits of the Eurozone. The answers presented in the face of the crisis were not an improvement on these deficits. They rather aggravated and deepened them. Instead of addressing the governance issues and adverse incentives, the answer of European politicians was to plaster over the problems with solutions buying time at the expense of long-term stability and reduction of imbalances. For them, economics seems to be the science of money pots, not of incentives and scarcities.
As it turned out, the promises on paper, specifically with regards to the Maastricht treaty did not pass the test of the crisis. The politicians running the show were effectively seeking quick fixes and sent the treaty and the rule of law wholesale overboard. But without the rule of law, any government degenerates into a band of robbers as the doctor of the Church Augustinus of Hippo observed already almost two millennia ago.
CG: When we met a few weeks ago, we talked about your professional background and especially the fact that you used to develop risk models for the banking system. Do you believe that this is why the central planners might be getting worried by your analysis and can you elaborate on your work and relevant conclusions?
MK: Well, it likely does have an influence on the credibility of my argument. 80% of banks in Germany use internal credit risk rating systems developed in projects I have managed and organized. In Austria the situation looks similar and in some other countries too. It is difficult to dismiss the warnings on systemic and credit risks if the person voicing them can point to a certain experience and “market share” regarding tools measuring those risks. But the critical point is about the argument. Understanding these tools also highlights the limits and weaknesses of our risk measurement and management infrastructure. And the silent contamination of the banks’ credit books has a lot to do with those limits.
The financial ratings built in the late 90’s and early 2000s were developed under the conditions of positive interest rates. They were not constructed to work in a system where the central bank artificially manipulates the interest rates down to the zero-line along the complete band of maturities and even into negative territory between overnight money and 5-year bonds, sometimes even longer maturity paper.
The key performance indicators inside the rating tools are distorted and blinded by this. They lose discriminatory power with regard to separating good credit from bad credit. The 12-year trend of falling defaults has seduced the banks and the regulators into thinking this is the new normal, instead of using their brains to understand that it is the result of a hidden subsidy for inefficient and unproductive companies called zero cost of capital. The government is pushing the banks in the same direction because it allows them to release credit risk reserves and thus show profits where in truth there are none. The tax collector, of course, is all in favor of this kind of creative accounting because those hot air profits produce tax revenues.
So, yes. Nobody likes to hear the message, but given my professional background, it is not so easy to dismiss.
CG: After a decade of loose money and central bank excesses, what were the consequences of these policies and what are your expectations for the markets and for the global economy at large in the next two years?
MK: There are several adverse effects on the consequences of which will cause us considerable pain in the next years. Firstly, the artificially low-interest rates have depressed the number of defaults. Companies which should have been sent into bankruptcy have been kept alive by the subsidy of zero interest rates. They now make up around 15% of all companies in Europe. These are zombie companies: dead, but walking and they have been the recipients of large sums of loans which are zombie loans. They will sooner or later fall in a big wave of defaults. Banks are not prepared to absorb this shock.
Secondly, the flat yield curve has eroded the business model of commercial banking by destroying the interest margins on savings and maturity transformation. The escape route to hand out more credit has only depressed the credit margins too and accelerated the accumulation of bad credit in the form of the above-mentioned zombie-loans. Various accounting tricks have been used to hide this for years, but the reserves covering the growing gap are now largely consumed and the problem bubbles to the surface.
Thirdly, the accumulation of zombie companies is a drag on the economy’s productivity growth which itself is the only source of long-term growth. No demand stimulus can replace that. The resulting slowdown of productivity growth translates into overall anemic growth rates for Europe’s economy. Thus, we cannot grow out of our debt problem, but are dragged into the swamp by the cure we try to apply.
CG: Governments the world over are drowning in debt, but as you mentioned, companies have also reached record debt levels, indulging in their own excesses, papering over their true financial state and going on acquisition sprees with borrowed money. As the era of cheap credit comes to an end, how extensive and how severe do you expect the impact to be?
MK: Very, very severe. The cheap credit has not only created the army of zombies, it has also led healthy firms to over-borrow and over-leverage and hide this with creative accounting. When this party comes to an end, we are in for a truly ugly awakening. As von Mises pointed out, the policy of cheap money creates large-scale capital and resource misallocation in the economy and this cannot be adjusted without a crisis.
The scale and severity of the crisis is directly proportional to the monetary loosening preceding it. The only question of that proportionality is if it is linear or exponential. When the delayed zombie defaults start to catch up, the entire equity capital of the Euro-zone banking system will be burned up in a matter of months. The resulting deflationary spiral could turn out to be as severe as the 1929 contraction of the world economy. No sector, country, industry or region will stay above the resulting deluge. The deflationary pressure will force the banks to open the floodgates of money printing in a way never seen before and thus trigger a hyper-inflationary scenario in combination with hundreds of thousands of failing companies. This will create a new kind of animal: The super-stagflation. So, fasten your seat belts, ladies and gentlemen.
CG: The picture you’re painting of the future is rather grim. What would you include in a portfolio to prepare for these eventualities and what role could precious metals play in it?
MK: Generally, there are two options to translate this scenario into an investment strategy. One is to aggressively bet on it. That means betting against the Euro and against the banking stock indices by effectively going short on both. This is a high-risk strategy though, since it requires to be very sure, not only about the unfolding and features of the scenario, but also about the timing. The returns are in exchange quite substantial for the risk taken, if such a bet comes to fruition.
The alternative is to shield your assets from the fallout of the anticipated crisis. It involves a more passive strategy. One can expect that a collapsing Eurozone will have a global impact, but as always it is true that in the land of the blind the one-eyed man is king. It is thus likely that the Euro will substantially depreciate against the US-Dollar, the Pound and other currencies outside the EU in the case of such an event. It does, therefore, make sense to allocate a substantial part of the portfolio in those currencies and seek securities with lowest possible risk. These are short-maturity government bonds, with 6 to 24 months maturity, diversified across a range of currencies which I would like to summarize here: the US-Dollar, the Canadian Dollar, the British Pound, the Norwegian Krona, the Australian Dollar, the Singapore Dollar, the Swiss Franc and the New Zealand Dollar. One can also consider the Polish Zloty, the Czech Krona or – for the not so fainthearted – the Russian Ruble. Diversification is important in this situation.
There is no guarantee that all these countries will get into trouble in the ensuing global economic turmoil that would follow after a Eurozone-collapse. However, none of these economies has accrued hidden imbalances comparable to the Eurozone.
Finally, it makes sense to put approximately 10% of liquid assets into precious metals. This is the ultimate reinsurance for variations of the crash-scenario which nobody can anticipate.
CG: Apart from the monetary and fiscal policies that have led us to the cliff-edge we face today, do you also see the social, cultural and political shift that has taken place, largely in the West, as a contributing factor?
MK: Absolutely yes. Indeed, the cultural decay prevalent in all western societies resulting from the Marxist “march through the institutions” since the revolt of 1968 is the deeper root cause of our crisis. It directly erodes and attacks the values on which every free society is built: Religion, family, private property, free markets, human dignity. It has leveraged a wrong, hyper-individualistic and egotistical philosophy to advocate a lifestyle at the expense of others, the profligate squandering of other peoples’ money and the negation of the value of human dignity as we can see it in the legal killing of unborn children and the hollowing out and ridiculing of spiritual and religious life.
The result is a society without children. They were sacrificed on the altar of hedonism. That is also highlighted by heads of state with no children: Merkel, May, Macron, Juncker, Varadkar, are only a few examples. How can we expect them to have future generations in mind if they cannot possibly care about them?
The resulting “short-termism” is feeding the socialist concepts of redistribution, equalization, the planning economy, favoring consumption over saving and investment, demographic decline and enslavement of the next generation to feed the previous one in an ever-declining ratio of net payers to net receivers. Sustainability is the buzzword of the century, when we discuss real or perceived environmental threats, but our society is not organized in a way that has sustainability in mind. The awaking from this party will be rude indeed.
Claudio Grass, Hünenberg See, Switzerland