Brexit: All Eyes On European Banks

We cannot shake Orwell’s haunting comments from 1984 that “The end was contained in the beginning.”  Somehow it strikes us as foreboding when we contemplate the upcoming English referendum (called “Brexit” by the media) on whether or not England should leave the European Union (EU).  Will the EU’s end be contained in its beginning?  Is it time to think more expansively about how far the cycle may run – in the opposite direction – from the near complete unification now manifest in the existing EU to what may come after?    

In our experience, cycles generally overshoot from one extreme to the other.  “Thinking the unthinkable” is often the hardest exercise of all in cyclical investing.  If the EU’s intellectual genesis was forged in armed conflict, could a vote to leave the EU set in motion a cycle that may, in the fullness of time, complete the cycle and result once again in armed conflict?  Surely, that possibility seems laughable – for now.  But the ability to ask seemingly radical questions and consider their answers with an open mind are hallmarks of the best investors.

Europe has been at peace for decades.  Each major step it has taken in the last 70 years has been to draw its countries ever more closely together.  After all, this referendum is, on the surface, nothing more than a simple vote with thoughtful people disagreeing on both sides of a contentious issue.  However, we have been watching events in Europe for many years now, and are disturbed at the ever more contentious arguments in the split between Germany and the creditor powers versus the weaker debtor nations in Europe’s south.  Angry debtor countries, such as Greece and Spain, feel oppressed by harsh austerity forced upon them by German-led creditors, and are dredging up the darkest memories from World War II.  Greece even reactivated an old claim that Germany owed it war-related reparations numbering in the hundreds of billions of Euros.  These are painful memories that go deep.  They threaten to reawaken long-simmering animosity on the continent.  European peace may be more fragile than it appears. 

Will events underway mark a trend change in the almost 70 years of European peace and integration?  The long, implacable sweep of history has a way of surprising us all, and taking us to places that we never expected.  Who knows, when the future of ongoing events has become the written past, maybe textbooks will date as the inflection point that led to the next conflict these votes in England and Spain taking place this month?  Stranger things have happened.

The real issue should be known to Europe’s politicians and especially understood by its central bankers.   The real issue is debt and how its tentacles spread throughout Europe and indeed the world.  The Euro as a currency is not just flawed; it’s also the financial equivalent of a thermonuclear debt bomb.  Its many and terrible design failures make it dangerous.  Its designers and defenders either don’t want to acknowledge its shortcomings or, even worse, are simply unaware of them.  Let us explain.

Europe’s banks are bigger, more leveraged, and more indebted than U.S. banks.  This means a smaller cushion to guard against unexpected losses.  Furthermore, the EU’s fragile financial system of massively overleveraged banks is choking on cross-border liabilities from other banks in a way that almost no one can truly quantify and even fewer understand.  Further complicating this issue, the governments that have borrowed in Euros are not free to print Euros to backstop their own banks.  Our concern is that this terrible flaw could spread far beyond the limited and understandable issues that divide Britain’s voters.  As we have argued many times (“Is Spain the Next Greece?” June 1^st 2016), those countries with currencies pegged to the Euro are most at risk from its design flaws – Spain, Italy, and France, just to name a few.  But the debts of these countries’ banks to other banks, and frankly the debts of those banks to others, create the preconditions of systemic weakness not seen since the days after Lehman Brothers failed.