Eurozone on the Path to Resolution – Guest: Brian Kelly

by Brian September 13, 2012 1:19 pm • Commentary

I want to take the opportunity to introduce RiskReversal readers to my friend Brian Kelly who runs asset management firm Shelter Harbor Capitol.  I have gotten to know Brian over the last 2 years as we have both graced the screens of CNBC during the 5 o’clock hour as contributors and I have learned a lot from, and appreciate his work as a macro strategist and portfolio manager/trader.  Brian is a frequent panelist on Fast Money Halftime Report, Fast Money and Money in Motion. BK has graciously allowed us to re-post his daily musings on the markets.  Follow Brain on Twitter @BrianKellyBK        –  Dan



Cross posted at Shelter Harbor Capital  – Originally Posted on September 12, 2012

Eurozone on the Path to Resolution

In the wee hours of the morning – for those of us on the US east coast – a group of judges in red hats set the stage for the resolution of the Eurozone debt crisis.  By allowing Germany to ratify the ESM, the constitutional court cleared the way for step 1 of the resolution process to begin.  Based on the experiences of Japan, UK, Germany and the US (1930s and in 2008) there are three key elements to managing a debt deleveraging.

1. Debt Monetization
2. FX Devaluation
3. Economic Growth

The key to resolving a deleveraging recession is the proper balance of the previous three elements – too much debt monetization and you end up with hyper-inflation, not enough economic growth and you end up like Japan…a lost decade (or two). For those interested in an in depth look at debt deleveraging, Richard Koo of Nomura is the expert.

The ratification of the ESM will formalize the debt monetization process that was started when Mario Draghi unveiled the ECB’s bond buying plan and when German leader Angela Merkel endorsed Draghi’s plan. Germany has always been the gatekeeper in the Eurozone crisis, the explicit support for debt monetization represents a game changing event for Europe. Clearly, Europe has a lot of work ahead and the process will not be without pitfalls, but Step 1 has now begun.

The next steps for the Eurozone are to devalue its currency and create economic growth. Ideally, nominal GDP for the indebted countries should be above their bond yields – in this way, these countries will be able to grow their way out debt. Of course, this is a tall order, but it is step that must be taken.

In conjunction with economic growth (or even an end to austerity), the Eurozone must find a way to devalue its currency so that peripheral countries can regain competitiveness.  Once again this may seem like an impossible task given the propensity of the US to print money, but there is another way for Europe to accomplish the currency adjustment needed…higher levels of inflation.
The following chart is the inflation adjusted exchange rate (aka real effective exchange rate) for both Germany and Spain since the introduction of the Euro.

In simple terms, the lower the rate the higher the competitive advantage. In order for those rates to converge, Germany must tolerate a higher level of inflation, which heretofore has been a non-starter. However, there has been a small change that may lead to step 2. Over the Weekend, Angela Merkel was reported to have said that she does not want Greece to leave the Eurozone, since a Grexit would harm the German economy. In order for Greece (or Spain) to remain in the Eurozone a currency adjustment must occur. Without a significantly weaker Euro the only way to accomplish the adjustment is to tolerate higher inflation. For that matter a significantly weaker Euro will also result in higher inflation.


The ECB decision with the backing of Merkel completes step 1. Step 2 will be accomplished with higher rates of inflation (especially in Germany), now the tougher part begins…economic growth. In the mean time, the tail risk has been removed and the Eurozone has at least begun the process of resolution.

Disclosure: Accounts managed by Shelter Harbor Capital are long Dax futures and EWG.