Fareed Zakaria Needs to Study More History

Fareed Zakaria

A good geopolitical discussion with CNN host and Time magazine editor Fareed Zakaria on Charlie Rose, although I take issue with one of Zakaria's suggestions:

Charlie asked him for his prescription for preventing conflict between the U.S. and China, and his response smacked of the same arguments and thinking which were prevalent prior to World War I.

Fareed stated that if the U.S. and China can increase their "dependencies" then this would prevent war from occurring. I was surprised to hear Fareed say this as he generally gives off the impression as someone who is well versed in history.

Fareed's thinking about what will prevent conflict is identical to what was said prior to World War I, the original era of globalization when arguably the world was even more interconnected by trade than it is today. Because everything was so interconnected, because nations like Britain and Germany traded as much as they did, war was considered impossible.

Many people are not aware of the fact that today's interconnected world is not our first experience with globalization. One of the better quotes on just how bound up the world was prior to WWI comes from John Maynard Keynes. Below he describes just how eerily similar life in early 20th century London was to today:

The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, in such quantity as he might see fit, and reasonably expect their early delivery upon his doorstep; he could at the same moment and by the same means adventure his wealth in the natural resources and new enterprises of any quarter of the world, and share, without exertion or even trouble, in their prospective fruits and advantages; or he could decide to couple the security of his fortunes with the good faith of the townspeople of any substantial municipality in any continent that fancy or information might recommend. He could secure forthwith, if he wished it, cheap and comfortable means of transit to any country or climate without passport or other formality, could despatch his servant to the neighboring office of a bank for such supply of the precious metals as might seem convenient, and could then proceed abroad to foreign quarters, without knowledge of their religion, language, or customs, bearing coined wealth upon his person, and would consider himself greatly aggrieved and much surprised at the least interference. But, most important of all, he regarded this state of affairs as normal, certain, and permanent, except in the direction of further improvement, and any deviation from it as aberrant, scandalous, and avoidable. The projects and politics of militarism and imperialism, of racial and cultural rivalries, of monopolies, restrictions, and exclusion, which were to play the serpent to this paradise, were little more than the amusements of his daily newspaper, and appeared to exercise almost no influence at all on the ordinary course of social and economic life, the internationalization of which was nearly complete in practice.

Speaking of history, if you have a little extra time there was another excellent interview on Charlie Rose with the historian David McCullough about his new book, The Greater Journey: An American in Paris.

The Biggest Loser (Besides the Irish) in Ireland's Ongoing Debt Crisis

Noted economic historian Barry Eichengreen has written perhaps the most scathing damnation of this week's Irish bailout. I strongly encourage reading the full piece.

Professor Eichengreen takes aim at Germany in particular. In the below passage he compares the Irish bailout to Germany's own hopelessly burdensome WWI war reparations, which played a key role in the rise of the Nazis and perhaps the Great Depression:

"Ireland will be transferring nearly 10 per cent of its national income as reparations to the bondholders, year after painful year.This is not politically sustainable, as anyone who remembers Germany’s own experience with World War I reparations should know. A populist backlash is inevitable. The Commission, the ECB and the German Government have set the stage for a situation where Ireland’s new government, once formed early next year, rejects the budget negotiated by its predecessor. Do Mr. Trichet and Mrs. Merkel have a contingency plan for this?"

The short answer to Barry's question is, of course, no.

Irish Bailout Rejection Fallout

European sovereign bailouts may wind up becoming a lot like Department of Defense contracts in that the only thing contract signing signifies is the beginning (rather than the end) of negotiations. For example, if the new Irish government rejects its bailout as expected there may be an attempt to stem the ensuing crisis by negotiating down the hopelessly high bailout interest rate of 5.8% (or 7.25% depending on how it's calculated). And Ireland's controversial low corporate tax rate of 12.5%, rumored during the height of the drama  to be on the table for european 'harmonization', may also be revisited.

Any such renegotiations should be viewed as window dressing aimed at delaying the final reckoning. The fundamental problem is that Ireland is insolvent. No amount of additional liquidity or tax rate bargaining alters this inescapable fact. Faced with this prospect, Europe's current leaders are struggling to determine who will take the biggest hit from Ireland's inevitable default.

Who Will Be the Biggest Loser?

Arguably the key issue to keep an eye on is whether senior Irish bank debt holders will be forced to take losses. If in fact Eichengreen's suggestion of 100% haircuts on insolvent Irish bank debt is adopted the ramifications for Europe's banking system would be difficult to overstate.

The below chart is helpful to understanding the implications of an Irish bailout rejection/and or default.

(click to enlarge)

The U.K. is Ireland's largest creditor with approximately $220 billion in exposure, so any Irish bailout rejection and/or default will weigh heaviest on Britain. Royal Bank of Scotland (RBS) and Lloyds TSB, which were previously placed on government life support, are particularly threatened.

An Irish rejection of the bailout will put substantial pressure on the still fragile British banking system, which post-bailout consolidation is now home to three of the world's five largest banks (including #1 RBS).

(click to enlarge)

In spite of the current austerity push in the U.K., the government participated in the Irish bailout and pledged approximately $10M to "a friend in need". An Irish Times editorial, reflecting the long and conflicted relationship between these two nations, greeted British 'kindness' with a degree of skepticism.

It's would appear that the U.K. (an EU member which never adopted the euro currency) helped bailout Ireland because rescuing a neighbor is politically more palatable than what would have been necessary if Ireland's debt situation had further deteriorated: recapitalizing the British banking sector (again).

A Lonely Lady

But if at some point an Irish default is inevitable, and the Eurozone nations align to protect their euro based banking system, Britain may well find itself the odd man out. And since further bank bailouts by parliament are politically DOA, Mervyn King and the Old Lady of Threadneedle Street may be left to step into the breach to recapitalize British banks. Any such Bank of England support would be coming on top of calls from the Cameron government for further quantitative easing to reduce the effects of government budget cuts and nagging inflation. In other words, sterling would be forced to do even more at a time when the currency is already stretched thin.

It is worth briefly reviewing the history of pound sterling in the 20th century. In the 1920s one pound fetched almost $5. The country was forced off the gold standard during the September 1931 Sterling Crisis, resulting in a sharp devaluation. Following the massive accumulation of debt during WWII, the pound was devalued again in 1948. This was followed by a further 15% devaluation in 1967. Following a severe recession in the early 1980s, the pound has traded as low as $1.03 in March 1985. Overall, there is well established history of devaluation when the going gets tricky.

While the recent plunge in the euro has provided a relative respite in what had been a steady weakening trend in the pound, Britain will bear the foreign brunt of any Irish bailout rejection and/or default. Further compounding this problem is China's curious financial support to Europe's 'Club Med' nations, but not Ireland, and Britain's total debt position which stands at a whopping 5x GDP (the world's largest total debt/GDP ratio). Based on these and other factors one can make a very good argument that over the medium-to-longer term the pound will continue its long drift downwards. Several ETFs are available to hedge against this risk.