Iron Capital Insights

  • Iron Capital Insights
  • May 16, 2012
  • Chuck Osborne

Austerity 2, Europe’s Mess and JP Morgan’s Embarrassment

Since we last stirred you with our insights on austerity, Europe’s woes have continued with almost all of Southern Europe now reporting negative GDP growth; JP Morgan has embarrassed itself with a loss that CEO Jamie Dimon called stupid; and markets have reacted as we thought they would.

While JP Morgan’s highly publicized loss has once again surfaced the anger many feel towards the titans of Wall Street, the coverage has really added more heat than it has shed light. The complicated nature of what occurred makes it difficult to understand, but I believe it was Albert Einstein who once explained that if you cannot explain a concept so that a kindergartener can understand it, then you really don’t understand it yourself. This is why we always start out investment education sessions by explaining the simple truth that there are only two ways to invest: You either own something that you believe will increase in value while you own it, or you loan money to someone who you feel confident will pay you back plus interest. That is it. When you own something – it could be stock of a publically traded company, stock of a privately traded company, a bar of gold, a work of art, or baseball cards – you had better understand what it is you own and what it is really worth. When you loan money –as simple as a direct loan to a family member or as complicated as the collateralized debt obligations (CDO’s) that have JP Morgan sweating – you had better understand to whom you have loaned and what kind of credit risk you are taking. JP Morgan evidently did not understand just how much they had loaned out, which, as Jamie Dimon said himself, is really just stupidity.

Of course the root cause of all this market turmoil and JP Morgan’s trading woes is the ongoing saga of Europe. In our last Insight I said there is no alternative to austerity. Of course there are those who claim that there is an alternative; they say Europe – or any of the individual countries who wish to exit the Euro and re-establish their own currency – can simply turn on the printing press, so to speak, and print enough money to pay all of its bills. This is often referred to as devaluing the currency because it causes a high amount of inflation.

They are not wrong exactly, but in reality austerity and devaluation of currency accomplish the same thing. Devaluation just has the political advantage of being dishonest. You see, if you are a retiree in Greece receiving a state pension check of €2,000 per month and the government says we can’t afford this payment and we must cut your check by €500, that is austerity. If they instead decide to inflate their way out, you will still receive a check for €2000 but it will be worth only €1,500 or potentially much less because of inflation. It is still the same pain, it is still austere, it is just less honest.

The thing the advocates of turning on the presses don’t understand is that governments do not create money; they print currency, but that is not the same thing. Money is an economic mechanism that allows one to store value. Just as all investing boils down to two basic roles, owner or lender, all economic activity ultimately boils down to barter. Our clients are a diverse group: some practice law, some run hotels, some load and unload cargo from ships, but all of them produce economic value. Money allows us to spend our time doing whatever it is we do best. I get to research financial and economic data and make investment decisions, and not worry about planting crops or hunting for meat or building my family’s house. You, our clients, value what I do and you pay me for it. I can then exchange that value for things my family and I need, like food and shelter. We all do this. If the government decides to greatly increase the amount of currency in circulation, that does not increase the value of my services.

My father grew up in the depression and he is fond of telling us stories about how he walked barefoot five miles to school, up hill both ways, often in knee-deep snow. (I think that is how it goes; to be honest his children stopped listening a long time ago.) He also talks about a loaf of bread costing a dime. When the baker bakes that bread he creates value. When my father was a child, that value could be stored in a dime. A loaf of bread is still a loaf of bread and it is no more valuable today than it was then; if anything it is less valuable, as we are a much more prosperous society today. My grandparents wouldn’t have thrown away any end pieces while struggling to feed seven children during the depression. However, today a loaf of bread costs $2.31 according to government data (and a lot more than that if you buy the whole wheat bread we eat at my house). Bread has not changed in value, but our currency has changed, and it stores much less value today than it did when my father was young.

Southern Europe has consumed much more economic value than it has created. It must find ways to pay back that debt. You can call it austerity or you can call it devaluation of currency but either way, life will be austere and markets will be disrupted. Austerity is the reality of Europe and it must be faced sooner or later.

Chuck Osborne, CFA
Managing Director