The Rise and Fall of Two Unions
Martin D. Weiss, Ph.D. | Monday, July 25, 2016 at 7:30 am
While most Americans are caught up in election fever, most Europeans are suffering Brexit aftershocks, obsessed with a looming collapse and asking a host of urgent questions:
Are European authorities telling the truth about the United Kingdom’s exit from the European Union? Or are they lying through their teeth?
One year ago, when Greece was threatening to exit the EU, those same authorities swore that it would be fatal to their union. But now, with the UK irrevocably on its way out, they say it’s “manageable”?
Don’t they know that, just in terms of GDP alone, the UK is nearly 15 times larger than Greece?
Or consider Cyprus. Back in 2013, when this small EU member was on the brink of collapse due to bank failures, the European Central Bank, the European Commission and the IMF thought the threat to the union was so serious they rushed in with an unusual bailout.
Now these same institutions are busily putting out the word that Brexit is somehow OK, despite the fact that the UK economy is 147 times larger?
Don’t they recognize the sheer dimensions of the shock? Don’t they realize that Britain’s GDP is bigger than Austria’s, Belgium’s, Sweden’s, Netherlands’, Ireland’s, Finland’s and Greece’s combined?
And what about London!?
Surely they must know that, among all the financial centers on the planet (including New York, Hong Kong, Tokyo and Frankfurt), London has the most active foreign-exchange market, the largest international debt market, the biggest money markets and the most derivatives trading. Or have they forgotten that, too?
In their collective amnesia, do they ignore the fact that London ranks #1 on the widely respected Global Financial Centers Index? Or that it’s the home of the European Banking Authority itself?
The bigger questions, of course, are these:
Can the EU survive?
If not, will its demise occur gradually over time or in a series of Black Swan collapses?
What impact will a continuing EU disaster have on the global economy?
What can US investors do to prepare?
These are very tough questions in the midst of a largely unpredictable convergence of economic and political forces. But strange as it may seem at first, some of the most relevant lessons are to be learned from the recent collapse of another major federation:
The Soviet Union
Yes, I know. The Soviet Union was built on the weak foundation of a centrally planned economy. The European Union is not. And I open this conversation by saying: That’s a very important difference.
But the similarities are equally important.
Like in the EU, the USSR enjoyed decades of economic growth, followed by years of economic stagnation and seething discontent.
Like in the EU today, the USSR was torn apart by powerful centrifugal forces — 15 republics with different languages and ethnic heritages, resentful of central government control, waiting anxiously for their chance to achieve autonomy.
And much as we’ve just seen with Brexit, the USSR was shaken by Black Swan events that ultimately triggered its demise.
For each of these three similarities, let’s compare the USSR and the EU side by side …
In the early years of the Soviet Union, authorities could boast a series of economic achievements: explosive GDP growth … near-zero unemployment … free education and medical care … plus the aura of income equality.
But in 1965, there began a two-decade period known as Zastoi (Stagnation). Growth slowed to a crawl. Agriculture floundered. Consumer goods disappeared from shelves. Living standards sank.
Dealing another blow to the consumer economy, the Soviet military’s top brass stepped up the arms race with the West, embarked on a costly war in Afghanistan, and boosted military spending to 20% of GDP.
Corruption and nepotism spread like a plague. Popular resentment of Moscow sweltered.
European Union: Like in the USSR, the early years of the European Union brought a series of successes: growth and expansion … the second most-widely traded currency in the world … low unemployment in most member states … headquarters for 100 of the world’s largest corporations … and much more.
However, in the wake of the 2008 debt crisis, economic stagnation overtook much of the Continent. GDP sputtered. Unemployment surged. The PIGS countries (Portugal, Italy, Greece and Spain) stumbled from debt crisis to debt crisis.
What’s worse …
According to the European Commission, itself, corruption across the EU is “breathtaking.” Three-quarters of Europeans surveyed say it’s widespread. Nearly all say it’s getting worse.
Italy could be the focus of the next major financial crisis. As Money and Markets editor Boris Schlossberg explains, Italy’s banks now have nonperforming loans that represent a whopping 18% of bank assets, over triple the level that makes regulators nervous. (See “Italy, Its Banks and the Future of the Euro.)
Perhaps most shocking of all, 22 eurozone banks are now vulnerable to Brexit, according Weiss Ratings. (For a list of their names, assets, country and Weiss Safety Rating, go here.)
Soviet Union: In the years leading up to the collapse of the USSR, separatist movements spread from the Baltic Republics to the Caucuses and beyond.
In Latvia, mass demonstrations began in 1986, under the slogan “Soviet Russia out! Free Latvia,” with even larger protests in 1987 to remember Stalin’s mass deportations of Latvians of 1941.
In 1988, all three Baltic Republics — Latvia, Lithuania and Estonia — literally joined hands as two million people formed a human chain that connected their three capitals.
We saw similar mass demonstrations in Kazakhstan, Armenia and Azerbaijan.
European Union: Anti-EU political parties are surging in:
Hungary, the home of the right-wing Fidesz party …
Poland, where the Law and Justice Party has scored major victories …
France, where the right-wing National Front took more votes in local elections of 2015 than the Socialists or the Republicans, and …
In the Netherlands, where the rising Freedom Party’s agenda is an immediate exit from the EU.
Not to mention Spain, Italy and Greece, where left-leaning parties have long sought to reject EU-mandated austerity measures.
Just small minorities with little national traction? Not quite. According to a recent Pew Research poll, the majorities in Italy, Spain, Germany and the UK believe these new parties are “a good thing.”
In both cases — the USSR and the EU — central governments, once credited with creating “economic miracles,” could no longer address rising economic challenges.
In both cases, there emerged a fundamental flaw in the very structure of the union:
In the USSR, it was inflexible, all-encompassing central planning.
In the EU, it’s an unwieldy central monetary policy, effectively imposing a single interest rate on all countries. Result: Bigger booms in some countries and deeper recessions in others. Worse, a single currency means that member governments forfeit their power to control their financial destinies, including steps they could take to avoid their own fatal bankruptcies.
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Soviet Union: Contrary to popular belief, the critical events that marked the beginning of the end were neither sudden nor unintentional. They were carefully planned, relatively modest reforms in the Soviet system designed to provide appropriate responses to changing times.
Perestroika (The Reformation), introduced by Mikhail Gorbachev in the mid- to late-1980s, gave Moscow ministries some more leeway for independent decision-making, while allowing unwieldy state-run enterprises more freedom to decide production levels based on actual consumer demand.
In parallel, Gorbachev’s Glasnost (Daylight), was designed to provide more transparency and freedom of speech, along with a new foreign policy that gave East European nations the signal that, unlike the old days, Moscow would not send in its tanks to block their own reforms.
But the changes were too little, too late for the Soviet republics and satellite nations; too much, too soon for the union, causing confusion, and unleashing the powerful centrifugal forces I cited above.
The historic trigger event came on May 2, 1989, when Hungary began dismantling its 240-kilometer fence with Austria, opening the first major crack in the Iron Curtain since the construction of the Berlin Wall nearly 27 years earlier.
East Germans and other East Europeans flooded to the West, first directly via Hungary, then via Czechoslovakia, and ultimately by tearing down the Berlin Wall.
Lithuania was the first to unilaterally declare independence, adopting the Act of the Re-Establishment of the State of Lithuania. Estonia and Latvia soon followed. Ultimately, even Russia, itself, adopted a declaration of sovereignty from the USSR, officially recognizing the end of the union.
European Union: While Perestroika and Glasnost were relatively moderate and introduced from the top, the same cannot be said for Brexit, the trigger event that now threatens to dismember the EU.
As I demonstrated at the outset, Brexit is huge, sudden and has struck Brussels from the outside.
Moreover, even as we speak, it’s catapulting anti-European movements to new highs.
Right now, according to International Business Times,
“The Five Star Movement in Italy, which recently won in 19 of the 20 cities it contested in July’s elections, is currently seeking a referendum on Euro membership. In the Netherlands, Geert Wilders’ hardline Eurosceptic Party for Freedom has an astonishing 13 percentage point lead, according to the most recent polls. And even in France, only 38% of people currently view the EU favorably.”
Former Irish Prime Minister John Bruton says Brexit is the most serious crisis the country has faced in 50 years.
And economic experts call it “the biggest breaking point since the Cold War.”
Global trade, already stagnating, could shrink dramatically. The global economy, already slammed by deflation, is bound to take a big hit.
And despite a raft of official statements seeking to minimize the disaster, some high authorities agree: Last week, the IMF slashed its global growth forecasts entirely in response to the Brexit news, predicting a “substantial increase in economic, political, and institutional uncertainty, which is projected to have negative macroeconomic consequences, especially in advanced European economies.”
Can the United States withstand the shock? If the nation had rid itself of major speculative bubbles, perhaps. But as Mike Larson has thoroughly documented in recent months, we can now detect speculative bubbles in …
High-yield junk bonds …
Debt-funded stock buybacks …
IPOs of high-risk companies …
Trillions of dollars of negative-yielding government bonds …
An auto leasing boom fueled by some of the riskiest lending in history …
Not to mention the speculation in commercial real estate.
Your Action Plan
Even more so than before, I suggest you invest with extreme caution. That means five critical elements for any investment strategy:
Quality. Investments that merit the topmost ratings from a totally independent source. Specifically, go to www.weissratings.com and in the second menu from the top, select “Stocks,” “Mutual Funds” or “Exchange Traded Funds.”
(For the reason ratings independence is so important, be sure not to miss my classic article, “Lies, Lies and More Lies” and “Harvard Business School: Ratings Agencies Drop ‘Independence.’”)
Liquidity. Avoid investments where trading volume is low, making it difficult to sell at times when you might need to do so with urgency. Also beware of certain annuities and mutual funds that charge high commissions or exit fees.
Cash. Currently, near-zero yields on short-term money markets is discouraging global investors from holding cash precisely when cash could be needed the most to avoid losses, and later, to pick up bargains. For institutions best able to safeguard your cash assets, go to www.weissratings.com and select “Banks” or “Credit Unions.” Seek to do business with banks rated B+ or better, while avoiding those with a D+ or lower.
Insurance. To help you find the safest and avoid the riskiest, in the www.weissratings.com menu, click on “Insurance Companies.”
Hedges. If you’re still overexposed to risk, continue to follow my hedging prescriptions in “My 7-Step Portfolio Protection Strategy.”
Above all, stay safe.
Good luck and God bless!
Martin (with Anna Zakharchenko contributing from Moscow)