Jewish World Review Oct. 31, 2002 / 26 Mar-Cheshvan, 5763

David R. Kotok

David R. Kotok
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Welcome to the world of an enlarged and open Europe | My wireless email flashed as we headed for the flight to Charles de Gaulle airport on Sunday, October 20th.

"The 'yes' campaign wins the referendum in Ireland to ratify the Treaty of Nice and pave the way for European Union expansion" reported Europe Breaking News.

Conversations in Paris with assorted financial marketeers and journalists lead us to some observations.  A week of mostly rainy Parisian weather did not  dampen our outlook for a successful eastward expansion in Europe.

The ten country expansion of the European Union (EU) will proceed expeditiously and is expected to complete by the end of 2004.  75 million people from ten candidate countries are destined to become part of this greater European economic sphere.  The countries are Estonia, Latvia, Lithuania, Poland, Slovakia, the Czech Republic, Hungary, Slovenia, Malta and Cyprus.  Romania and Bulgaria could be admitted by 2007. 

Turkey remains a subject of political debate and has not been cleared for entry.  To understand this, one must note that EU and EMU member Greece still consumes about 5% of its GDP in defense expenditures because of the enmity between Greeks and Turks.

Detractors of the enlarged EU point to the obstacles.  There are many skeptics and many issues.  Nay Sayers note what has to be negotiated among diverse and socialistic governments with policies that often restrain competition and inhibit economic growth. 

Here is one simplistic example which may be multiplied a thousand times in a thousand industries.   French dairymen do not want to subsidize Poland's dairy farmers who will become their open border competitors.  On the other hand French restaurateurs want the competitive advantage gained from Europe-wide food importation.  French winemakers in Bordeaux don't care because they have a premier position in the European market and the enlargement of the EU will not be of significance to them.  They do not view Eastern European winemakers as a threat to their market share.  That means the Bordelaise will sell their internal French political influence to the highest bidder in return for domestic French policy which favors their industry.  They are wine drinkers and do not care who drinks whose milk.  

The detractor list is as long as one's imagination.  Each points to specifics and the associated difficulties of gaining an agreement.  True enough!  Eastern enlargement will ultimately require a detailed set of rules of trade among these many diverse countries.

Supporters point to the success of the euro and to the potential to enlarge the European Monetary Union (EMU).  They believe the economics of transparency and open borders will overcome those that favor protective barriers.  We agree.

Results so far indicate that EMU members achieve a lower cost of capital and a low inflation rate than non-EMU members.  The two items are connected.  This result is driven by the single mandate, anti-inflation policy of the European Central Bank (ECB). 

Here's an example from the first round of EMU.  Consider that the long term interest rate today in Italy is in the low single digits.  Italy's inflation rate is about as low as the U.S.  Ten years ago this outcome  would have been unthinkable.  Italy then had high inflation and its capital markets were entirely financed by high yielding short term paper.  There were no long term bonds denominated in lira; no one would buy them. 

What is now reality for Italy can be the future for the Eastern countries.  True: not all of the ten countries are presently eligible for admission to the EMU.  And also true that getting into the EU does not guarantee entry to the EMU.  But you cannot get the latter without first getting the former.  And the former is about to be a reality and not a dream.  

The Czech Republic can presently fulfill EMU requirements.  Poland is getting close.  But that is now and not two years from now. 

We expect inflation rates and interest rates among the ten new countries to start converging with those of the existing 12 EMU members.  This was the process that unfolded during the pre-euro years leading up to the original Maastricht treaty.  We expect to see a similar convergence again.

Policy in the euro zone may be best described as tight monetary and easy fiscal.  That means the ECB will have vigilance about inflation on its mind as interest rates are set.  That also means large amounts of euro denominated debt issuance will occur.  It is needed for the enlargement to succeed.  Tight ECB monetary policy insures that the interest rate on that debt will remain low.

The new countries will begin to experience growth before they are officially admitted.   Some investment has already started in anticipation of enlargement.  It was delayed because the Irish referendum failed the first time; that delay is about to be reversed.  The rate of Eastern Europe investment will accelerate.

In sum, this larger Union of European countries will eventually stretch from the Atlantic Ocean to the Russian border and from the Mediterranean to the Baltic Sea.  It will have a larger population than the North American threesome of Mexico, Canada and the U.S.  The euro block and the dollar block will represent over half the world's output. 

In Paris, we sensed a change now that the Irish passed the referendum.  The optimists about Europe believe they can prevail over the detractors.   We believe it, too.  All the important economic issues are negotiable, some are difficult; none are impossible. 

Welcome to the world of an enlarged and open Europe where 1000 years of war, high defense budgets and governmental oppression are going to be replaced with freer trade and greater exchange of ideas.

JWR contributor David R. Kotok is President and Chief Investment Officer of Cumberland Advisors, Inc. His articles and financial market comments have appeared in The New York Times, The Wall Street Journal, Barron's, The Bond Buyer and numerous other publications. He can be seen on CNN, CNNfn and CNBC. Comment by clicking here.


© 2002, David R. Kotok