Europe and the European Union have some very big problems. These problems will almost certainly detract from the economic growth of Europe over the next few years and have some dampening effect on the rest of the world.
Attention has been focused on Greece, but other countries in the EU, namely Spain, Portugal, Ireland and Italy, are also suffering from debt loads that will make it difficult to generate satisfactory growth while, at the same time instituting fiscal austerity. Members of the European Union have pledged to constrain fiscal deficits to 3% of GDP and government debt to 60% of GDP. Greece’s deficit is 13% of GDP and debt is 120% of GDP. The unemployment rate is 10.6%. Spain’s numbers are 11% and 66%, with an unemployment rate of 20%.
While Greece is in the most serious position by a considerable margin, all of the so-called PIIGS (Portugal, Italy, Ireland and Spain) have problems with the same basic roots. When the European Monetary Union was created, they were admitted with currencies that were overvalued relative to the more northern countries, Germany in particular.
Let me quote John Mauldin’s latest letter, which has an articulate explanation of what has and is happening:
“That (the undervalued currency) meant that Greek consumers could buy products and services that previously may have been out of their reach. Plus, with government debt at low rates, the Greek government could borrow more to finance deficit spending, without the threat of higher interest rates. And Greece began to increase its debt with abandon.
Additionally, as it now turns out, Greece basically lied about its finances in order to gain admission to the union. It never complied with the fiscal discipline that was required for entrance.
With the high exchange rate, however, came the consequence of higher labor costs relative to, above all, Germany. While reviewing some economic facts about Greece, I came across the factoid that Greek workers had the second highest level of actual hours worked. But even with that, Greece was running a trade deficit that is currently 12.7% of its GDP.
And with the onset of the current recession, their fiscal deficit went from bad to worse. Their total debt is now €254 billion, and they need to finance another €64 billion this year, €30 billion of it in the next few months.
Bottom line, without some help or a bailout, they simply will not be able to borrow that money. And since a lot of that money is for “rollover” debt, that means a potential for default if they cannot borrow it.
European leaders said today that Greece will not be allowed to fail, hinting of a bailout. But there are a lot of “buts” and conditions.
Between Dire and Disastrous
While German Chancellor Merkel has indicated a willingness to help, the German finance minister and other politicians are suggesting German cooperation will either not be forthcoming or only be there at a very high price; and the price is a severe round of “austerity measures,” otherwise known as budget cuts. Greece is being told that it must cut its budget to an 8.7% deficit this year and down to 3% within three years.
For my American readers, let’s put that into perspective. That is the equivalent of a $560-billion-dollar US budget cut this year and another such cut next year. That would mean huge cuts in entitlements, Social Security, defense, education, wages, subsidies, and on and on. And repealing the Bush tax cuts? That would just be for starters. No “let’s freeze the budget” and try and grow our way out of it, as we effectively did in the ’90s, or gradually cutting the budget a few hundred billion a year while raising taxes. That combination of tax increases and budget cuts would guarantee a US recession. Unemployment, already high, would climb higher.
And yet, that is what the Greek government is being asked to do as the price for a bailout.
A few facts about Greece. Some 30% of its economy is underground, meaning it is not taxed. In a country of 10 million people, only 6 (!!!!) people filed tax returns showing in excess of €1 million in income. Yet over 50% of GDP is government spending, and Greece has one of the highest public employee levels as a percentage of population in Europe. And its unions are very powerful. Nearly all of them have gone on strike over this proposal.
A National Suicide Pact
Now, here is where it actually gets worse. If Greece bites the bullet and makes the budget cuts, that means that nominal GDP will decline by (at least) 4-5% over the next 3 years. And tax revenues will also decline, even with tax increases, meaning that it will take even further cuts, over and above the ones contemplated to get to that magic 3% fiscal deficit to GDP that is required by the Maastricht Treaty. Anyone care to vote for depression?
And add into the equation that borrowing another €100 billion (at a minimum) over the next few years, while in the midst of that recession, will only add to the already huge debt and interest costs. It all amounts to what my friend Marshall Auerback calls a “national suicide pact.”
Normally, a country in such a situation would allow its currency to devalue, which would make its relative labor costs go down. But Greece is in a currency union, and can’t devalue. Or it would restructure its debt (think Brady bonds) to try and resolve the problem.
The dire predicament is the one where Greece cuts its budgets and more or less willingly enters into a rather long and deep recession/depression. The disastrous predicament is where they do not make the cuts and are allowed to default. That means the government is plunged into a situation where it has to cut the entire deficit to what it can get in the form of taxes and fees, immediately. As in right now. And defaulting on the interest on the current bonds wouldn’t be enough, although it would help.
Why not just let Greece go under? Part of the argument has to do with moral hazard. If Germany bails out Greece, Ireland, which is actually making such cuts to its budget, can legitimately ask, “Why not us?” And will Portugal be next? And Spain is too big for even Germany to bail out. At almost 20% unemployment, Spain has severe problems. Its banks are in bad shape, with large amounts of overvalued real estate on their books (sound familiar?) and a government fiscal deficit of almost 10%. While Spanish authorities say they can work this out, deficits will remain high.
The fear is one of contagion. Some argue that Greece is only 2.7% of European GDP. But Bear Stearns held less than 2% of US banking assets, and look what happened.
I have been trading emails with Lisa Hintz of Moody’s, and she sent me the following note:
“It turns out from the BIS [Bank of International Settlements] numbers, that the largest holders of Greek debt are French, followed by the Swiss, although my guess is that a lot of that is hedged, and I don’t know that the BIS picks that up, and then the Germans. The numbers as of last June were France €86 billion, Switzerland €60bn, and Germany €44 billion. I have seen more recent numbers of France €73b, Switzerland €59b, and Germany €39b. In terms of GDP, for Germany it is minimal – just over 1%. Of more concern, for France it is nearly 3%, and for Belgium 2.5%. For Germany, the debts of Ireland, Portugal and Spain are much bigger problems. They may, however, worry that if there is a contagion, they will have to take marks on that debt. That would be a real problem – nearly 15x the size of the Greek issue.”
The recent credit crisis was over a few trillion in bad, mostly US, mortgage debts, with most of that at US banks. Greek debt is $350 billion, with about $270 billion of that spread among just three European countries and their banks. Make no mistake, a Greek default is another potential credit crisis in the making. As noted above, it is not just the writedown of Greek debt; it is the mark-to-market of other sovereign debt.
That would bankrupt the bulk of the European banking system, which is why it is unlikely to be allowed to happen. Just as the Fed (under Volker!) allowed US banks to mark up Latin American debt that had defaulted to its original loan value (and only slowly did they write it down; it took many years), I think the same thing will happen in Europe. Or the ECB will provide liquidity. Or there may be any of several other measures to keep things moving along. But real mark-to-market? Unlikely.
The entire EU is faced with no good choices. It is coming down to that moment of crisis predicted by Milton Friedman so many years ago. And there is no agreement on what to do.”
So Europe is not a pretty picture. It is difficult to imagine a painless solution that will preserve the economic integrity of the EMU and the Euro. I have to believe that the growth of the entire region will be affected by the austerity budgets that must be instituted by the PIIGS. There will be increased labor strife, and bitter political fights, both internal and external.
The implications for investment portfolios? Unless you think you are expert enough to navigate these waters you should be very cautious about having significant portfolio positions in European securities. Other parts of the world should be strongly preferred.
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