The Future of Europe

We have all heard the range of opinions on the effects of the sovereign debt crisis in the European Union.  Greece has gotten the most press as their crushing debt load and rapidly declining economy has their citizens up in arms.  We have all seen the footage of peaceful protests on the Greek Parliament building turning suddenly violent and scary.  Portugal and Ireland are the next worse off in terms of their balance sheets.  Both have large overall debt loads and large current deficits that need to be addressed.  The most recent fear is that of Italy and Spain who have each much larger economies and therefore pose a drastically greater threat to the global financial system.

The question then is how does this whole situation get resolved?  To answer that question we look a little deeper into the situation and ask further questions.  Who are making these decisions?  What are their primary interests?  Who are their constituents and what do they feel about it?  All in all its a messy situation but one that I think has a logical outcome.  One that is not nearly as scary as some people might think.

The Problem
Greece is a failed economy at the moment.  Every ounce of austerity that gets passed is causing massive civil unrest.  The Greeks have been used to a certain lifestyle, and now because of excess spending by the government, who paid investment bankers lots of money to keep their large amounts of leverage hidden, its time to pay the piper, and everyone has empty pockets.  While some commentators call out the Greek people by saying they were living beyond their means with very generous government benefits which they did not pay for, (in Greece you are considered a sucker if you pay your taxes), I think the Greeks have a legitimate beef.  Their government told them that this way of life was ok and that it was sustainable.  Now the government pulls back the curtain and says “sorry, we were wrong and the party is over”.  Its understandable to be a little upset at that situation.

What revealed all these problems, of course, was the 2008 financial crisis.  The only thing that keeps the party going for a country like Greece is the ability to keep borrowing, and keep hiding the liabilities.  Once that merry-go-round stops, the game is up.  Now the risk is that by defaulting on its obligations, Greece brings into question all the other financially challenged nations in the Euro-zone.  Creditors think “If Greece defaults, what is to stop Portugal and Ireland?” and therefore demand higher interest rates to continue to lend to these countries.  This higher interest rate increases the cost of funds, and thereby makes a difficult financial situation even harder, making it a vicious circle of decline.  The endgame being the default of Italy and Spain, which would hamstring the entire European economy and throw the entire global economic system into a funk for many years.

The Likely Solution
The only way to stop this kind of negative feed-back loop is to get out in front and make a credible back-stop at some point in the Domino chain.  Its obvious to everyone in the financial markets that Italy and Spain are “Too Big to Fail” and need to be included in that backstop.  The question is, where do they get the funds to make this kind of back stop?

That’s also the main question with the recent resolution that was passed.  Sure the European Financial Stability Facility (EFSF) has been boosted on paper to around one trillion Euros, but where is that money coming from?  The banks are being asked to take “voluntary” (key to avoid a “credit event” default) haircut on Greek debt of 50%.  Where do they get the extra capital to keep their balance sheets in good shape?  Assuming 50% mark-down on Greek debt is one thing, being that its a small amount, but now we have Ireland and Portugal getting in line to get some “voluntary” forgiveness as well.  The amounts of losses and the drain on bank capital is growing.  Where does it stop?

The most likely resolution is going to have to include a global coalition to support bank debt.  The Europeans have enough capital on paper to address the potential losses, but not enough to sufficiently “shock and awe” the credit markets into believing that a resolution will hold up.  And, much like the “Lehman Moment” of 2008, as confidence continues to falter, the losses continue to mount.  It becomes a problem of chasing a moving target, where you cant aim at the size of the problem where it is now.  You have to lead out a sufficient distance and tackle the problem as it could grow to, much you like a quarterback has to lead a receiver downfield.

I regret to inform everyone here in the US, that we will all be a part of this solution eventually.  In a time of increasing austerity, and suspicion of bail-outs, it will be a political nightmare to announce any kind of assistance to this problem.  We had enough trouble bailing out our own financial system.  But I don’t think it will be all that bad, and people will need to realize the necessity of this situation.  First of all, China will NEED to be included for this all to work, however, China will definitely not go it alone.  They will need the assurances of the US that they will cooperate as well.  How big this eventually gets in terms of the commitments needed, I have no way of knowing.  But they are coming, and hopefully with a combined effort between the two largest economies in the world, no actual capital will have to be deployed, but merely placed on the table to reassure the markets.

Will the EU Hold Together Under the Weight of this Crisis?
The answer to this question is unequivocally yes.  Very quickly there are two main reasons for my confidence in this.  The first is that the Maastricht Treaty which formed the EU holds no provisions for countries to exit.  Just like the Hotel California, you can check in, but you can never leave.  Therefore, there would need to be an amendment passed by all member countries to arrange for some type of exit strategy.  Euro leaders have made it abundantly clear that this is not currently on the table.  Some would say this is posturing and that they are looking into behind the scenes, but I am not so sure.  That leads us to the second reason, which is incentives.

What happens if Greece leaves the EU from the perspective of just Greece and Germany.  For Greece, they would go back to using the Drachma as their currency.  This currency immediately becomes worthless as it is backed by a failed economy.  All their debtors have to work out some form of payment in a combination of Drachma and Euros.  This doesnt just go for the sovereign debt, but every single foreign financial obligation from every business in Greece.  The logistics of working that out are nightmare-ish at best, and (I would guess) impossible at worst.

For Germany, they would also be adversely effected by such an event.  Germany is an exporter of high-value specialized manufactured goods.  If Greece leaves the Euro-currency it instantly becomes stronger, and therefore makes all of these German goods more expensive.  In an environment where growth is hard to come by as it is, the Euro becoming more expensive is a headwind that the Germans can ill afford.

The Bottom Line
I am optimistic at the end of the day, despite the fact that every analysis I have read from every analyst out there, says otherwise.  The solution agreed upon last week was a start, and greatly exceeded market expectations, but is clearly not a long-term solution.  It has shown that the leaders in Europe have a political will to keep this European experiment moving forward.  The simple fact is that these countries need each other, and despite the line from all the doubting pessimists “calls to China for money are not going to work”, the rest of the world needs a functional Europe.  China will go along if it can get the US, Japan, and other governments to put some skin in the game.

We have to all look at this situation through the lens of the costs and incentives of possible outcomes.  Euro Area Depression and destruction is not good for anyone, and a chaotic destruction of their financial system will un-hinge the global economy.  So while analysts correctly predict that a solution will be difficult, the alternative is unacceptable, and avoidable with global coordination.

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