The situation is Europe is deteriorating and more people are realizing this. They are also realizing that none of the solutions are very good, either. To summarize, Europe has too much sovereign debt, which is on the books of its banks, which also have too much debt; and there is a huge trade imbalance between core and peripheral Europe. All three problems must be solved in order to prevent the Eurozone from imploding. While the debt is the focus today, the trade imbalance is the biggest problem. It is impossible for a country, without gimmickry or without creating larger problems, to balance its government and business deficits while running a trade deficit in the long run. This is true for all countries at all times.
The Eurozone must find at least €3 trillion, and some think the true amount is closer to €6 trillion, to pay for the sovereign debt “haircuts” and bank losses. This cannot be found by borrowing or creating a special fund. The only way to deal with it is to allow the ECB to print more euros, essentially putting a floor underneath Eurozone bonds, especially those of Italy and Spain, both of which governments are too big to save by conventional means.
Nikolas Sarkozy is arguing that the ECB must be allowed to deal with the bank problems by supplying whatever funds are needed. This is of course his position, as French banks are so insolvent that it is not possible for France to bail them out and remain an AAA-rated country. If France loses its AAA rating, the EFSF debt rating is essentially meaningless and the fund will be downgraded – and this will be disastrous as its borrowing rate would increase above 7% - the rate currently recognized as the ceiling to keep the payments at a realistically serviceable amount.
If the ECB does not backstop the banks and Italian and Spanish debt, the Eurozone will fall into a deflationary debt spiral. The large majority of European banks are basically insolvent. They simply hold too much sovereign debt of all types, at leverages approaching 40 to 1. They have this debt on their books at face value. Even a write-down of 10% wipes out most of their capital. It would be an unmitigated disaster. The bank regulators have no clue what mark to market means, but the market does. Bank financing dries up quickly and there is a default moment. Allowing banks and sovereign governments to default at the scale we are talking about means Europe would be plunged into a depression. That of course means the value of the euro would plummet. And enormous fallout would be exported.
Angela Merkel has been adamant in being against the ECB printing money to bail out Europe. It would mean a devaluation of the euro. Merkel’s stance underscores German reluctance to assume more liability for taming the debt crisis even as it moves on to France, the euro region’s second-largest economy, and threatens to trigger a global recession. This is perfectly understandable.
The London Telegraph recently published a six-page document, attributed to the German Foreign Ministry, suggesting that partial bankruptcy must be made possible for all euro members "unable to achieve debt sustainability. There must also be the option of an orderly default of struggling euro members to reduce the burden on taxpayers" in other Eurozone countries that are paying for its bailout, the document said.
Merkel and Germany are playing a very high-stakes game with France in particular and the rest of Europe in general. Germany is in a game where the costs of leaving the euro, or a real euro break-up, are extremely high. But the costs of bailing out the spendthrift members of the Eurozone are also extremely high. Either way the cost is formidable. It is not a choice of whether they will bear a huge cost burden, but just what form that burden takes.
The Germans would like the rest of Europe to get their budgets and deficits under control before they have to accept those costs. Not getting those agreements means that there will be no end to the amount of money Germany will have to pay. It would eventually put their own credit rating at risk. They can envision how that works out. Without real spending controls, what disciplines a nation to not spend as much as it can get away with? What Germany wants is for some mechanism to ensure (and assure their voters) that the rest of Europe will control their deficits. And that means some type of European-wide control on spending and for governments to give up their sovereignty in exchange for the backing of Germany and/or the ECB. Without some sort of real controls in place for national deficits is not a solution from the German taxpayer point of view. Allowing the ECB to print without real fiscal guarantees from the various beneficiary governments simply postpones the inevitable and means a great deal of cost in the meantime.
France cannot backstop its banks without losing its AAA rating. And if that happens before the elections next year, Sarkozy is toast. Further, if they really nationalized their losing banks, it would put them in a very precarious financial position. The French economy is already very dependent on government spending. Taxes are about 46% of GDP and government spending is 53%. The national debt is at 82% of GDP and rising, as the annual national deficit is 5.7%. France is likely to grow at less than 1% for the year and is also likely to slip into recession along with the rest of Europe in 2012. If they do slip into recession, the deficit will rise as costs explode and revenues fall. Not a good thing when the markets are beginning to question your debt. French interest rates on its ten-years bond rose to 3.72% this week. That is about 1.9% over German bonds. Just a few years ago that difference was less than 20 basis points (0.2%). That is the market clearly indicating concern about French debt.
Both Italian and Spanish 10-year debt rose to over 7% this week before the ECB stepped in and bought €10 billion of the debt, bringing rates back into the mid-6 range. Without ECB buying, the interest rates would be soaring.
The markets are beginning to wonder, what is the difference between Italian and Spanish debt and Greek and Portuguese debt? Rising interest rates make it even harder to get your deficit under control. France has an even larger future-liability problem than the US. And taxes are already at a level that any increase is just not really useful and could hurt more than it helps. And if you think the Greeks don’t like austerity, try cutting French farm subsidies or pensions or government salaries. The streets will erupt. And I think that it’s going to happen – it’s just a matter of when. This is why Sarkozy is trying to get Europe to backstop the banks and limit the banking crisis. They are approaching the theoretical limits of their economic ability to absorb more debt, and the market knows it. This is why he is opposing the German plan. It means a disaster for France.
No matter what Europe does, not matter what Germany and France do, Europe is in for a lot of pain. Recession most assuredly and likely a severe one, if not a depression. There will be discontent in the streets. From a European perspective, printing money is a real problem, and for some countries an economic disaster. But what the US and the rest of the world needs is for Europe not to let its banking system implode. A recession will hurt exports, but Europe only accounts for a little over 10% of US exports. Losing even 20% of that is a problem, but not a disaster. What is a disaster is another 2008 banking crisis.
The US, while not robust, is (maybe) growing at 2-3%. While not generating enough jobs to really make a serious dent in unemployment, the economy is not making the situation worse. But that could change. The concern is the European banking crisis coming to the US and the rest of the world. And recent data suggests that the markets are beginning to share that concern.
Credit spreads are rising, as is the cost of interbank funding. The credit default swaps on the banks that participate in the interbank lending market, have shot up to levels beyond what was seen during the Lehman crisis. The CDS’s are telling you that “smart money” has grave doubts about the solvency of the interbank lending market. And we are seeing spreads begin to widen in the US. They are not at levels that suggest a crisis is imminent, but they are worrisome. And this is the type of thing that you see before a crisis becomes evident. Credit market turmoil has a very nasty way of leaking into all market prices.
The markets are right to be focused on Europe, because the Europeans could bring the whole thing down on our collective heads. We must hope they get it right and that someone really decides what to do, instead of bluffing. The US stock markets are also going to continue to be headline driven until they do.
It is doubtful if the euro will survive with the current mix of countries. Greece is likely to go, as is Portugal. Can Spain really get its deficit under control in time? Do we see a “two-euro” world, one in the northern states and one in the southern? So many choices and none of them good. But the enormous danger here is the implosion of the Europe banks – because fallout will come to the U.S.
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