Much has happened globally since my last post, with most of the news still centering on Europe. The usual back-and-forth of Greek loans vs austerity cuts (and subsequent rioting) has been recently accompanied by a much larger player in the arena, Italy. This isn’t really much of a surprise, since the growth slowdown that’s slammed Europe is making its way through the EU (European Union) members one-at-a-time, with crisis’ hitting the southern periphery due to the excessive debt they hold. What is new however, is the way the Europeans are addressing these crises; they have formally created a new entity to deal with the debt of struggling nations. But before we get into that, the fictional example below may be of help to clarify what is being contemplated.
Let’s say our fictional individual has accumulated an inordinate amount of debt during the boom times of 2003-2007 and now that it’s become unmanageable due to a variety of factors, he’s decided he needs to do one of two things to restore sanity back into his life: either refinance it at historic low interest rates or default on it (bankruptcy). The fastest solution (although with negative consequences) would be default. Doing so would give him a fresh start rather quickly, allow creditors to write off the losses (and know what those losses actually were) and be a sobering lesson that living outside of one’s means only leads to pain. The negative consequences (to him) would be that credit would be unobtainable for a lengthy period of time and his ego might be seriously bruised. The positive aspects would be that the debt might be completely gone (liquidation) or at the least would be paid back on a manageable basis, probably discounted from the original amount. All in all, though, the bottom line would mean that he’d have his fresh start, but recovery would be difficult (he’d have to live within his means, as limited as they might be) and there would be few, if any support resources to help him.
HOWEVER, what if, as an alternative to default, he walked into his local bank and told the banker that he’d like a loan to pay off all of his debt (preferably at zero to 3% interest)? Of course, the first question the banker would ask is what collateral our individual had. The next question would be what his income stream looked like and what the total debts are. Let’s say our individual answered with “well, the only real collateral I have is my house, which is worth about half as much as what I owe and I’m only working part time at present. And oh, by the way, I’m hoping that my creditors will take only half as much as what I owe, especially since I have a few credit cards that I owe on and also that pesky home equity line of credit that never seems to go down. That will help me out a lot. I’m also hoping that I can pay back the loan you’re going to give me with an IOU, since my future income will be much higher than it is right now. Things should get better, right? I mean, they always have…why should now be any different?”
Sounds rather ridiculous, doesn’t it? But before I go further, let me just say that I fully understand that this situation is not fictional at all to many Americans and Europeans. Desperation exists out there for too many people and some relief, any relief, is preferable to the stress of wondering what tomorrow, let alone next year, looks like. And the irony is, that for as many individuals and families that are struggling to work through their own deleveraging process (paying off or defaulting on debt), most of the countries they live in are trying to do the same thing, looking at the same solutions to do so. Ok, I’ll get off my soapbox now.
So why the illustration of our fictional, heavily indebted individual? As you may have figured out, this is basically what is underway in Europe right now. Loans are being given to financially troubled nations with payback dependent on the future ability of those nations to pay. Of course, it’s a bit of an oversimplification, so first some background on the two primary European financial “players”, the ECB (European Central Bank) and the EFSF (European Financial Stability Facility).
The ECB was an entity created in 1998 by the member nations of the European communuity to monitor monitary policy of the euro. Since the EU is comprised of 13 different countries which use the euro for their currency, there needed to be a central bank to manage the common currency (euro). Each country’s contribution was based on a combination of their population and GDP (gross domestic product or what it produces annually), with the starting amount having been approx $5 billion euros. This cash is spread among the ECB’s central banks (member banks), with each bank being a “shareholder”. These “shares” cannot be used as collateral for loans, meaning that each country cannot take out a loan against the amount of shares it has (leverage), thereby attempting to solve its own financial crisis by its own manipulation of the euro (the more euros in the market equals lower value, therefore for a country such as Greece, a lower euro would mean more exports, since the price of the euro would fall in relation to the value of the dollar, thereby making its exports cheaper. The unintended consequence however, would be that the same would hold true for the stronger countries of the EU, such as Germany), making them more competive as well. Further, the ECB’s primary objective is to keep inflation in check (the prices of goods and services). It does this by manipulating the interest rates it charges the member banks, much like our own Federal Reserve does. It does NOT have the ability to “print” or create money as our Federal Reserve does.
What the ECB can and has done (under criticism from some member states) is to buy the debt (bonds) of some of the troubled countries in the EU. This is very similar to what our own Fed has done, in buying treasuries to keep interest rates artificially low. However, while the Federal Reserve is buying US debt, which is arguably from a stable economy with a stable government (therefore with low volatility), the ECB is buying debt from economies which are unstable at best, highly volatile at the worst. What this means is that the ECB is buying debt that may or may not pay full value at maturity and in fact, may not be able to make the interest payments during the life of the bond. If it cannot do either, a real risk is created where the value of the euro may be in jeopardy, since those bonds might not get redeemed for what was paid for them. Indeed, they might not get redeemed at all. Such a scenario would cause a severe loss to the ECB, since those assets would now, at best, become worth only a fraction of their initial value or become worthless entirely. And it isn’t just the ECB’s member banks that are at risk; any pension fund, foreign government or corporation which bought those bonds are also at risk. This type of risk is what’s referred to as “sovereign debt risk”, because the debt of the troubled country finds its way outside of the host country into other entities, thereby infecting other countries’ institutions, as well as running the risk of not paying back those who bought it (default). Another problem of bond buying is that the ECB’s pockets are only so deep; since they cannot “print” money, their ability to relieve the troubled nations of their debt is limited.
While the ECB was confident it could manage the Greek situation (it’s too easy to say “Greek tragedy”) by granting loans in return for the Greeks drastically cutting expenses and living within their means, it became clear that as other member nations started experiencing their own debt difficulties, another entity would be needed to stem the tide of all-out contagion. As mentioned above, we now have Italy coming right behind Greece with its own debt fiasco. Italy is not Greece, in that it is the third largest economy in Europe and contributes much to the global economy. Therefore, the creation of the EFSF is either insightful (to help fund countries in need) or another example of the region “kicking the can down the road” (since the fundamental problems, notably debt and spending, have not been dealt with).
The EFSF is an entity that was created on May 9, 2010 to help financially troubled EU countries. The basic idea is that, unlike the ECB, it creates bonds, which it sells and utilizes the proceeds to give loans to those countries undergoing financial difficulties, either by capitalizing banks (deposits) or by buying government bonds. The actual EFSF bonds are backed by guarantees by the euro nations (13 of them) in proportion to their share of capital in the ECB. This is called the “ah-ha” moment. Two things should stand out clearly here: first, the bonds that are being created are going to be backed by those very same nations that they’re supposed to be helping. What this means is that the ability of those countries to pay back their loans is completely contingent on their ability to grow their economies at a rate that’s substantially higher than the norm, which will be difficult considering the austerity measures that will undoubtedly be forced upon them in return for those loans. Additionally, the growth rates of most of those countries will be dependent upon exports, since most economic growth from southern Europe is export driven. This means two things: US appetite for European goods must increase dramatically (along with Japan, China and other emerging markets) and the euro must lose value for the price of those goods to be competitive with, you guessed it, China and other emerging markets.
The second “ah- ha” factor is that, since Germany is the 900 pound gorilla in the EU room (they have contributed most of the ECB capital), they hold quite a bit of the responsibility and arguably, “say” in what the criteria will be for helping these nations out. This is why European news events ALWAYS revolve around what Germany (and to a lesser extent France) either decide or don’t decide on. Whatever the eventual outcome is for those nations that need a loan will be, Germany (and France) will be directly affected by it. If those countries needing loans do in fact eventually recover, the overall strength of the euro (and the area) will eventually strengthen as well, since it will attract investment; if they don’t recover, the euro will weaken, thereby weakening the overall area via a flight to stronger currencies.
To sum it up, financially strapped nations are guaranteeing bonds sold to help those same nations out, to be paid back by higher than normal growth while under austerity agreements (lower taxes, see “The Irony of Austerity”), utilizing a currency that’s trading above the dollar. And since eventually there will be more nations taking advantage of this “program”, the question which arises is, “who’s going to buy all of these EFSF bonds”? And did I mention that these bonds are all rated AAA? Another question is “can everyone simultaneously grow their economies while paying their way out of debt”? Not likely. The only solution I can think of is that we all need to do our global duty and buy that Ferrari and some Greek olives! But save some cash; you’ll need to buy something Irish and Spanish as well. Hope as a strategy, indeed! At this point your head may be spinning, as common sense seems to have moved on to a distant planet. But, as they say, “wait, there’s more”. We haven’t discussed the size of the EFSF program.
The initial size of the program was 440 billion euro (its lending capacity), but can be increased by 60 billion euro using the EU budget as collateral (they’d better get growing!). ADDITIONALLY, there is another 250 billion euro that can be tapped into the IMF (International Monetary Fund), for a total of 750 billion euro lending capacity. Once again, two points to be made here:
First, the IMF consists of 187 members (nations) from around the world (including the United States). This brings a whole new dynamic into the picture. If the full lending capacity of the EFSF is utilized, not only will European capital (money) be at risk, but other nations’ capital will be as well, since they contribute to the IMF. This raises the political argument of whether US dollars should be used to help save the European continent at a time when we’re having to deal with our own budgetary/debt woes. Further, it’s fair to ask if we should be partially funding our competitors versus our own domestic companies/institutions. Once again, just how many customers are out there and how can all the global nations grow out of the same problem at the same time?
The second point is that in terms of the size of the EFSF, numbers being tossed around to save Italy are approaching 300 billion euro. If most of that money will be used for just one country, what about others that may (will) need it? What about Spain? Portugal? Ireland? Italy’s problems are on the front burner at present, but others are sure to follow. Just this week Italy’s 10yr bond yield surpassed 7%. This is what happens when the bond market suddenly sells bonds at heavily discounted prices due to a lack of confidence in a government (remember, there’s an opposite relationship between price and yield of bonds). At present, it’s a bit below that, but only because Italian Premier Silvio Berlusconi has agreed to step down; no formal solutions to Italy’s debt problems have been reached. No nation can continue to pay its mid term debt when servicing that debt increases to 7%.
As I said earlier, common sense, like Elvis, has “left the building”. Surely, some nations will be saved, but some must default. Italy for one, as the region’s number three economy, is being categorized as too big to fail. A massive default by them would plunge Europe into at the very least, a severe recession. Probably more like a depression. Italy has a chance of growing its way out of its problems, but I’m not completely convinced. The political will to force austerity via spending cuts while attempting to stimulate industry might not be there. And, as stated earlier, there are other countries in the same situation. Others, like Greece, remind me of the old saying “throwing good money after bad”. Their outcome is eventual, if only because their export economy is too small to pay back all the loans they have (or might) receive.
Two things are certain: first, not all of Europe’s nations can accomplish the same goal at the same time. It’d be like all the teams in either NFL conference all going undefeated in the same year. The decisions to be made will not be easy and the problems are coming fast. Secondly, like all problems, these will get worked out. Maybe not in the way most want, but they will. And as they do, however long it takes, new opportunities will unveil themselves and money will be made. Most importantly, lessons will be learned.
Thank you for reading.
DB
