America First? When it comes to GDP we get the bronze!

America First? When it comes to GDP we get the bronze!

Yesterday we talked about how the American economy, despite all the euphoric headlines since the election, didn’t deliver much of a performance in the fourth quarter and in fact we saw the weakest full-year GDP growth rate since 2011 which was well below the U.K.’s 2016 growth rate of 2 percent. Today we learned that the Eurozone as well kicked our economic tuckus in 2016.

GDP grows 0.6% in final quarter of 2016, beating expectations and taking annual figure to 1.8%

Yep, that hurt. So much for America being the “cleanest shirt in the economic laundry.” Despite headwinds ranging from the accelerating Greek drama to the mountain of Italian non-performing loans that led to the nationalisation of Banca Monte dei Paschi di Siena, Brexit, failed Constitutional reforms leading to the resignation of Prime Minister Renzi in Italy …. the list goes on, they beat us.

 

Last week talks between the U.S. and Mexico hit a serious bump after a President Trump Tweet led Mexico’s President Peña Nieto to cancel their upcoming meeting, while the administration has been threatening a 20 percent tax on imports from Mexico, which would put serious upward price pressure on, (among other things) fruits, vegetables and auto parts. Today Peter Navarro, Trump’s top trade advisor, accused Germany of currency exploitation. According to the FT, “In a departure from past US policy, Mr Navarro also called Germany one of the main hurdles to a US trade deal with the EU and declared talks with the bloc over a Transatlantic Trade and Investment Partnership dead.”

While last week’s meeting with the British Prime Minister Theresa May ended with some serious hand-holding, over the weekend the President’s sudden implementation of an immigration ban left, “our closest ally flailing after the UK government was openly contradicted by US diplomats over which British nationals were covered by the measure.”

After Trump’s election victory, the Bank of Japan was initially more optimistic about more favourable economic conditions amid expectations for stronger American growth. That enthusiasm has been fading as yesterday, ahead of a two-day policy meeting, officials are less optimistic about the impact on Japan’s economy. According to the Wall Street Journal, “We now realise that we know very little about him.”

Trump’s team has been poking our allies in some uncomfortable ways, making many around the globe nervous, and yet the VIX (a measure of implied volatility) is pretty much yawning.

The 90 percent of the America economy that is not represented by either inventory build or state and local government spending managed to grow at a whopping 0.6 percent annual rate in the fourth quarter.

Amidst all this, the Fed keeps talking about further rate hikes

Under Armour (UA) just released its fourth quarter and full year results and was yet one more citing currency headwinds.

Upon the announcement of Trump’s immigration ban on Friday, the markets started to fall. Monday the S&P 500 fell 60 basis points and is now down 0.76 percent from its most recent closing high last Wednesday. Bespoke compiled headlines over the past few days that reveal concerns the Trump hope trade is starting to fade.

Is this an inflection point? Too soon to tell, but we can say that having an administration with no political history who has pretty much tossed out the rule book is likely to cause heightened volatility, which is not reflected in market pricing. Erecting trade barriers and surprising the market, let alone allies, is likely to induce more caution in the C suite.

This morning we also saw that compensation costs in 2016 rose 2.2 percent, significantly faster than GDP of 1.6 percent, which makes another Fed hike more likely. We’ll be hearing from the Federal Reserve on Wednesday and will be looking to see if the tone from the FOMC meeting is more dovish than we heard in Fed Chair Janet Yellen’s testimony on January 19th. We will also hear from over 100 companies this week on their earnings, putting the relative complacency in the markets to a test.

Source: Eurozone’s economic recovery picks up speed

Greek Crisis with Neil Cavuto

On July 6th I spoke about the Greek Crisis with Neil Cavuto, a tragedy which is starting to feel like a Sisyphean set of negotiations stuck in a Groundhog day style loop. Bottom line is Greece cannot be expected to honor its debts. Any additional debt is simply a form of much needed aid, to help the country until it comes to terms with the reality of just how many promises that have been made to its citizens will need to be broken. This Greek tragedy reveals the extent to which all nations within the Eurozone may be forced to give up their sovereignty when things get really tough. The concept of the Eurozone was intended to ensure peace between nations weary of centuries of war and prosperity for all.  Prosperity is a long way off for many and peace, well the level of acrimony is becoming dangerously high.

Germany and Greece: An Impossible Relationship?

Germany and Greece: An Impossible Relationship?

This morning the markets in Europe rose giddily on the belief that the problems with Greece were resolved, despite the bureaucrats insistence that they were in fact, not at all. By late afternoon in Europe, it had become clear that there was no resolution, but the talks continued. I swear I’ve had breakups that seemed an awful lot like this!

Most people have at some point in their lives been in a relationship, be it romantic or platonic, with another person who has a different view  of “The Way Things Ought to Be.” This can be over something as mundane as how frequently one ought to exercise to how much and how loudly one ought to laugh or perhaps just how much fun is appropriate in one’s life or the really volatile one, just how wild one ought to get into the wee hours!  Having a material discrepancy over “The Way Things Ought to Be” can be highly destructive to the relationship, leaving both parties fuming at each other in an indignant, self-righteous huff.

Germany and Greece: An Impossible Relationship?

A giant banner protesting Greece's austerity measures hangs near the Parthenon on Acropolis hill in Athens early May 4, 2010. A group of demonstrators from Greece's communist party, KKE, staged the protest atop the Acropolis as Athens braced for a 48-hour nationwide strike by civil servants which would also include the shutdown of travel services.    REUTERS/Pascal Rossignol  (GREECE - Tags: EMPLOYMENT BUSINESS POLITICS CIVIL UNREST)

 

 

 

 

 

 

 

These two are the sovereign equivalent of that couple that seems rather fascinated by each other, perhaps some seriously passionate sparks on occasion, but are eventually at each other’s throats, utterly baffled as to how the other cannot see just how clearly WRONG they are! Each is convinced that if they just lay down the law and point out precisely what the other ought to be doing instead of what they are doing followed by an ultimatum, the indisputable “rightness” of their position will become clear and they’ll get their way… because that’s so often how human nature works!

Deep in German culture is a profound belief, darn near religious, that inflation can never be used to manage debt.  For Greece, that’s a bit like arguing ouzo is best used as a floor cleaner! The nation has been wracking up debt then discarding it in a variety of ways, often via inflation for over two centuries. Carmen Reinhard and Kenneth Rogoff, in their book “This Time Is Different,” determined that between 1800 and 2008, Greece spent 50.6% of the time in default or restructuring!

Germany on the other hand derives great joy and satisfaction from strictly following the rules – tell that to a nation so tied up in bureaucratic red tape that trying to resolve the proper way to handle something there goes a bit like this.

A Greek entrepreneur goes to a public agency and asks, “What do I need to be able to do this thing X?” 
Answer: “A, b, c, d, maybe e, probably f, not sure though about g.”

Hmmm, OK… so our entrepreneur goes to another agency and asks the same question.
Answer: “E, f, not sure about a, definitely not c but definitely g and we’ve never heard of b.”

Exasperated our entrepreneur seeks the advice of a prominent attorney, thinking they’ll be able to properly chart the course, only to discover that they’ve got no idea either.  There are so many laws sitting on top of contradictory laws and regulation upon regulation that there is no clear answer.  Ta da!  Welcome to graft.  If there is no one clear answer on the books, you just have to buy a temporary one from whomever is in charge that day.

In the end our entrepreneur gives up, forgets trying to build a business and gets a job as a public employee!

So here’s the  problem now.  Germany thinks that if it strong arms Greece out of the eurozone, the rest of the eurozone trouble-makers will get scared straight, fall back in line and Germany can relax that everyone will from now on start playing by the rules. So far what Germany is pushing will not allow Greece’s economy the room it needs, culturally and financially, to change – “Dear Eurozone: I love you but you are just no good for me.”

What if Greece gets the boot, defaults, starts all over again and after a while its economy is more robust than Italy’s or Spain’s?  That’d be a bit like having one’s ex show up to a friend’s party with their gorgeous and very successful new significant other; more than just a little bit awkward.

Can’t you just see the love?

Shove It! A Greek Tragedy?

Shove It! A Greek Tragedy?

The headlines are once again dominated by the living Greek economic tragedy, vacillating between dire predictions of a Greek collapse and ensuing global financial calamity to ebullient, (and frankly rather ludicrous) stock market jumps of joy on hopes of a pseudo happily-ever-after. Conventional wisdom has been to lambast the Greeks with the usual damning triumvirate of a nation whose citizens are either lazy, stupid or evil… or all three. The nation is currently in a technical default, having failed to make payments already due on loans to the International Monetary Fund (IMF), but has claimed that it will make a single lump sum payment later in the month for all monies due in June. The size of the Greek debt relative to GDP is second only to Japan, which given its ability to control its own currency is a very different animal.

Debt2GDP

 

To put the level of Greek debt in context, at a total of $352.7 billion, it is about half of the $700 billion that was approved by Congress for the Troubled Asset Relief Program in 2008.   So in the context of global debt, it isn’t that big of a deal, what is a big deal however is the precedent the situation will set for the Eurozone, the second largest economy in the world. I can’t imagine just how much coffee and antacids have been consumed this week in Luxembourg, as all sides find themselves stuck between a rock and a hard place, with no clear common ground.

As for that excruciating austerity we keep hearing about, meaning the cuts governments were wailing about having been forced to endure. Errrr, hmmmmm, not so sure where that is coming from when we look at data from the IMF on the next chart….

EuroDebtByYear

Spending cuts? Where? All three countries have increased their debt to GDP ratios since the crisis began. So here’s the real scoop.

 

Greece has a massive government full of rules and regulations on darn near everything that makes it very difficult to start or run a business and a tax code that makes War and Peace look like a summer beach read. Now all these rules, regulations and taxes were put in place for ostensibly good reasons, like most bureaucratic shenanigans, “We need to protect hotel employees, cab drivers, restaurants, nurses, fishing boats, gardeners etc. etc. etc.” The problem is that when you add up all this “protection” for existing businesses, employees, consumers, tradespeople… it becomes increasingly tough to run a business.

 

To make up for just how tough it is, the government has made it a practice to promise people lots of safety in the form of pension systems, welfare aid, etc. The math here isn’t too tough to figure out. If on the one hand you make it really hard on people to get things done and on the other hand you provide ample support for a decent living for those who aren’t working for whatever reason, well you’ll have less people working their tails off, which means less money available to tax and spread around to those who aren’t working. But that’s ok, because hey, we are part of the Eurozone and can get debt cheap, so we’ll just borrow whatever we can’t get through taxation and spend that. No worries.

 

That worked for a while… until the market started looking at the math a bit more in depth and realized that Greece had reached the point where it really cannot sustain its debt any longer.

Greece is like the family with a single income earner holding down two jobs that pay slightly over minimum wage who needs to support a spouse, some kids, manage a $525,000 adjustable rate mortgage whose rate keeps rising, has two cars in the driveway in desperate need of rather costly repairs, a cousin who just moved in and has some serious health problems and found out today that the roof has a major leak. Now the bank keeps calling and telling you that you need to work harder and cut back on the spouse’s spending habit as your mortgage rate continues to rise and you are already late on a few months’ worth of payments and your credit cards are maxed out. Your boss is telling you that your skills are seriously lacking and your cousin says she can’t possibly live in that room you gave her unless she gets to redecorate it on your dime. At some point, you throw your hands up in the air and tell everyone to shove it!

 

Earlier this week, according to a report by the Financial Times, Greek prime minister Alexis Tsipras argued that,

 

“The pensions of the elderly are often the last refuge for entire families that have only one or no member working in a country with 25 per cent unemployment in the general population, and 50 per cent among young people.” That’s Greek for shove it.

 

How does a politician manage this type of pressure from back home? Ms. Merkel and Mario Draghi just aren’t that scary or persuasive!

 

So that’s where we are. The majority of Greeks have decided to go the “shove it” route and sent Yanis Varoufakis to deliver the message, in a rather debonair manner we might add, (that’s Yanis on the left in the picture below.) This has left Germany’s Angela Merkel, the European Central Bank’s Mario Draghi and France’s François Hollande in a tizzy as they try to figure out how to work with a Greek envoy that appears to be quite confident their game theory skills will eventually get them whatever they want. Italy’s Renzi, by the way, is mostly back home dealing with his nation’s struggling economy and the seemingly eternal roll of sitting between the U.S. and Russia – poor man has enough on his plate!

Greeks

 

So here we stand with Greece still wanting to be part of the Eurozone club, having never, even upon admission to the club, been able to satisfy the requirements for membership. To be fair, many nations who were let into the Eurozone club never have been able to meet them either.

 

Bottom Line: What does a Grexit mean for the rest of the world? First, it likely means a stronger dollar relative to the euro, at least in the near-term, as there will be a flurry of uncertainty given that (1) the Maastricht Treaty didn’t provide any way for a nation to exit the Eurozone and (2) there will be fears that other member nations may try to find wiggle room around their heavy sovereign debt loads, which will give some cause for concern about the future of the Eurozone. Eventually, all that flurry will likely pass as frankly a Eurozone without Greece is stronger than one with it. Holders of Greek debt will be hit hard, which means a lot of European banks, (primary holders of all that debt) are getting even more complicated. However, the Eurozone economy is still struggling, thus the ECB will continue on with its euro-style quantitative easing, which means that over the longer run, the U.S. dollar is likely to continue it bull run.

RT Boom Bust with Erin Ade talking about the Fed, Greece and Italy

On May 28th, I appeared on RT’s Boom Bust  with Eric Ade, talking about about the Fed, Greece and Italy.

For some time the Fed has been talking about raising rates, but the stream of economic data we’ve been seeing doesn’t give the FOMC, (Federal Open Markets Committee) much of an argument for raising rates.  Employment gains have also been exceptionally deceptive, with much of the gains in low paying industries.  However, if the Fed doesn’t raise rates, that significantly reduces the arrows in their quiver if/when the U.S. goes back into a recession, which given the normal business cycle timeline, would be reasonable to expect in the near-to-mid term.  That being said, with all the manipulations in the markets and the economies since the financial crisis, nothing is “normal” and the unreasonable has become the reasonable.  The single most important price in the economy is the price of money.  Once that is no longer priced freely  by the markets, which is impossible with all the interest rate manipulation by central bankers everywhere, the price of everything else gets seriously distorted.

We also discussed the prevailing narrative I wrote about in an earlier post surround Greece and the potential Grexit, which is based on the assumption that the nation’s problems stem from a workforce that is either lazy, stupid or worse.  Finally we discussed how much of what is happening in Greece, is present elsewhere in the world and in particular causing much of the economic angst in my second home, Italy.

 

Greece – Lazy, Stupid or Evil?

Greece – Lazy, Stupid or Evil?

My regular readers are already familiar with what I like to call BUC

Lenores Law BUC

Lately I’ve been mulling over a new one, which applies quite well to the discussions around Greece, but I think is universally applicable – L4

Lenores Law L#

I was speaking with a friend of mine who lives in the States and she was asking me about the view of Greece from Italy, (I’m working from Genova, Italy at the moment) and commented on how the country really needs to get its act in gear and what is wrong with those lazy Greeks who want Germany to endlessly subsidize them.

Dog-with-perked-ears

 

My ears immediately perked up!  That sounds a lot like L4.

 

 

 

Yes, Greece is a disaster, but having been to the country, (I’m in love with Santorini and Mykonos) and having seen just how hard many of the Greeks work, my ire got up hearing that as the explanation for why the nation is struggling.  Let’s look at the data on just how lazy those Greeks really are.

Data compiled by the Organisation for Economic Co-Operation and Development (OECD) shows that in 2013, Greece had the second highest number of average annual hours actually worked per worker at 2,037 hours- only Mexico worked more!

How many hours for those diligent, finger-wagging Germans?  1,388 – two thirds the hours that those lazy Greeks worked! The Germans sit at number 34, BEHIND Russia, Ireland, United States, Italy, Portugal, Canada, Spain, Sweden, Belgium, France, Denmark and Norway!  Yes, the average annual hours worked in Germany in 2013 was LESS than Greece, Italy, Spain and Portugal!

So what gives?  Why is Greece and for that matter Italy, Spain and France struggling?

There is no easy answer for that, but lets take a quick look at the data.

According to data compiled by the World Bank benchmarked to June 2014, out of 189 countries ranked for ease of doing business, Greece was number 61 while Germany was number 14.  (The lower the number the easier it is.)  Italy sits at number 56, Spain at 33 and Portugal at 25.  For comparison, the United States is number 7.

For getting credit, Greece ranks number 71 while Germany was 23.

For getting electricity Greece ranks 80 while Germany ranks 3.

For enforcing contracts, Greece ranks 155 while Germany ranks 13.

So maybe it isn’t that those Greeks are lazy, stupid or evil.  Maybe they just have government bureaucracy that makes it excruciatingly difficult to earn a living, no matter how hard you work!  As a gentleman named Henry David Thoreau once said in “Civil Disobedience, “That government is best which governs least.”

Or as another fellow for whom I have a rather mad crush said, “Government is not the solution to our problem; government is the problem.”

Greece in Hotel California

Greece in Hotel California

Greece was all over the headlines again last week as the deadline for debt talks neared. The           Maastricht Treaty, which created the European Union, is starting to sound an awful like the Eagles “Hotel California,” with many in Greece left rethinking, “This could be Heaven or this could be Hell.” The treaty provided a lengthy list of requirements to enter the Eurozone “hotel,” but provides no way to exit, making all members, “…just prisoners here, of our own device.” Greece, among quite a few others, didn’t exactly meet the economic fitness requirements to obtain membership in the Eurozone. The current members were well aware that Greece was essentially doping to get the level of performance required and were all too willing to look the other way. After all, “We are programmed to receive. You can check-out any time you like, but you can never leave!”

 

After Greece made it onto the Eurozone team, things went quite well for a while. The global economy appeared to be performing in tip-top shape and “dealers” for Greece’s performance-enhancing creative debt securitizations were ubiquitous. Now before anyone gives into the desire to finger wag, first recall that parts of the US economy also indulged in such performance-enhancing financial supplements, (housing and now the auto sector). Frankly, pre-financial crisis the proliferation of creative debt securitization on the global stage was a lot like an excerpt from a Lance Armstrong post-2012 doping deposition, “Everyone was doing it. You had to if you didn’t want to be left in the dust.” Pssst, a version of this is still going on today, just ask any company that is juicing its EPS by using newly issued debt to fund stock buybacks such as Apple (AAPL), IBM (IBM), Monsanto (MON), CBS (CBS) and many more.

 

Today, global economic conditions are such that the hills have gotten a hell of a lot steeper, the pavement is full of cracks, there are powerful headwinds, rain flurries and Greece’s pre-crisis performance-enhancing suppliers are no where to be seen. Debt-doping allowed the nation to get away with all kinds of economic sins, gorging itself on regulations and labor laws akin to years of multiple-pint nightly threesomes with my two favorite partners-in-crime, Ben and Jerry, followed by many a lazy day-after spent series-binging on “Ex-wives of Rock” while sprawled on the couch munching on peanut butter Cap’n Crunch out of the box. Now with no “supplements” available, an overweight, out-of-shape and endocrine-exhausted Greece is being told to get pedaling faster and faster on a bike with bald tires, a broken gearbox and gyrating handlebars.

 

You would think that Germany, of all countries, would remember that driving a nation into the economic ground is never a good idea. Most economists and politicians refer to Germany’s understandable fear of hyperinflation but that overlooks the much more relevant and painful lesson from the impossible demands placed on the country post WWI, which destroyed not only its relationship with its neighbors, but also its democracy and ultimately led to WWII. How ironic that the Maastricht Treaty, which was conceived in part to prevent another war between European neighbors, is now the cause of so much inter-European strife!

 

Greece simply cannot pay its debt, which is pretty much its standard operating procedure. According to Kenneth Rogoff and Carmen Reinhart, “from 1800 to 2008, Greece was in default 50.6% of the time,” so angry bondholders, how about a reality check? Last week we mentioned that the nation’s economy had contracted by 26% from 2008-2013, yet it is still managing to remain current on its debt payments while running a primary surplus of about 1.5%. That would be a seriously crowd-pleasing performance on NBC’s The Biggest Loser!  The problem is its creditors want Greece to increase that surplus, meaning ride even faster up that blasted hill! Even Jillian Michaels wouldn’t push that hard.

 

Last Thursday Greece formally requested a 6 month extension after four weeks of brinkmanship, which was quickly returned with an “I don’t think so,” from Germany.  On Friday night a four month interim pact was reached that will once again kick the can down the road, albeit a much shorter road than after previous kerfuffles, conditional on Greece submitting a list of reforms by Monday 23rd.  Greece submitted such a list close to midnight on Monday, which the eurozone commission officials claim contains significant changes from “a more vague outline originally discussed at the weekend.”  One official reportedly said, “We are notably encouraged by the strong commitment to combat tax evasion and corruption.”

 

The Eurozone finance ministers will hold a conference call on Tuesday to determine the acceptability of Greece’s proposed reform plans.  Most likely an agreement will be reached.  The bailout money will continue to come and the European Central bank will continue to stand behind the nation’s banking system.  However, all the finger pointing and accusatory language has greatly damaged relationships and backed both parties into difficult corners.  The next round of talks in four months could be even more contentious.

The New, New Normal

I’m fairly certain that when the G20 convened, many of the attendees believed that as a result of their high-minded meetings, some brilliant announcement would be given to the markets and once again the world would be deemed safe, at least for a little while.  Instead, the Cannes meeting ended with no solutions and not even a pledge to find solutions. Is this the new normal?  Papandreou is on his way out, which means the odds for passage of the latest rescue plan are improving, but at this point, that means very little for long-term Greek prospects.

Last week the ECB reversed its rate increase from earlier this year, cutting short-term lending rates by 25 basis points to 1.25%.  This should hardly come as a surprise with the Eurozone economy deteriorating at a faster pace than was expected.  Markit, a global financial information services company, reported that Eurozone GDP fell at a quarterly rate of 0.5% in October with little chance for a pick up in the near term.  Output fell and new order inflows contracted at the fastest pace since June 2009.  Eurozone PMI fell to a 28 month low of 46.5 in October, dropping from 49.1 in September.  This is the sharpest drop since November 2008.

In Germany, whose strength has been keeping Europe afloat, industrial production dropped 2.7% in September, on the heels of a 0.4% drop in August.  German factory orders dropped 4.3% in September.

One of the most concerning trends last week was the rise in Italian bond yields, with the 10 year soaring at one point to 6.64% while at the same time German bund yields dropped 2 basis points to 1.79%.  Italy is rapidly approaching the levels that pushed Greece, Ireland and Portugal into bailout mode, but this time the stakes are markedly higher.  Italy’s economy is the 8th largest in the world and its bond market is the third largest!  That’s a bigger problem that all the aforementioned nations combined and it is highly unlikely that Berlusconi’s majority government will survive.  Contagion anyone?  Over the weekend Italy rejected an offer for IMF assistance, but conceded to intensive monitoring with published quarterly fiscal results.  Talk about too little too late!

It is amazing to think that just 11 days ago, on October 27th, the market soared on promises that the EFSF would magically be expanded and levered up by some as yet still unidentified sources and all would be well in the world!  Once again, China was touted as being keen on getting involved.  Is anyone really surprised at this point that they aren’t?  Then in what can only be described as irony on a global scale, the ECB left China after being rejected and headed over to Japan, who debt to GDP is nearing a mind-boggling 228%, with hat in hand looking for support.  That’s like going to the neighborhood crack dealer in search of rehab options!

Italy is now clearly being targeted as the next bailout candidate, but there just isn’t enough firepower to handle the land of linguine.  It needs to refinance $413 billion in the coming year with market rates currently at levels that it simply cannot afford.  How much more can the ECB take on?  They’ve already bought over $100 billion of Italian bonds since August, with very little impact on yields.

Greece’s default appears more likely and more imminent that ever before and there are entirely too many under-capitalized European banks, which means, systemic risk.  This coming at a time when Italy, (remember that this is the 8th largest economy in the world) will need to refinance $413 billion!  Ah fusilli!

For anyone who thinks that Europe’s woes won’t creep across the pond, keep in mind that between 15% and 20% of S&P500 sales and exports are derived from Europe.  Europe is also China’s largest export market, so this has significant global implications outside of the danger to credit markets.

Bottom line – there is no end in sight to the Eurozone debt crisis and the U.S. will not go unscathed.  To make it even more exciting, countries responsible for half of global GDP will be holding elections in the next year, and we all know how candidates love to take advantage of a crisis and stir the pot!  Volatility and fear will be the norm.  Invest accordingly.

Understanding the Eurozone

To understand what is happening in Europe, one needs to first appreciate the context, the raison d’être for the Euro itself. One of the primary goals of the Euro was to prevent the kind of recurring conflicts that spawned two World Wars on the continent in less than a century.

This union joined the Teutonic North with the Club Med South under a unified currency but provided for neither a unified fiscal policy nor effective controls. The result was that much of the Eurozone enjoyed lower-than-market interest rates essentially subsidized by Germany’s financial track record and the belief that Germany would and could do what was necessary to ensure the credibility of the Euro. During the good years, this system appeared to work well, but just as we saw in the United States, providing a lower-than-market interest rate tends to induce more borrowing and more profligate spending than would have otherwise occurred – think Liar loans and home equity line funded spending sprees.

When the global economy was strong, the underlying problems were well hidden. I think Warren Buffet said it best, “It’s only when the tide goes out that you learn who’s been swimming naked.” The 2007-2009 global recession was quite an outgoing tide, revealing the economic rot that had developed within. The €110 billion bailout in May 2010 for Greece was intended to buy time for the nation to get its economic house in order, but in a story not unlike the too big to fail saga, corruption continued, taxes remained unpaid and government assets and jobs were not reduced as promised.

Germany and the other strong economies are left with two grim options. The first is to aid the struggling nations of Greece, Portugal, Ireland, Belgium and possibly Spain and Italy as well with little hope for a near-term end to the bailouts. The other option is for the Teutonic North to do nothing, resulting in a Greek default of some sort. This would mean large losses for German and other Teutonic banks, thus a bank bailout vs. sovereign bailout. Talk about being caught between a rock and a hard place.

This is all the more complicated by contagion factors. Let’s say Germany gives Greece a haircut on its debt. You can bet Ireland will be stomping its feet demanding a similar easing. Portugal and Spain and potentially even Italy might soon follow suit. If you are an Irishman, wouldn’t you be enraged to know that while your country is going to have to toil for decades under a massive debt burden, Greece got a handout, partially courtesy of your own struggling economy? So you pressure your Statesmen to fight for what just seems fair. Now we’ve got politicians under pressure from their own people to get as good of a deal on their debt write-down as the next guy. Where does it stop? Talk about a competitive death spiral of debt and asset, (on the bond-holders side) annihilation!

Thus one of the biggest challenges in both managing and assessing the magnitude of the Eurozone crisis boils down to human nature. No one likes to see the other guy get off with less pain for similar infractions. Wars have been started for less. There is no way to confidently quantify such a scenario as now we are in the realm of emotions and mobs – innately unpredictable. When this situation gets to a point where the photo-ops and meetings no longer satisfy the markets, when the reality of just how dangerous this situation has become is clear to all, the market panic could be intense. I recall with much frustration the endless assurances given to the market in 2007 and 2008 by various corporate and government officials, claiming that the problems had been contained. We’ve got essentially the same cast of characters in Europe right now who couldn’t get it fixed the first time around telling us that this time they’ve got it under control. Perhaps, as miracles do happen, but as the saying goes, “Hope is not an investment strategy.”

So here we are, back at the beginning of this little tale wherein the creation of the Eurozone was to prevent the kind of recurring conflicts that spawned two World Wars on the continent in less than a century. On that front it has been less than a resounding success. The wise investor acknowledges just how much of the path and timing for the Eurozone crisis simply isn’t knowable with any degree of confidence and protects themselves accordingly.

How and Why of Greek Debt

How and Why of Greek Debt

When a nation has more debt than it can manage, it has two options (1) inflate its way out by printing more money or (2) restructure the debt.

Typically the most politically feasible solution is to inflate.  Generally wages tend to keep up to some degree with inflation, so the employed feel as if they are getting a raise and don’t gripe too much.  Those in the population who have debts prefer inflation as the relative “cost” of their debt decreases over time, e.g. with 5% inflation, debt declines in real terms by 5% every year.  It is the savers who suffer most as they watch inflation eating away at what they’ve built – in a converse to inflation reducing debt, savings declines in value by 5% every year.  This is why inflation is often referred to as a hidden tax.

The Europeans cannot inflate their way out of too much debt for the PIIGS as the U.S. is way ahead of them in the race to the bottom and they have conflicting needs across countries.  A monetary union without a political, fiscal and cultural union is complicated at best.  So why the continued kick the can?  The largest banks (German Deutsche Bank, the French BNP Paribas, Société Générale and Crédit Agricole SA among many others) have not increased their reserve capital, which would dilute shareholders, and do not want to take losses on their significant holdings of PIIGS bonds.  The euphemistic “restructuring” of these bonds would by definition require some sort of write down in value for the banks.http://www.insidermonkey.com/blog/wp-content/uploads/2011/06/Who-holds-Greek-debt.jpg

Bank’s hold these bonds as assets on their balance sheets.  They are required to maintain a certain level of assets relative to the amount of loans they give.  If the value of their assets were to suddenly drop, they could find themselves in violation of the regulations concerning this ratio.  As you can imagine – that is not good for the banking sector and lending!  We saw the last time this occurred the credit markets effectively shut down, any type of borrowing was nearly impossible, and the engine of the global economy geared way down.

So how did the U.S. get out of the bog in which the Eurozone is currently mired?  In the Spring of 2009, the U.S. banks were eventually forced to raise hard common equity that was then used to absorb losses on loans.  The fixed income market did bottom out in the Fall of 2008, but when banks sought this equity, their stocks did not wither on the vine, albeit life wasn’t exactly rosy.  Rather than taking this approach, the International Monetary Fund (IMF), the European Central Bank (ECB) and the German and French banks are giving Greece just enough liquidity to roll their debt, not the permanent equity investments that were made here in the U.S.  The Euro approach is just a temporary patch on a cracking dam.  Only when the European banks raise equity, as we did here, and the PIIGS debt is restructured will there be a true resolution.