October 30, 2011

Euro Zone in Crisis: Is Anyone In Washington Listening?

by Hal Gershowitz

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It is not necessarily true that as goes the Euro, so goes the Dollar.  But as goes the EU, so goes the US is as certain as the rising (or setting) sun if American fiscal policy continues to emulate that of the European spendthrifts.  The EU heads of state have after marathon, round-the-clock meetings in Brussels last week, inked a plan to finesse a Greek default (which is an eventual certainty) in a way that doesn’t immediately plunge the rest of Europe into a financial hell, and quite possibly drag America along with it.  Although under the best of circumstances, the picture remains bleak.  Market analysts who focus on short-term stock market movements responded with sighs of relief.

The Germans, understandably, wanted those who have loaned Greece money (primarily, the European banks) to take a loss of about half of the value of their loans in order to ease the extremis in which Greece finds herself.  France, whose banks are holding a lot of Greece’s debt, preferred to rely more heavily on a pumped up bailout fund to ease the burden on Athens.  Given that the German taxpayer is certain to be the biggest funder of the proposed additional bailout, it is not hard to understand the rising tensions on the continent.

One can’t blame the banks for their reluctance to dance at this party.  Based on commitments the EU countries made to keep their debt to no more than 60% of GDP and their deficits to no more than 3% over the prior year, Europe’s banks became major financiers of the new Euro countries.  But many of the European countries that were financially irresponsible prior to the advent of the Euro had no intention of changing their ways subsequent to exchanging their old currencies for the new Euro.  Greece flat out misrepresented its financial condition when it applied to become a member of the Euro Zone.

As it became apparent that many European countries had little or no hope of servicing their debt which, in some cases, was running over 100% of the agreed upon debt-to-GDP limits, the banks, which had bellied up to the bar to buy the debt of countries such as Greece, Spain, Italy, Ireland, Portugal, etc. were asked to write down (or forgive) a substantial portion of what was owed to them.  Just last summer, the banks agreed to a 21% haircut.  Now, they have been forced to make that a 50% haircut. They are not happy.

The banks are also being required to raise well over $100 billion over the next six months to shore up their balance sheets with ”safe assets” equal to 9 percent of their total capital. This will, it is argued, assure investors of the banks’ financial health.  Good luck.

The great concern, of course, is that no one will want to hold or buy the debt of the gaggle of other European countries with debt way over the limits that were set as the basis of the Euro Zone in the first place.  The situation is somewhat analogous to private companies ignoring their loan covenants.  Over half of the 27 European Union countries already exceed the 60% debt-to-equity ratio limitation.  Last year the average debt-to-GDP ratio of the EU countries was running well over 80% and the average of the 17 Euro Zone countries now exceed 85%.

The political leaders of the EU countries are determined to save the Euro, although deep differences exist over how to accomplish what is becoming an increasingly difficult task.  German Chancellor, Angela Merkel has succeeded in prodding her country’s lawmakers into approving a plan to more than double the existing $610 billion bailout fund to $1.4 trillion. Given the growing reluctance of the German taxpayer to continue underwriting the lion’s share of these gargantuan bailouts, she rates high marks for political courage (although perhaps she wants to prolong the day of reckoning so that Euro doesn’t collapse on her watch).  The Europeans have jumped through hoops to facilitate a soft landing for a Greek default (that is, after all, what a 50% haircut amounts to) out of a well-founded fear that credit availability for the rest of Europe’s overly indebted countries could either disappear or come at very high cost.

The risk of contagion is very real.  If concern over the solvency of the weaker countries such as Greece and Portugal persists, that anxiety can easily, even predictably, spill over into larger economies such as Spain and Italy at which point the solvency of the entire European banking system, which has huge exposure to these economies, could be called into question.  Banks suddenly might refuse to lend to one another out of fear that their banking counterpart may have solvency problems.  Remember Lehman Brothers?

The deal arrived at to save the Euro, if not the EU itself, includes several components including the restructuring of Greek debt, the infusion of fresh capital into major banks on the continent and the expansion of the existing bailout fund.  This agreement will, it is hoped, help avoid panic in Italy and other Euro countries.  Some of the troubled countries, such as Spain, Portugal and Ireland have made progress to shore up their fiscal affairs, but Italy remains particularly worrisome because of its huge debt-to-GDP ratio (124%) and its dysfunctional government (sound familiar?).  Thus far, Italy has failed to produce the budget cuts promised by Prime Minister Berlusconi. Given Italy’s huge debt, now over $2.65 trillion, his colleagues in the EU want more than promises or letters of intent promising to do more.

Sadly, this agreement to tamp down the jitters over the sorry state of Greek finances will, at best, convert Greece from an utterly lost cause, to merely a basket case.  Greece was on course to have, by the end of next year, a debt-to-GDP ratio of 272%, not only unsustainable, but also politically unsurviveable.  The agreement reached in Brussels, including the 50% haircut banks will take, will reduce, by the end of 2020, Greek debt to 120% of GDP.  In other words, from deadly to merely terrible.

As a recent of study of economic history by Reinhardt and Rogoff shows, economies cease growing and begin to contract at debt-to-GDP ratios in excess of 90%.  And that is exactly the tipping point to which the United States seems unalterably headed.

While public debt in the United States has increased by over $500 billion each year since fiscal year 2003, increases during the Obama Administration have been enormous with increases of $1 trillion in FY2008, $1.9 trillion in FY2009, $1.7 trillion in FY 2010 and $1.3 trillion during the 2011 fiscal year that just ended.  As of last week, the gross debt of the United States was $14.9 trillion, of which the public held $10.2 trillion and $4.74 trillion was intragovernmental holdings.

Today, as we write this essay, the US Treasury is auctioning (selling) debt in transactions that settle, ironically, on October 31 (Halloween), which will drive outstanding US public debt to an amount larger than the entire American economy of over $15.0 trillion.

Not a problem, many on the left say.  We’re not like the EU countries that can’t print their own currencies. We own the dollar; we can produce all we need to service our debt. Spend on.  And that is just what we are doing.  We can continue to collect taxes from only about 50% of tax filers to extract more from our highest earners, and shut our eyes to the long-term consequences of copying the collapsing eurozone by continuing to spend, tax and incur debt that jeopardizes economic growth.  If we do so, we are inviting a fate no different than theirs.

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One response to “Euro Zone in Crisis: Is Anyone In Washington Listening?”

  1. Mark J Levick says:

    A thought provoking analysis. Assuming our elected representatives can read, they are either derelict in their duty or profoundly stupid as it is clear that they have no intention of curtailing deficit spending.

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