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“Those who can not remember the past, are condemned to repeat it” George Santayana

July 6, 2012

It is fitting that a Spanish poet, novelist and philosopher has perhaps the most important quote with regard to the continually deteriorating European economic situation. The most recent European “deal” notwithstanding, the European situation is far from settled and will likely get far worse before it gets better. In fact, it will ONLY eventually get better when there are structural changes (e.g. real reductions in debt burdens) in the economies in question, most notably Greece, Spain, Italy and soon France. (In the Socialist spirit of “helping” to solve their problems, the new President of  France has promised to reduce the retirement age to 60 from 62 while raising the top income tax rate to 75%, both of which will only further exacerbate his country’s debt problems.)

For Spain, the recent “deal” was simply additional Euro loans to the Spanish banks with more Euro printing to fund this. Interestingly, Spain’s problems emanate primarily from an overheated real estate market which came crashing down with the 2008-2009 recession. (Does this sound familiar?) In fact, Spain’s official debt-GDP ratio of 68.5% is by European and US standards not that bad. (e.g.compared to the Euro area’s average of 87 percent, France’s 90 percent, Italy’s 120% and Greece’s even higher ratio).  However, Spain’s “official” data excludes many other liabilities to the ECB as well as the current bailout funds which moves it to a more stratospheric 146.6% ratio. The big problem is that Spanish banks are way undercapitalized and now hold huge amounts of bad mortgage debt. Unfortunately with 24% unemployment  and a 7% interest rate on 10 year bonds and a contracting economy, it wont be long before even Spain’s “official” debt-GDP ratio soars even further.

So what are the EU and the specific countries trying to do about their growing financial and economic problems?

While  some (most notably the Germans) are talking seriously about financial austerity measures, the de facto strategy that has emerged is more Euro Bonds (or the European Stability Mechanism-ESM which is now a permanent rescue funding institution). This was the essence of the “deal” that was reached last week that allowed the ESM funds to directly recapitalize banks in Italy, Spain and other ailing economies. (In exchange, the Germans got a Euro Bank supervisor to oversee all such activity, though it is still unclear how much power this supervisor will have).  Of course, these loans don’t come from thin air, instead they are backed by the printing of more Euros. Further, to help stimulate the EuroZone’s contracting economies, the ECB recently cut the lending rate to 0.25% from 0.75% ( meaning of course, still MORE printing of Euros). BUT because the problems in Europe are fundamentally structural (e.g. “fixed” pensions and retirement benefits are growing rapidly, the population is aging and working age population is declining and the economies are contracting or not growing much) only “structural” solutions involving substantial cuts in these benefits and efficiency improvements in the tax code will remedy the situation.  

There is also lots of talk about complete financial/fiscal integration of the EuroZone countries but this will take many years (if it happens at all) and is already being strongly resisted by Germany as well as by Finland and Netherlands.  This is very logical. Countries such as France, Italy, Spain, and Greece have very high debt loads and their economies are contracting with no immediate end in sight, so the debt will keep growing with eventual default becoming increasingly likely. Germany and a few other Euro countries that are still relatively healthy don’t exactly want to have their fates hinged upon the total aggregate health of the EuroZone. Germany is a bit like the doctor who has been brought in to a hospital to treat patients (e.g. Italy, Spain, Greece and France) that have a highly contagious and potentially lethal disease– probably would rather avoid going on staff at that hospital!  

On the other hand, Germany as well as many of the other European countries economies rely heavily on trade with other less healthy EU members. Worsening financial debt situation of these countries reduces trade opportunities and thus hurts the Germans as well. So expect the German “doctor” to make many more visits to the hospital dispensing more medicine (ECB loans) in the future while keeping a safe distance from the patients at the same time.

The European situation is very instructive and is the classic economic and financial “Catch 22”. Countries such as Greece, Spain and Italy and soon France need to rid themselves of high levels of debt in order to avoid a financial “death spiral” (i.e whereby interest rates on debt keep rising, because bondholders see an increasing risk of default, this higher interest cost must be funded by more debt which in turn increases rates further until there is eventual default–which is catastrophic for everyone in that country and not exactly good for everyone else).  However, in order to actually REDUCE debt, these countries must end deficit spending and even start running surpluses through a combination of tax increases and cuts in spending. But in doing so, the short run economic impacts can be very negative which in turn will reduce tax revenues and make the task that much harder to accomplish. Further, these “austerity” measures are highly unpopular with the rank and file workers who will see their future and current promised pension benefits cut significantly as a result. However, there is no other way to get back to fiscal solvency and “default” on the nation’s debt will mean far more drastic cuts in all government pensions and services, hardly an option that EuroZone countries want to consider.

Given the painful and unpopular consequences of “austerity” (and particularly the more severe form of “austerity” that is actually needed), it is not surprising that we see constant attempts of the EU thru more borrowing (and Euro printing) to “solve” the European debt crisis. The most recent meetings did little as far as ensuring actual austerity targets are met, while expanding the ability for more ECB loans to be made to troubled countries and banks. The markets greeted this with considerable glee for several days, but the financial optimism has quickly faded. Expect another European market “crisis” to emerge later this summer with another stop-gap “solution” in effect involving more Euro printing designed to postpone the inevitable further.   

Meanwhile, the US with its $15.7 trillion total debt burden which is now more than 100% of GDP ironically remains the “safe haven” for world wide investors. This of course is a mirage.  What makes us different from European countries is that (1) the dollar is still viewed as “valuable” and “safe” by the world and in relative terms much more so than the Euro (2) we control a printing press that allows us to print as many dollars as we want to and (3) for the time being at least the perceived safe investment are US treasuries despite their incredibly low yields. However, we need only look to Europe for our lesson in recent history to see what happens once debt levels become unsustainable and what the likely future is for the US under our current fiscal/monetary path.

Most importantly, we need to avoid repeating the mistakes that have already been made in Europe. The biggest of all throughout most of the EU zone was the promise of very generous pensions and medical benefits that couldn’t possibly be funded. (However, states like California and Illinois are still repeating this mistake in the US). In addition, inefficient tax policy discouraged investment and economic activity in many of these countries resulting in declining tax revenues as it choked economic growth.  Finally, there was little recognition of the fundamental law of public finance: when times are good, pay down the debt and put some money away for the rainy days. Instead, the integration of the EU countries under one common currency in the early part of the last decade allowed for low-interest borrowing which was pursued by banks, countries and consumers with reckless abandon.

The bottom line for the US: Let’s not repeat Europe’s mistakes and instead bring our fiscal and monetary house in order before it is too late.

One Comment
  1. Mark D Arch (Art Vandalay) permalink

    Spanish victory in Euro Cup 2012 wins forgiveness of all ESM debts and one-month non-stop party compliments of the Germans. For semi-final victory Italy wins forgiveness of only Bundesbank debt.

    Greece, on the other hand, is hopeless and helpless.

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