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Oct 17 2011

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“European Dreaming” on Debt Crisis

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Expectations vs Reality Will be Revealing

According to the Book of Genesis, God created the world in six days.

Now, according to European Union (EU) officials, Europe will have a comprehensive plan to deal with the continent’s unraveling sovereign debt crisis in – yes – six days.

Talk about a “God complex.”

Really, a problem that the Europeans have been unable to agree upon nor settle in nearly two years, is now slated for swift disposal in 144 hours?

How is that remotely possible?

Consider that shorn of the many complex technicals, the EU crisis is rooted in three buckets; questionable sovereign debt, current account deficits and economic growth.

The EU apparently plans to tackle the immediate and pressing issue of questionable sovereign debt head on by October 23rd.

 To that end, the expanded European Financial Stability Fund (EFSF) has finally been approved by all 17 nations of the EU and the new European strategy will layout how the fund will be used to backstop banks and governments. Additionally, the Europeans will outline plans for bank recapitalization throughout the Euro-zone, to cushion the impact of expected sovereign debt write-downs.

In tandem, EU officials are also preparing to force major league “hair cuts” on Greek debt holders (predominantly European banks) to make Greece’s debt load more manageable.  The EU will also approve more money for Greece to prevent it from defaulting through the end of the year.

And with luck, the IMF and the sovereigns will offer constructive assistance to in-need countries.

But despite how impressive this sounds, and how it has already reassured the markets, it is hard to see the practical implementation here,  where the goals are necessarily at cross purposes.

Consider that the EFSF that just made it through 17 national parliaments has already been overtaken by events. It’s too small to deal with the problems that have grown exponentially as the tedious process of national approvals has moved forward. Questions of leveraging the fund through the European Central Bank (ECB) have run into not-unexpected opposition.

As for recapitalizing banks, the dominant approach, articulated by Germany, is for banks to follow a three-step process that begins with banks seeking private sources of capital to bulk up their reserves, then seeking national, and failing that, EFSF or ECB help.

But that view is simply at odds with reality.

Consider that France’s three top banks were just downgraded due to their holdings of EU sovereign debt. That is on top of a baker’s dozen of Spanish and Portuguese banks that have been downgraded.

Oh, and Spain – the country was downgraded, while Belgium was put on a watch list.

Who is going to want to put private money into EU banks without some form of guarantee, particularly when the actual sovereigns are teetering?

Indeed, what is recapitalization except an acknowledgement of financial weakness, which, without some form of comprehensive guarantee (a la TARP) would incentivize investors to move in the opposite direction and flee Europe?

Which runs head-long into the Greek drama.

How big a “haircut” is imposed on Greek bond holders will have a a real and material impact on the very financial institutions that European leaders are directing to go out into the market and find private capital. If Europe goes ahead with the three step recapitalization process, it is only going to lose time in getting to a result that is needed now; an immediate EU wide guarantee on the banks.

But there is no structural mechanism in the EU to make that a reality, nor, crucially, is there political support for such a colossal guarantee.

Indeed, has anyone been watching how painful the vote on the expanded EFSF has been? Angela Merkel won EFSF approval by five votes. The Slovak government actually fell as a result of the vote.

And this was for an inadequate financial substitute, not a continent-wide guarantee.

Outside of Europe, while magical powers have been ascribed to the IMF, the reality of its ability to materially impact the EU crisis is limited by structure and resources.

So, Europe has a serious expectations management problem.  Stocks are rising across the world on the belief that the EU will come up with a viable, longer term solution that will settle the debt crisis for good. At this point the impact is actually questionable beyond the optics.

But even if Europe were able to resolve the contradictions in its current approach and create a viable relief plan, it is temporary, because it does not, indeed, it cannot address two other crucial factors: national current account deficits and growth.

Greece is in a deep recession with negative growth.  That downward spiral has been so quick that the EU has had to revisit the bailout terms and its size because the Greek economy contracted so fast, busting budget projections and larger deficits.

And that is the paradox throughout the weaker EU states, that in turn threatens to take the stronger states with them through a connection to the euro.

The social contract which has expanded government benefits exponentially in these weaker countries over the last twenty years has had no correlation to economic growth. These states have created an entitlement system that simply do not have the revenue resources to fund it.  As the current accounts deficits have mounted, the national debts have exploded, leading to today’s crisis.

So there can be no “final” resolution to the debt crisis until the threatened EU nations make painful changes to their spending policies and create pro-growth economic strategies that will generate the revenue to pay for government services and pay down the debt.

But on this front, there is little if any real action.

Italian Prime Minister Silvio Berlusconi barely survived a confidence vote last week in the Italian parliament. He has talked tough on the budget, but seems incapable of making the systemic changes necessary to putting Italy on the road to recovery. Only the quiet intevention of the ECB to buy Italian bonds has kept the yields on those bonds from entering unstable territory.

The same is true in Greece were, despite all the government cuts, the current definition of what is considered “essential spending” is still grossly out of step with what is required to balance the budget. The same can be seen in Spain, Protugal and Ireland.

These are the real threats to Europe that will not be addressed by October 23rd, and the reason that investors should be much more circumspect in their expectations.

 

 

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