To Solve the Crisis You Must Solve Three Problems
2012 Foreign Debt Maturing
There are three main problems in Europe.
- Most of the banks are massively insolvent, because they have 30 times their capital invested.
- The sovereign debt of countries that are going to have trouble paying that debt. If the banks have to mark down the debt to what its real value is – or to what it will soon be – they will be bankrupt on a scale that makes 2008 look like a waltz in the park. If banks can’t make loans, then businesses must cut back, which means fewer jobs, products, and services, which quickly becomes an ugly spiral. If countries must step in and save their banks, then they have to assume some of the losses.
- The largest problem, and that is massive trade imbalances. Germany exports products to the peripheral European countries, which run trade deficits. A country cannot reduce private-sector leverage, reduce public-sector leverage and deficits (balance its budget), and run a trade deficit all at the same time. That is simple, unavoidable math, based on 400 years of accounting understanding. Ultimately, there must be a trade surplus if leverage and debt are to be reduced.
For most of the past two years, European leaders have tried to deal with the problems as though they were short-term liquidity problems: “If we just find the money to buy some more Greek bonds, then Greece can figure out how to solve its problems and then pay us back. Given enough time, the problem can get solved.”
They have now arrived at the understanding that it this not a short-term problem. Rather, it’s a solvency problem of the various governments, which of course creates a solvency problem for their banks. They are now addressing the problem of solvency and providing capital until such time as certain countries can get their budgets under control and the bond market sees fit to provide the capital they need.
Greece runs a trade deficit of about 10% of GDP. Until they can stop that bleeding, they cannot get their government and private budgets under control. It is not simply a matter of cutting budgets or raising taxes. Indeed, their economy will continue to shrink, making it more difficult buy foreign goods without increasing their own production of goods and services. It is a vicious spiral. And that same spiral will spin up to take in all of Europe. Again, more on that later, as we consider what their choices are.
But for now, let’s start with my contention that if you do not solve all three problems you do not solve the real problem. Greece cannot “stand on its own” without a change in its cost of production relative to Northern Europe. Neither can Portugal, et al., unless Germany either changes how it exports and consumes more, or Germany is willing to fund Greek (and Portuguese and Italian and…) debt, so those countries can continue to run large deficits.
The eurozone debt crisis returned with a vengeance on Friday as Standard & Poor’s, the credit rating agency, downgraded France and Austria – two of the currency zone’s six triple A rated countries – as well as seven nations not in that top tier, among them Italy and Spain.
S&P, under political fire since it announced a review or eurozone debt in December, gave 14 of 16 countries – including France, Italy and Spain – a negative outlook, which it said meant a one-in-three chance for each country of a further downgrade this year or next.
The agency downgraded France and Austria by one notch to double A plus, while it cut Italy Spain and Portugal by two notches. Portugal has now been relegated to “junk” status by the three main rating agencies following similar actions by Moody’s in July and Fitch in November. Ireland held its rating.
The agency’s move prompted an immediate political backlash.
Earlier, financial markets slid as news of the downgrade leaked and investors sold the euro, eurozone equities and sovereign bonds, especially from Italy and Spain – the latter move pushing down yields for German Bunds and US Treasuries, held to be havens.
The downgrades came in lockstep with new problems for the eurozone on other fronts – debt-restructuring talks between Greece and holders of its debt broke down over how large bondholders’ losses should be, raising the spectre of a Greek default in March.
The downgrades – announced after US markets closed on Friday – come after the S&P in December warned the six triple A nations and nine others in the eurozone that it had put their creditworthiness on review as a result of the debt crisis and the worsening economic outlook.
Cyprus, also downgraded on Friday night, was already on review, and Greece not under consideration.
Ahead of the statement confirming the downgrades, the euro fell more than 1 per cent to a 17-month low against the dollar and early gains on European stock markets were erased.
Sovereign bond markets were also rattled, with Italy and Spain’s borrowing costs creeping up again after several days of sharp drops. France’s 10-year bond yields edged up, to 3.05 per cent, while Germany’s 10-year bond saw its yield drop to 1.75 per cent as investors returned to safer assets.
There are 40 elections in 2012. Everybody is going to do their best to get us through the elections. Governments will continue to print money, propping up economies all over the world. Will it work this time? Will it postpone the crisis in 2012 and push it into 2012?