By now, you all know that S&P downgraded 9 eurozone countries debt ratings on Friday. The markets yawned at the news, and truthfully with the exception of the Italian cruise ship tragedy, Europe hasn’t made a major headline in weeks. That said the continents debt woes continue to deteriorate, and the only significant force that can change this is the ECB, which like the U.S. Fed has found more negative unintended consequences than positive results from its actions.
First and foremost, Europe’s problems stem from a difference in competitiveness among European countries, and you can’t solve it by lending money to the less competitive countries. The solution is to deflate wages and prices in the south, and inflate in the north. But given Germany’s history, it will never inflate.
Proof that the ECB does not understand the problem lies in the December agreement among European countries that each country could have a structural deficit of no more than half a percent of GDP. If a deficit goes above 3% of GDP, the country would be sanctioned. This agreement is awaiting ratification by all countries. When you agree to a prescription like this and you are uncompetitive, your currency is terribly overvalued, you can’t devalue, and your interest rates are too high, that is a recipe for depression. It is an economic death sentence, worse yet is that several countries won’t ratify it, and their financial markets will be repriced accordingly. They will then exit the Euro, and the world will witness the turmoil escalate to the next level.
Greece is bankrupt, yet it has no capacity to devalue its currency by the required 50% to try to recover. When the Greek banking system goes bust, people will realize that the Greek private sector is also bust and worse yet is that banks in other countries will be in trouble, requiring nationalization (government takeover). Governments don’t have the funds to pay for nationalization, thus they will be forced to issue more debt.
There are three main problems in Europe. The first is that most of the banks are massively insolvent, because they have 30 times their capital invested in the second problem, which is the sovereign debt of countries that are incapable of paying the debt. If the banks have to write down the debt to what its real value is, or what it soon will be, then they will be bankrupt on a scale far worse than 2008. Countries cannot operate properly without functioning banking systems.
The third and largest problem I hinted at early in this blog post is the massive trade imbalances. I have written recently in blog posts that Germany exports products to the peripheral European countries, which run trade deficits. A country cannot reduce private sector leverage and deficits (balance its budget), and run a trade deficit all at the same time. Folks, it’s no different for a country than it is for an individual, you must run a cash flow surplus if debts are going to be reduced.
Greece runs a 10% trade deficit, when one considers the leveraged nature of their government two things must happen, the first is cutting budgets, the second is raising taxes, both of which will cause their economy to continue to shrink, it’s a vicious spiral that will ultimately suck in all of Europe – the world’s largest economy. As I have said in the past, if you want to fix governmental and banking systems problems, the first thing you have to do is stop rewarding the bad behavior. In our example, governments keep kicking the can down the road avoiding the unthinkable, which simply makes the unthinkable a larger, more global problem.
We estimate that a long and painful period of debt restructuring and austerity is in store not only for Europe, but global markets as the world’s largest economy sabotages growth in all other economies around the world. In a separate future blog post I will discuss the ridiculously high 2012 GDP estimates currently endorsed by all the major investment banks, for now let’s simply say that these estimates currently at 3-3.5% will likely be reduced to 2-2.5% in the coming months, and ultimately we believe the Europe effect will sap 1% of the 2-2.5% reduced GDP forecasts.
A long only stock and bond asset allocation strategy will likely be impaired on both fronts in 2012.
Be Well.