In honor of Father's Day, I present an article that's a bit more challenging than my normal light fare. It's from John Mauldin's InvestorsInsight financial newsletter, and is actually an excerpt from a book called A Roadmap For Troubling Times by Louis-Vincent Gave. The article is The Problem with the Euro, and the excerpt begins a bit down the page, at "The Change in Policy."
It's heavy going, but one interesting thing I took from it, thanks to some help from my own Personal Economist (aka Porter) is this: Countries, unlike people and businesses, don't go bankrupt—because they can always print more money. Yes, that brings on inflation and a whole host of problems, but it keeps them in business. However, this is no longer true of the countries of the European Union. France, which is struggling under a national debt of 70% of its GDP, can no longer cover itself by printing more francs, since its present currency, the euro, is outside of its control. Many other European countries are in similar straits.In the mid 1990s, Europe's leaders got together and, in essence, said: "wouldn't it be great if we all got to borrow at the same rate as Germany?" And everyone around the table agreed that this would be a good thing. The decision was thus taken to a) create a currency which would resemble the DM, b) that this currency would be managed by a central bank with a mandate very similar to the Bundesbank's and c) that countries around the Euroland would strive to harmonize their fiscal policies (Maastricht Treaty rules and Stability and Growth Pact) to ensure the long term survival of the Euro. At the time it was also envisaged that the collapse in interest rates in certain countries (Italy, Belgium, Spain...) would give a tailwind to growth which would allow governments around the more indebted EMU countries to tighten their belts and clean up their fiscal houses.
The collapse in interest rates happened, as yields converged to the German rate... but unfortunately, the clean-up in fiscal houses did not. In fact some countries like France cashed in the "growth dividend" and voted themselves greater benefits such as the 35-hour work week.
There is a credit gap between fiscally strong countries like Germany, Ireland, Finland, the Netherlands, and Austria, and fiscally weak countries like France, Italy, Portugal, Spain, Greece, Belgium, and those of Eastern Europe, and it is increasing. This is manifested by the fact that the yields on bonds issued by the various governments differ despite the fact that they are all denominated in euros. For instance, German bonds yield less than Italian bonds because they are perceived as less risky. This difference is the "spread."
[A] widening of spreads represents the worst of both worlds for European banks. For a start, it puts their balance sheets under pressure. For seconds, it cuts down their income as the writing of CDS on Europe's weaker sovereigns slows to a crawl. For Europe's policy-makers, the widening of spreads poses a serious challenge which, if left unchecked, could cut to the very credibility of the Euro and the European construction exercise. It could also trigger a negative spiral such as the one we saw in the US whereby as the cost of borrowing increases on the weakest signatures, rolling over debt becomes more problematic, hereby inviting higher spreads etc.
This widening is a sign that the market is starting to acknowledge that the promises have not been kept. Thus, the best thing for Europe's governments would be to start keeping the promises that were made ten years ago. [Emphasis in the original] But of course, the main problem with that solution is that it implies that Europe's governments will have to tighten their belts over the coming quarters, i.e.: at the worst possible time in the cycle. After all, it is always hard for a government to pull back and shrink its size of the GDP cake... but in an economic slowdown, it is close to impossible.
It is all the harder to do when there is little political will for far-reaching reforms.... And we should make no mistake about it: reforming Europe's welfare states will take real sacrifices. Take pensions as an example: for years, most European countries have run a pay-as-you-go system whereby people of my generation will pay directly for the retirement benefits of my dad's generation.... In other words, Europe's pension systems are usually massive pyramid schemes; they work as long as the base grows and ever more people contribute to the bottom of the pyramid. The problem, of course, is that in a growing number of European countries, the base is no longer growing.
[T]he credit crunch which has thus far mostly only engulfed the US is starting to make its way into Europe. And soon enough, Europe's banks will likely be reporting losses and write-downs....
A few years before his death, Professor Milton Friedman declared: "It seems to me that Europe, especially with the addition of more countries, is becoming ever-more susceptible to any asymmetric shock. Sooner or later, when the global economy hits a real bump, Europe's internal contradictions will tear it apart." Today, one should question whether the "real bump" is being hit and whether Milton Friedman will end up being proven right.
This bears watching; the EU may have more problems than Ireland's rejection of the Lisbon Treaty. I certainly hope this isn't Friedman's "real bump." And that bit about the government pulling back and tightening its belt? The United States isn't that much better than France when it comes to national debt vs. GDP. Are any of our presidential candidates listening?
Here are some statistics, from the CIA's World Factbook, of the public debt as a percentage of GDP for several countries. (2007 estimates): United States 60.8%, Switzerland 45.3%, France 64%, New Zealand 20.7%, Italy 104%, Brazil 45.1%, China 18.4% (though I'm not sure what this means in a place like China), Canada 68.5%, United Kingdom 43%, Greece 89.7%, Russia 5.9%, Germany 63.2%, Kenya 40.5%, Israel 80.6%, Egypt 105.8%, Japan 195.5%. I'm not at all sure what to make of these figures. Perhaps, like infant mortality statistics, they are so flawed by measurement and recording differences as to be meaningless. But I note two things: (1) The U.S. isn't the only nation with a debt problem, and (2) the world is doing a lot of robbing Peter to pay Paul—or, more accurately, robbing Peter's children to pay Paul's parents.
If you can tough it out through the financial matters, the article is well worth reading.
