European Debt Crisis has No Painless Solution

It seems as though every few weeks for the past six months an article appears in the mainstream financial media displaying a headline along the lines of “European Leaders Meet to Resolve the Debt Crisis,” as if a solution to the crisis is just around the corner. Unfortunately, the scale of the sovereign debt problem in Europe is far beyond the reach of any relatively painless solution that financial markets will find satisfying. The following excerpt is from the latest Frontline Thoughts commentary by John Mauldin, in which he reviews the European situation and outlines the difficult choices facing the European Union.

Europe has three main problems.

1. A growing number of its countries are insolvent or close to it. It is increasingly likely that the only way forward is for defaults of some type, to lessen the burden of debt to a level where it can be dealt with and that will allow the countries the possibility of growth, which is the only real answer to the problems they face.
2. Because of growing fears of multiple defaults (just Greece would be bad enough!) most of the banks in Europe are seen to be insolvent and in need of hundreds of billions of euros of new capital. The interbank market in Europe is in a shambles, and banks park their cash with the ECB, at a lower rate of return, as that is the only institution they trust. They clearly do not trust each other. As an aside, I heard from many sources while I was Hong Kong and Singapore, meeting with readers and friends, that European banks (especially French) are cutting back on their trade lending, which is making normal commerce more difficult. Didn’t we just go through that in 2008?
3. The real problem in Europe is the massive trade imbalances between the peripheral countries and the so-called core countries. Without the ability to adjust currencies, those trade imbalances will render any debt solution moot, as a country cannot balance its budget while it runs a trade deficit and its citizens and businesses also deleverage. I have written about this arithmetic problem on numerous occasions. There must be balance or there must be a mechanism to achieve balance.

One cannot solve one problem without solving all three. Either they all get done or none truly get done. You can kick the can down the road by solving problems 1 and 2, but problem 3 will put you shortly back to square one.

Europe is now trying to address problems 1 and 2. They are talking about a “new treaty” that will require austerity of a real kind, although I understand that Germany has put in a clause that gives it some extra time to achieve its own balanced budget. And the ECB is dispensing euros through the back door to banks, in exchange for anything resembling collateral. Not directly of course, as that is prohibited, but the same thing is being accomplished, despite objections in some quarters, mostly German.

Let’s turn to some charts from a well-written report called “The European Crisis Deepens,” from the Petersen Institute, by Peter Boone and Simon Johnson. Both authors have a long list of credentials.

The first one is a chart of the cost of five-year credit default swaps. Notice they all are rising. (This is a log chart, so the scale rises by a factor of ten for each level.) Now, notice that Portugal is where Greece was last year. Then pay attention to the fact that Italy is likewise where Portugal was last year. Just thought I would give you a preview of coming attractions, horror-movie edition.

Then they offer us this chart, which compares the labor-unit costs of six countries in Europe. Only Ireland has seen their costs drop, as their labor has accepted pay cuts and productivity has increased. And pay attention to the ever-rising costs of France vs. Germany. This trend suggests France is on a path that Greece took. There are dragons down that path.

And it also illustrates the problem of why it will be so hard for Greece to turn around without being able to resort to a currency devaluation. They have to endure a 30% pay cut relative to core Europe if they want to compete. There will be no volunteers in Greece for such cuts. After two years of IMF and European institutional involvement (meddling?) in Greece, there has been hardly any movement in Greek labor costs.
Greece is not alone. Are you reading of any general pay cuts in the proposed solutions for Italy, where labor costs are now above those of Greece? Likewise, no move in Portugal (not shown in graph). The entire eurozone is out of balance, and no one is making any moves to deal with it or even acknowledge the basic problem.

Much of establishment Europe was predicting a positive GDP for the region only a month ago. The recent trend suggests the data they were smoking was hallucinogenic. And given the seriousness of the problem, it must have been primo stuff. Germany was in recession for the 4th quarter of last year and is likely to be there this quarter, which is the technical definition of recession. Clearly, peripheral Europe is in recession, some countries in what looks like it could be called a depression. Below is the Purchasing Manager’s Index for six major countries in Europe. I have added a thick red line at the 50 mark, below which there is negative growth.

With all of the above as a backdrop, let’s now see if I can outline the choices Europe faces. First, let’s take Greece, because it is instructive. Greece has two choices. They can choose Disaster A, which is to stay in the euro, cutting spending and raising taxes so they can qualify for yet another bailout; negotiating more defaults; getting further behind on their balance of payments; and suffering along with a lack of medicine, energy, and other goods they need. They will be mired in a depression for a generation. Demonstrations will get ever larger and uglier, as the government has to make even more cuts to deal with decreasing revenues, as 2.5% of their GDP in euros leaves the country each month. There is a run on their banks. Any Greek who can is getting his money out.

Greek voters will then blame whichever political group was responsible for choosing Disaster A and vote them out, as the opposition calls for Greece to exit the euro. Which is of course Disaster B.

Leaving the euro is a nightmare of biblical proportions, equivalent to about 7 of the 10 plagues that visited Egypt. First there is a banking holiday, then all accounts are converted to drachmas and all pensions and government pay is now in drachmas. What about private contracts made in euros with non-Greek businesses? And it is one thing to convert all the electronic money and cash in the banks; but how do you get Greeks to turn in their euros for drachmas, when they can cross the border and buy goods at lower prices, as inflation and/or outright devaluation will follow any change of currency. It has to. That is the whole point.

So how do you get Zorba and Deimos to willingly turn in their remaining cash euros? You can close the borders, but that creates a black market for euros – and the Greeks have been smuggling through their hills for centuries. And how do you close the fishing villages, where their cousin from Italy meets them in the Mediterranean for a little currency exchange? What about non-Greek businesses that built apartments or condos and sold them? They now get paid in depreciating drachmas, while having to cover their euro costs back home? Not to mention, how do you get “hard” currency to buy medicine, energy, food, military supplies, etc.? The list goes on and on. It is a lawyer’s dream.

There is a third choice, Disaster C, which is worse than both of the above. Greece can stay in the euro and default on all debt, which cuts them off completely from the bond market for some time to come. This forces them to make drastic cuts in all government services and payments (salaries, pensions etc.), and suffer a capital D Depression, as they must balance their trade payments overnight, or do without. Then they choose Disaster B anyway.

The only real options are Disaster A or Disaster B. Whether they opt to go straight to the drachma (Disaster B) is only a matter of timing. They will get there soon enough.

Why then do they wait? What’s the point of going through all these motions? Because Europe fears a disorderly Disaster B. For the rest of Europe, it is the Abyss. The Greek hope is that Europe (read Germany) keeps funding them in order to keep back from the edge of the Abyss.

As one European diplomat noted, “There is a growing sense that despite the valiant efforts of Papademos … the reluctant Greek establishment is biding its time to the next elections, banking on the assumption that the world will continue to bail them out, no matter what.”

Europe is getting closer to the point where it must make a decision about what to do with Greece. In theory, the deadline is March 29 for the next round of funding. It is a game with very high stakes and deadly serious players. Can Sarkozy be seen as weak and giving in to Greece, with elections coming up in April? Can Merkel appear to give in and keep her troops in line? There are elections not long after that in Greece. Can Papademos cave in to further cuts and promises on future debt that will be hard to keep and intensely unpopular?

The markets are getting exhausted. There will be no private market for Greek debt at any number close to what is sustainable. Greece will be on European life support for a very long time if they stay in and there is no disorderly default. It will mean hundreds of billions of euros over the decade, debt forgiveness, etc. There are no good choices.

And Europe will all too soon face what to do with Portugal, which will want to dispense some haircuts of its own. Don’t forget Ireland, which is very serious about not paying the debt the previous government took on for its banks in order to pay British, German, and French banks. That is a default that is in the cards. I think “polite” Ireland is just waiting until its $60-billion default is seen as small potatoes, which will not be too long, as Italy must raise almost €350 billion just to roll over current debt. Italy projects that its deficit will be down to 2%, but if Europe goes into recession that projection goes out the window.

The bottom line is that Italy (and most likely Spain at some point) cannot raise the debt it needs at rates it can afford without massive European Central Bank involvement. Rates are already approaching 7% again. That is unsustainable from an Italian point of view. Germany must be willing to allow the ECB to take on massive balance-sheet debt, or Italy will not make it without haircuts. And a mere 10% haircut for Italy dwarfs what is happening in Greece – and doesn’t do much for Italy. If they go for a haircut, it will be much larger. French banks holds 45% of Italian debt. Italy is too big for France to save. They cannot even backstop their banks if Italy becomes a solvency risk. They simply cannot get their hands on that much money without destroying their balance sheet. The most recent downgrade of their debt was just the first of many.

Speaking of downgrades, Egan Jones downgraded Germany from AA to AA- and put the country on negative watch. This is important, as this is what I believe to be the most credible rating agency; and over 95% of the time the other “Big 3″ agencies generally follow their lead, after a period of time. Part of the reason for the downgrade is all the debt that Germany is guaranteeing. Sean Egan was one of the first serious analysts to suggest that Greece would default. He was talking a 95% eventual default a long time ago. (Very nice gentleman, by the way. Or maybe he just left his Darth Vader mask at home when I met him.)

Europe will have to make its choice this year. Either a much tighter, more constrictive fiscal union with a central bank that can aggressively print euros in this crisis, or a break-up, either controlled or not. I don’t think they can kick the can until 2013, as the market will not allow it. Either the ECB takes off its gloves and gets down to real monetization when Italy and Spain need it, or the wheels come off.

The quote at the beginning returns to mind: “If we want everything to stay as it is, everything will have to change.”

Like any long trip, the drive (or flight) seems to take forever, particularly if you are very young or you are an investor. But then suddenly you are there. The LTCM crisis mentioned above took a long time to develop, but then it ended with a bang. One day Lehman or Bear is a big player and the next they are gone. I think this is the year the crisis moment for the euro arrives. Let’s hope they are ready.

The only paths to true structural repair involve great economic pain and it is simply a question of how long Europe can continue to avoid facing the inevitable. If Mauldin is correct and the crisis reaches its breaking point in 2012, it will be a tumultuous year for the global economy and for financial markets.