The End of the Euro

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It has been clear to me for many months (since at least June) that the Euro as we know it is at an end.  Some people are now optimistic that it will "only" result in a northern-Europe Euro zone, but I believe even that is highly unlikely as "bond vigilantes" descend to pick the carcass clean.

While this (relatively) slow-motion train wreck has already been well-described in the media, it's instructive for us to view as a preview to our own future.

A traditional (if imperfect) measure of a country's debt-related economic health is the debt:GDP ratio.  In other words, the total debt outstanding compared to the total value created by that economy in a given year.  It's easy to imagine a similar number for people - your total outstanding (unsecured) debt to your annual income.

The conventional wisdom is that a country whose total debt is less than 100% of its annual GDP is still in basically decent financial shape.  The further you get above that line, the more nervous investors (and ratings agencies) get.  There's no hard-and-fast rule of when there's a problem.  A stable country with a very high ratio (Japan has nearly 200%!) can be considered a fairly safe investment, while a less-sober country (*cough*Italy*cough*) can be in trouble with one as small as 120%.  Also important are rates of change of debt; growth of GDP; signaling by central banks; and many other factors.

Two key principles in these sorts of situations are:

  1. Perception is reality.  As long as people expect you to succeed, you can run very high debts.  The problem is, as soon as they begin to suspect that you'll fail, interest rates rise on the money you have to raise.  Even if you're no longer running up new debts, the old bonds mature and have to be paid off.  If you owe, say, $2.2T in debt, and have a balanced budget (are borrowing no more to keep your spending going), and your average interest rate is 3%, you're spending $66B in interest payments.  However, as those bonds mature, you have to pay them off, probably to the tune of at least hundreds of billions per year.  That money has to come from somewhere, so you have to "roll over" that debt.  If investors become worried that you're in financial difficulty, you'll have to pay higher interest rates on the new bonds.  If that goes to (say) 7%, you're now spending $154B in interest a year - and you're no longer in primary balance on your budget, and need to borrow even more to pay the interest on the new debt. Of course, that new borrowing will also be at a higher rate...
  2. This will be completely fine right up until the moment it isn't.  This stuff doesn't slowly get worse over a decade; it's fine and no one can see a problem, and then all of the sudden (in historical terms) it's a five-alarm fire and it's all over.
It's time to pull the fire alarm.

The Euro Zone is a bunch of mostly-autonomous governments who have decided to have a central bank and a common currency.  However, they each are individually able to borrow money.  Which, a number of them have done with great enthusiasm.  In theory, there were supposed to be limits on how much each country could borrow, but the reality has been that those limits have no real teeth, and they've been routinely flouted.

As Buffet said, "It's only when the tide goes out that you learn who's been swimming naked".  As the global economy faltered, the sharks began to circle.  Europe is now made up of a "core" - France and Germany and some other northern European countries whose debt is no more than about 80% of their GDP; and a "periphery" of southern countries that have ratios of 90%, 100%, 120%.

Six months ago the view was that the "periphery" was made up mostly of small countries, economically - Portugal, Greece, Spain, those sorts of places.  Clearly, if things got too bad, France and Germany would simply step in, pay the overage on their debts, and everything would be basically OK.  Sure, those countries would have to cut their budgets substantially as a term of it, and that would be unpleasant for them, but, it's not a global crisis.

Then, two things happened.  The first is that Germany made it absolutely clear that they weren't interested in being on the hook for an infinite amount of other people's loans.  They were, in other words, not interested in borrowing money to pay off other countries' debts, so those countries could have higher standards of living while Germany had higher taxes.  On the face of it, that seems like a reasonable position, but it is likely to cause Germany long-term harm as the Eurozone falls apart.  The second is that, suddenly (and perhaps in consequence of this), it turned out that one of the countries in real trouble was Italy.  Italy has the 8th largest economy in the world; and the 3rd largest in Europe.  Germany probably couldn't bail Italy out if it wanted to.  As a number of commentators have noted, it's "too big to fail, and too big to bail."

It has been quite amusing to read the European editorialists who pronounce "The European Central Bank [ECB] simply must do..." and then go on to lay out a list of actions that the ECB has already very explicitly said it is not going to take, because it would require German support that doesn't exist.

Now.  It's important to freeze the frame, here - in mid-October, 2011.  This crisis is, in principle, easy to fix.  Italy, Greece, Portugal, Spain, etc. simply need to trim their budgets, and/or raise taxes.  If they can bring their government spending into line, with a bit of a surplus to pay down the debt, they'll be able to send a credible signal to the bond market that they're getting their houses in order, and they're still good investment risks.  Simultaneously, Germany, France and the rest of the (relatively) solvent Eurozone simply have to say, "We are confident that our southern neighbors will put their houses in order.  So confident that we'll happily guarantee any bond they issue."

The incentives to get this right are enormous.  Unfortunately, they are not directed at the correct people:  Politicians. The core countries' electorates have made it clear that, damn the consequences, they are not spending their hard-earned dollars bailing out the profligate periphery.   The peripheries' electorates, meanwhile, have made it clear that, damn the consequences, they are not giving up their early retirements and extensive social safety nets just because those snooty northern Europeans say so.  "Who do those Germans think they are, trying to rule all of Europe from Berlin?" 

Politicians respond to those incentives until it is absolutely impossible not to.  For the periphery, that means when it becomes impossible to borrow new money, and it becomes necessary to finally do something.  The "something", however, will be to leave the Euro and go to their own currency so that they may print it with abandon and buy another couple of years.  That will then be the death knell for the Euro, however, as it will cause a domino run of bank runs as progressively "stronger" economies see mobile capital take flight to safer quarters.

My prediction for Europe?  Some periphery government will be unable to raise new money to roll over debt - which could be very soon indeed, perhaps before the end of the year and probably before the end of January - and will need to leave the Eurozone.  When it does so, it will destroy the Euro, completely - there will be no northern Euro, because the bond vigilantes will eventually set their sights on France.  Perception is reality, and that perceived vulnerability will become an actual one, and the currency union will shatter.

The effects here will be larger than most expect, because their banks are here and our banks are there.  Both of them will suddenly find all their Euro holdings to be of unknown risk (i.e., "junk"), and will be unable to meet reserve requirements.  There will be a bloodbath as these assets are unloaded.

All of those banks will need to park all of those assets, somewhere.

The only logical choice us US Treasuries.
In the long run, that is a disaster for us.

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This page contains a single entry by Brett Thomas published on November 26, 2011 10:01 AM.

Messes, Foreign and Domestic was the previous entry in this blog.

Government Spending as a Percent of GDP is the next entry in this blog.

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