Conceived by dreamers and promulgated by politicians, the European project “United States of Europe” is coming to an end.
With the highest concentration of nation states per square mile than any other continent, Europe had the most and deadliest military conflicts in human history. The European project’s premise was an integrated Europe would prevent further conflicts such as World War II which killed more than fifty million Europeans.
Although the intention was good, the implementation was flawed. The Maastricht Treaty in 1992 established a monetary union without a political union. It established a central bank to set interest rates and print currency but not a treasury to tax at a federal level. This allowed member countries to borrow at similar interest rate as Germany, the most productive, efficient, prudent and fiscally conservative country. With cheap borrowed money peripheral countries Portugal, Ireland, Italy, Greece, and Spain spent beyond their means while remaining far less productive than Germany.
The Maastricht Treaty stipulates that member government’s debt to GDP must not exceed 60%. When the newly elected Greek government came into power in November 2009, it exposed the cooked accounting books of the prior government - Greece’s debt to GDP of 115% more than exceeded the treaty’s limitation. Unable to borrow in the open debt markets, Greece asked for help from the International Monetary Fund and the European Union. In May of 2010, The IMF and the EU agreed to a €110 billion rescue package under the requirement of fiscal austerity, deregulation, asset sales, and enforcement of tax collection.
After a year, the IMF and EU’s game of kicking the can down the road can go no further. They are at the end of the road with the realization of Greek’s broken promise of fiscal austerity, deregulation, asset sales, and enforcement of tax collection. With Greece’s current 157% debt to GDP, the fear of a Greek default has caused contagion to hit Italy, the third largest country in the European zone with 120% debt to GDP.
It is simple arithmetic that mature countries with over 100% debt to GDP will face default if they continuously run budget deficits. Consider the simple case of a country with 100% debt to GDP and taxes at a 50% rate of GDP. If the interest on its debt rises 1% because of investor fears, the debtor’s economy must grow by 2% in order to make the interest payment of its debt if all its debt must be rolled over. For a mature economy, growing GDP by 2% is not an easy task. With the global economy contracting now, making payment on higher interest would be impossible.
For Greece, the debt to GDP is 157%, budget deficit is -9.5%, unemployment is 15.2%, growth rate more negative than -5%, and tax receipts from its famous tax dodgers are much less than 30% of GDP. The one year yield on Greece government bond is 97%. No government can borrow at that kind of interest rate to fund its deficits, especially when its tax collectors are on strike. Greek default is a certainty.
Here is what might happen when Greece defaults, as described by Economist Andrew Lilico:
- All banks in Greece will instantly become insolvent.
- The Greek government will nationalize banks in Greece.
- The Greek government will forbid withdrawals from Greek banks.
- Greece will institute curfew to prevent riots.
- Greece will re-denominate all its debts into "New Drachmas".
- New Drachma will devalue by some 30-70%.
- The Irish might, within a few days, walk away from the debts of its banking system.
- Portugal will decide whether to default.
- Many French and German banks with significant losses will no longer meet regulatory capital adequacy requirements.
- European Central Bank will become insolvent.
- French and German governments will meet to decide whether
(a) to recapitalize the ECB, or
(b) to allow the ECB to print money to restore its solvency.
- French and German will recapitalize their own banks, but declare an end to all bailouts.
- There will be carnage in the market for Spanish banking sector bonds.
Under Mr. Lilico’s scenario, Europe would enter a deep recession. Since the U.S. is the largest capital market with the strongest military, investors would deposit money in the U.S. – a safe haven of last resort. This would cause the U.S. Dollar to rise, lowering exports and profits of U.S. multinationals when earnings are repatriated back to the U.S. The U.S. markets would fall. Consumers would retrench and all developing countries exporting to the U.S. and Europe would suffer lower sales, leading to a global recession.
To prevent chaos of a default as just described, politicians have been planning to obfuscate the situation so when Greece defaults, no one would realize it. Various plans have been floated such as bond buy-backs, bond swaps, Eurobonds, and fiscal union.
The idea of bond buy-back is to use rescue money to purchase bonds from private investors at the current deeply discounted price to lower the debt outstanding. The problem with the buy-back is the bond seller will not sell at the deep discounted price knowing there is a large pot of rescue money.
Bond swap allows bondholders to exchange their current bonds with new longer maturity bonds paying lower interest. This would give more time for Greece to pay back its loans. The problem with this solution is to have enough bondholders willing to participate. From a bondholder’s perspective, it is best not to participate and keep full interest payments while other bondholders participate and take a loss so Greece can survive.
Eurobonds has been touted as the panacea for the debt crisis. Instead of having each country in the EU sell its own bonds, a single Eurobond will be used to raise capital. The troubled countries will be able to borrow at the same rate as Germany. The problem with this solution is German’s Chancellor Merkel and the majority of Germans object. The rationale is cheap money is what got the peripheral countries overly indebted. With the Eurobond, there will be no market disciplinary force for fiscal rectitude.
The problem with bond buy-backs, bond swaps, and Eurobonds is the use of more debt to solve a debt problem. It does not address the fundamental problem of inability to grow the economy and inability to pay. Fiscal union will solve the long term problem but it does not address the current liquidity and solvency issue. This solution requires every country in the EU to vote for the plan, a very time consuming and contentious process.
Greece is in a debt death spiral, a negative feedback loop of doom. Where Europe ends up politically and economically from this crisis depends on the decision of Germany. If Merkel has the political will for the European Project to succeed, she would forgive debt of troubled countries. The problem she faces is seventy five percent of Germans don’t want to pay for profligate countries. West Germans were willing to pay for the unification with East Germany because they were once a single country with relatives and friends speaking the same language under the same heritage. Can Merkel convince her fellow citizens to be more generous like the Americans who sacrificed the lives to save Europe and spent mightily on the Marshall Plan to rebuild the world? Even if Germans agree, will the other sixteen countries agree to lose its sovereignty and give up its political control of taxation and spending?
The other position is to let the market take its course. Germany would recapitalize its own banks after they write off Greek debt. This would be cheaper but anti-Europe.
The end of the road is here. Germany must decide. The markets are impatient and will force a solution.
Greece should default on its bonds to stop a deterioration of the economy, said Mario Blejer, a former Bank of England adviser who took the reins of Argentina’s central bank after its 2001 default on $95 billion.
Italy joins Spain, Greece, Portugal and investment bank Morgan Stanley among distressed borrowers that turned to China since the 2007 collapse in U.S. mortgage securities set off a crisis that widened to engulf euro-region sovereign debtors. Italian officials held talks in the past few weeks with Chinese counterparts about potential investments in the country, an Italian government official said yesterday, adding that bonds weren’t the focus. China has currency reserves of $3.2 trillion. Italy has 1.9 trillion euro in debt. Italy needs to sell about 70 billion euros of debt this year to cover its deficit and finance redemptions.
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