Sunday, August 21, 2011

The European Problem

The United States is a sovereign nation with a dollar currency.

The euro zone is not a sovereign nation, but it has a common currency. Thus, there are many sovereign-states in the euro zone with one common currency, the euro.

Therein lies one big European problem. The European single currency, multi-sovereign approach simply isn't logical. That said, an immediately effective solution will be difficult to achieve, if not impossible. That's because there is no fiscal or political union within Europe, and therefore no European political decision making body.

So it's a mess. While the finances, debts and obligations of each sovereign are its own, the currency is a shared one. Although each country (Germany, France, Italy, Spain, Greece, Portugal, Ireland and so on) is responsible for its own spending and taxation, none has the power to alter the price of its currency. It's an untenable situation.

Typically when a sovereign country can't pay its bills, it doesn't go bankrupt, as do individuals and companies. Unless the sovereign chooses the path of outright default, it can accomplish the same thing as bankruptcy by debasing or otherwise inflating its currency. However, this method of currency devaluation is not an option for countries having the euro as their common currency.

Now let's bring the multi-national banks into the story. When there are sovereign-debt problems, there are always going to be related bank solvency problems as well. The banks are the ones holding the debt of the sovereigns (and each other, too) that borrowed the money which they now can't repay.

And when and if the sovereign defaults on its bank loans outstanding, the banks get stuck with the losses. That in turn means the banks will be less able to service their own debts. As a result, their solvency is often at risk, too. This is called counterparty or default risk, and it's now a huge one for the banks, especially European banks, who loaned to the financially weak sovereigns.

Here's what then can happen. A race for the exits ensues as all of the banks try to rid themselves of this sovereign debt as well as the debt of other banks who hold sovereign debt as well. In other words, all bank swimmers try to get out of the pool at the same time. It amounts to a simple and widespread run on the sovereign and many of the multi-national banks as well. When such a "run" occurs, the result is instability and chaos. This can then turn into a nasty global recession. Not a pretty picture and one to avoided, for sure.

As an example, we'll use Greece, one of the weakened European PIIGS (Portugal, Ireland, Italy, Greece and Spain). For self inflicted wounds, Greece is financially now a dead man walking, being insolvent with no realistic hopes of getting back on track economically. It needs rescuing in a big way. But who will rescue Greece and then the other PIIGS, should the dominoes start to fall in a widespread manner?

How about Germany coming to the rescue? It is relatively strong compared to all other European countries, but the German citizens don't want to bail out the Greeks (would you?). Still, Germany doesn't want the euro to implode and chaos and a serious continent wide recession to occur either. That would likely end up in financial chaos and a recession throughout Europe and perhaps the rest of the world, too. It's between a rock and a hard place.

In sum, the power to tax and spend belongs to individual nations or sovereigns. No European institution has the ability to stop spending by any single nation.

Financially what is needed, of course, is some kind of euro bond or continent wide fiscal authority. However, that would inevitably lead to more than making each nation responsible for the finances of the others. The logical next step would be some kind of overall fiscal or political union.

But as it stands today, most countries don't trust each other, and they sure don't trust Germany based on its long history, if nothing else.

So since the strong don't want to assume the obligations of the weak, and the weak don't want to relinquish their sovereign rights to tax and spend, currently it's a stalemate. Sadly, until this impasse is broken, the situation will remain an ongoing threat to global financial stability, and the various financial markets, too. Thus, look for the markets to force action by the sovereigns sometime during the next several weeks. The sooner the better.

Lessons for Europe's Crisis From U.S. and Brazil concerns this sovereign-debt dilemma, and includes a discussion of relevant lessons from our early American history. The story is told of how our first Treasury Secretary, Alexander Hamilton, persuaded Thomas Jefferson and James Madison to agree to the U.S. government assuming the various state debts in 1789. Although perhaps not widely appreciated, Hamilton did much to make America into potentially a great nation with this single act. In exchange for an agreement with the Virginians for the U.S. to assume all of the states' outstanding debts, our nation's capitol was built in Washington, D. C..

{At the time of the states' debt assumption by the nation, Virginia had relatively few debts, and Massachusetts was heavily indebted after the Revolutionary War. In our modern European dilemma, Greece is Massachusetts and Germany is Virginia. We'll soon see how it all turns out, and if the Europeans have learned any worthwhile lessons in the past 222 years.}

Sovereign debt is different than other debt. When a sovereign can't pay its bills, no matter what the weak sovereign does or doesn't do, its creditors are at risk of losing most or all of their investment unless some stronger sovereign body comes to the rescue. Today Greece is the prime example of a nation that is insolvent, meaning that it's broke, but it is also a member of the euro zone.

Let's recap.

The euro zone is a monetary union but not a fiscal or political union. If that sounds unworkable, in my opinion it is, at least for the long haul.

Total European debt is the sum total of the various sovereign debt levels. But Greece can't pay what it owes, and other countries, specifically Germany, don't want to assume the financial obligations of Greece or any other financially weak countries. Some of the other countries that are also in a weakened financial condition are Portugal, Ireland, Italy and Spain. Europe as a total is in relatively good shape, but there is no total Europe.

So Europe has its own Alexander Hamilton and Thomas Jefferson moment of truth ahead of it. What will they do, and especially the Germans? As little as possible for as long as possible, I predict. But as much as required to avoid a complete debacle throughout the continent and world. Somehow in the end we'll probably have to play a role here, too, as will China and perhaps others.

We're all connected, but it would be nice if the Europeans engaged in a little self help from time to time.

Thanks. Bob.

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