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Monday, May 7, 2012

Europe ... The Lenders Are in Charge Now

European elections in France, Greece and Germany didn't go so well this weekend for the fiscally responsible.

"Austerity" was rejected and "stimulus" was embraced by angry citizens throughout Europe. Socialism is alive and well over there.

But what's in store now? Well, here's my take.

Europe is one step closer to a necessary and long over due financial restructuring. But first there may be a crisis or two for them to overcome. We'll watch and see.

How do countries go bankrupt? Indirectly, that's how. Creditors, beware!

Bankruptcies always occur when the accumulation of massive debt has taken place. However, countries don't go broke as such. Instead they devalue or debase their currency, often through inflation. Hence, what was once worth $1 before the devaluation may be worth 20 cents after the devaluation. Debtors love it, and creditors hate it. The poor suffer the most from it.

In many of Europe's largest countries, monetary policy and fiscal policy have been treated separately for each member nation since the adoption of the common Euro currency in 1999. The idea , wrongheaded from the outset, was that while members would share a common monetary policy and currency, the Euro, each country would continue to manage its fiscal affairs separately, albeit responsibly.

It didn't turn out that way. In brief, Germany did and the rest didn't.

Thus, Greece now can't devalue its currency and neither can France. At least not without leaving the Euro currency.

On the other hand, Germans don't want to get stuck with the bill that countries like France and Greece have run up with their wasteful and irresponsible easy money spending during the  Euro years.

We won't go into detail here. Suffice it to say that the adoption of a European common currency unaccompanied by a binding union of political or fiscal policy was a really bad idea from the beginning.

Meanwhile, the various sovereigns all pledged fiscal responsibility and headed for the economic cliff together. Now they've arrived at the edge and don't like what they see.  Neither do their angry citizens.

So who's in charge now? Well, I would argue that it's the creditors or bondholders, and not the government officials, new or old, or the citizens either.

Euro-Zone Elections Pose Bond Market Challenge puts it this way:

"The weekend's election results don't make pretty reading for European bond investors. Until now, elections have followed the bond-market orthodoxy: Votes in Spain, Portugal and Ireland delivered governments that promised to follow the euro-zone prescription of austerity and reform. The victory of Fran├žois Hollande in France and the fragmented outcome in Greece mark the first time Europe's voters have rejected this. The problem is that bond markets are still likely to call the shots.

Mr. Hollande's defeat of incumbent Nicolas Sarkozy was at least expected. . . .

The real uncertainty lies in Greece, where the dominant New Democracy and PASOK parties were widely rejected, with more than 60% of votes going to former fringe parties. The two parties looked set to gain 149 seats in parliament, short of a 151-seat majority. New Democracy leader Antonis Samaras has three days to form a coalition government, but many are skeptical a robust alliance can be formed. Fresh elections are a possibility. Meanwhile, there seems little room for maneuver on Greece's bailout targets. That cocktail may reignite fears about a Greek exit from the euro. Citigroup Monday lifted its probability of exit to 50% to 75%. Investors should watch Greek bank deposits for signs of capital flight. Greek bank shares plummeted by 17% to 20% on Monday, and Greek bond prices fell sharply from already low levels.

While the elections have delivered a new political constellation, the environment that the new leaders must deal with remains the same. The euro zone faces a deepening recession: Spanish industrial production fell 7.5% on the year in March, data released Monday showed. Spain and Italy remain at risk of a funding crunch. The European Central Bank is resisting calls to do more to help.

A new lurch into crisis is possible.

That would test whether euro-zone governments can deliver greater solidarity and support, something favored by Mr. Hollande, and implicit in Greek requests to renegotiate the bailout deal.

Germany remains crucial on this front, but its position seems little changed. German officials Monday called for Greece to comply with its program. They struck a conciliatory tone with Mr. Hollande on growth, but continued to oppose higher spending: growth must come through gains in competitiveness.

Despite the voters' rejection of current policies, bond markets are still in the driving seat. While nervous about the effects of austerity on growth, investors won't sanction higher borrowing. Greater euro-zone unity would ease their fears too. But they won't hesitate to spell out the costs if politicians fail to deliver."

Summing Up

As a practical matter, here's how countries go bankrupt. Inflation and devaluation.  Stiffing the creditors and bailing out the debtors, that's how.

Individual countries that are in charge of their own currency and monetary policies go bankrupt indirectly by cheapening their currency and leaving their creditors holding the bag of cheap currency.

The common Euro currency was designed to prevent that outcome in Europe by making it "impossible" for countries to leave the Euro. At least that was the plan.

However, massive accumulations of debt always end up in bankruptcies, and this time will be no exception. The only question is how, who and when. You see, Greece already is over the cliff with no way back, at least on its own. It has only bad choices to make.

If lenders decide to stop loaning money to poor sovereign credit risks, or to raise the interest rates on new loans dramatically, which they should and will, the sovereign borrower has no remedy other than default or cheapening its currency.

In the eurozone, individual member countries like France, Greece, Ireland, Italy, Spain, Portugal and elsewhere don't have the option of currency devaluation. At least not yet.

But the bondholders won't be patient for very long, if at all. So look for some combination of a Euro weakening, rising interest rates and for credit to dry up as well. And that definitely will hasten the arrival of a new round of Europe's financial crisis.

In simple terms, the bond vigilantes are in charge, no matter what the politicians and the voters may choose to say.

The only viable solution is to use a common sense approach. Living beyond our means and endlessly growing government welfare entitlement programs aren't perpetual options.

Sooner or later the creditors rebel. They then signal clearly that they've had enough. In Europe that time is nigh.

Sustainable economic growth always depends on private sector investment and not government spending.

Government has no money of its own to spend and when creditors stop granting it easy money and low interest rate loans, all hell will break loose.

We just never know exactly when.

Thanks. Bob.