Thursday, June 28, 2012

European Two Day Summit Meeting ... Not Much Likely to Happen

European leaders are meeting today and tomorrow concerning how to prevent their financial wheels from coming off totally.

Although the ObamaCare Supreme Court ruling today is getting all the headlines in the U.S., events at the European summit are equally if not even more important to the economic future of Europe and the world, including the U.S.

Practically speaking, Greece has defaulted. And now Spain and Italy are close to the edge as well.

Will they default or will Europe "vote" to inflate instead? In a fiscal debt driven crisis, those two alternatives --- default or inflate --- are the only available options other than private sector growth. And growth isn't coming to either Spain or Italy anytime soon. Hence, keeping the wheels on is very much job #1.

It's good the EU expectations are low has the overview:

"There’s been a lot of talk about what European Union leaders are discussing at the summit than began earlier Thursday. And there’s been a lot of discussion of what they may do, and what they won’t do – even if almost every person who studies the situation knows what they should — and will have to eventually — do anyway.

But at least for the umpteenth EU summit, expectations do seem to be lower. And that’s a good thing, . . . Maybe markets won’t end up so disappointed.

After more than a dozen similar summits since the European sovereign debt crisis began, where officials kick the can down the road, “people have little hope this will be the one where they make a decision,” (an investment manager) said Thursday. “They need to eventually discuss the structural issues, but I don’t think that will be solved at summit #19 or 20 or 21. We expect more noise and more false starts out of Europe.”"

There actually is very little Europe can do anytime soon about cleaning up its financial mess, but let's look more closely at the important future "keys to the game."

Optimism on Europe Doesn't Add Up says this:

"In Europe there is hope, and then there is math. And the two are on a collision course.

Optimists are counting on the latest make-or-break European summit that starts Thursday to deliver convincing steps toward the fiscal and banking unions deemed necessary to keep the euro alive.

Unfortunately, even best-case scenarios for the two-day summit won't change some bleak arithmetic. This suggests the debt crisis will rage in Spain and Italy for years.
For government debt to shrink as a share of gross domestic product, economies typically need growth plus inflation, known as nominal GDP, to exceed borrowing costs. In short, the economic pie expands faster than the debt.

Yet Spain and Italy will struggle to post any rise in nominal GDP this year. And it will probably shrink around 2.5% in each country next year, warns Ben May of Capital Economics.

Meanwhile, Italy had to pay nearly 3% Wednesday to sell six-month debt, compared with 2.1% a month ago. Both countries also have seen yields on 10-year debt rise to between 6% and 7%. That doesn't bode well for debt-to-GDP ratios.

Italy's already is 120%, second only to Greece in the euro zone. It should expand to 135% by 2015, Mr. May said.

Spain started from a lower level, but its climb has been striking. Debt to GDP has doubled in the past four years to an expected 80% or more in 2012. That will surely climb further when Madrid is handed the tab for its bank bailout. The country's prime minister sounded the alarm Wednesday, saying, "We can't finance at current prices for too long."

It may have little choice. While growth falters, overhauls of labor-market practices mean higher joblessness in the near term. And when it comes to inflation, wages and prices also must remain below Germany's to restore competitive balance in the euro zone. So even if Spain and Italy make all the right moves, their debt burdens likely will rise.

The hope in Europe is that this week's summit will deliver enough signs of progress that investors can safely start buying Spanish and Italian debt again. That would bring yields down and spark a virtuous economic cycle.

Maybe. But it will be tough to make the numbers work."

My Take

Without a resumption of reasonable economic growth, countries like Italy and Spain
will continue to fall deeper into what is already a very deep financial hole.

{NOTE: The same is true for the U.S., but that's another story. Besides, as the cleanest of the dirty shirts, we have years and years and years to go before approaching their beggar status. We'll get our act together long before then if we heed their example, which I'm betting we will.}

In order for Spain's and Italy's financial situations to show the necessary financial improvement, each country's nominal GDP growth will need to exceed its borrowing costs. Otherwise its debt as a percentage of GDP will only deteriorate further. But both are entering recessions, so near term economic growth isn't on the horizon for either of them.

Accordingly, Spain and Italy (as well as Greece, Portugal and others) now very much need Germany to ride to the rescue. However, bailing out other nations isn't at all popular among German citizens for obvious reasons.

Besides, Germany doesn't have unlimited borrowing power. Although it's a giant in Europe, it's a relatively small economy compared to ours. As a result, the Germans will rightfully be extremely cautious about "bailing out" southern European countries and agreeing to share their debt obligations.

In other words, without a common fiscal union throughout Europe being agreed upon sometime down the road, Germany would just be committing its resources without any reasonable chance of being repaid or even insisting that its resources were being managed prudently. Of course, other than the Germans, the rest of Europe's sovereigns are for the most part imprudent when it comes to living within their means, to say the least. {NOTE: Take heed, my fellow Americans.}

On the other hand, Germany's economy very much needs the European Union to continue in existence, since it depends heavily on exports to other European nations for much of its own GDP growth. Thus, Germany's financial future depends in substantial part on the rest of the zone continuing to function.

It ain't easy being Germany these days. Of course, it ain't easy being Greece, Cyprus, Spain, Italy, Portugal, Ireland or even France either.

Summing Up

The euro currency will continue to weaken considerably over time.

That weakening in turn will allow  currently uncompetitive European countries to become more competitive with their exports. In turn this will also strengthen Germany's export business outside Europe as well.

The price for this weaker currency will be higher inflation and higher costs for imports, including oil.

But that's how default will be avoided, or at least that's the likely plan.

In addition, the good citizens throughout Europe finally will have to come to grips with the simple fact that their government knows best protective "emperor" in fact has no clothes. Street protests won't change that.

This simply means that the socialistic welfare state administered by government officials won't be able to continue indefinitely.

To have any real and lasting financial security, each nation's products and services must be able to be sold profitably at globally competitive prices.

And unless a country's economic growth resumes at a reasonable pace in relation to its outstanding debt levels, its debt and overall financial situation will only worsen.

That's the simple "math of the matter."

Thanks. Bob.

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