Thursday, July 26, 2012

Europe's Woes Seriously Threaten Global Stability

Europe is a financial mess. Maybe even beyond hope, at least as far as the Euro is concerned.

Many southern euro zone countries have already entered a recession and others are teetering on the brink of one. None of that is news.

What is news, however, and needs to be clearly understood is the impact of increasing interest rates on a highly indebted country's ability to service its debts.

And there are lessons from Europe for us to learn here in the U.S. as well.

In fact, in due course we may be facing a similar issue to the one confronting Europe if we don't take appropriate remedial action soon. Accordingly, it's both helpful and necessary for We the People to know what we need to avoid and why. We'll take a shot at that debt to growth to interest rates conundrum herein.

In Euro Zone, Debt Pressure Tightens Grip the debt to GDP to interest rate level story is described:

"With August fast approaching, Europe’s summer just got a lot less relaxing.
Signs that cracks in the euro zone are widening sent markets on the Continent down sharply on Monday, as doubts grew about Greece’s ability to make good on its debt payments and Spain’s economy — the region’s fourth largest — was straining under the pressure of the government’s austerity measures.

Additionally, in a blow to the euro zone’s most stable countries, Moody’s Investors Service late Monday cut the outlook for its AAA credit ratings for Germany, the Netherlands and Luxembourg to “negative” from “stable.” The agency cited the fallout from an increased likelihood of a Greek exit from the euro and possible greater costs for supporting countries like Spain and Italy. . . .

“Europe has become incapacitated,” said Alessandro Leipold, a former deputy director at the International Monetary Fund.

The immediate concern is that if Greece does not present an acceptable budget-cutting plan — as it has promised to do as a condition of its bailout — Europe will not give it the money it needs to make interest payments. That in turn could lead to a default on its debt, causing financial contagion as investors worry about what will happen to bigger economies like Spain’s and Italy’s.

European leaders have pulled the region back from the brink of collapse time and again. But many investors, economists, government officials and international monetary officials are worried that finding a solution keeps getting tougher now that Europe’s debt crisis is in its third year.

“Everyone is looking for an easy way out, but there isn’t one,” said Stephen Jen, a former economist at the monetary fund who runs a London-based hedge fund.

German officials on Monday continued to sow doubt about Greece’s future in the euro monetary union. . . .

Spain’s interest rate on 10-year government debt spiked to 7.51 percent, its highest level since the euro currency was established in 1999, before ending Monday at 7.43 — still well above the 7 percent level that many analysts fear could eventually shut Spain out of public markets and force it to seek a bailout.

Italy’s 10-year bond yield climbed to a six-month high Monday, to 6.35, as it wrestled with its own debt problems and the risk of an economic collapse in its autonomous region of Sicily. . . .

Greece has survived for nearly three years on money doled out by European taxpayers. But among the Greek people, the new prime minister, Antonis Samaras, is under pressure to make good on election pledges to soften some of the harshest austerity terms linked to Greece’s loans.

The country is burdened by debt that is 165 percent of overall economic output and an economy set to shrink by 7 percent this year. Now the new government is proposing to cut 11 billion euros in spending without laying off any of its 150,000 or so public sector workers — a trick that most economists see as impossible. . . .

Officials from the troika overseeing the Greek bailout — the International Monetary Fund, the European Central Bank and the European Commission in Brussels — say privately that they doubt the country will be able to meet its official target of bringing its debt down to 120 percent of economic output by 2020. . . .

While analysts believe that Europe will figure out a way to get Greece the cash to make good on this obligation, they are not so sure about what will happen after that. . . .

The escalation of the crisis has renewed calls, including from Spanish government authorities, for the European Central Bank to offer its own support via a program that would aggressively buy Spanish and Italian bonds. The thinking is that would drive down yields and make the debt attractive to investors again.

However, some analysts believe that holding out for such an intervention is futile. Germany, these people say, will not budge from its core belief that all the weak European nations — from those that have been bailed out like Greece to those on the verge of a bailout like Spain — must bring down their deficits and debts to manageable levels if they intend to stay in the zone.

“In the end, I believe the euro zone will break up, it is just a question of how many more crises we will live through before that happens,” said Douglas McWilliams, the chief executive of CEBR, a London-based economic forecaster.

Mr. McWilliams believes that a Greek exit, if it comes, would prompt investors to question the membership of other countries with competitiveness problems like Spain and Italy. And he disputes the view, said to be held by a growing number of German public figures, that Europe can afford to let Greece leave the zone, as its new 500 billion euro rescue facility can serve as a firewall to halt the spread of contagion.

“Once Greece goes, then you start to look at the other troubled countries,” he said."

My Take

When countries have debt equal to or greater than their annual GDP, there is a great likelihood that they will default on their debt. This is especially the case when nominal growth is less than the interest rates they pay for borrowed funds. Thus, creditors become the ones who make the decisions and they tend to stop loaning additional money to overly indebted borrowers, sovereigns included.

Following is a short explanation as to why this happens when debt approaches annual GDP and interest rates exceed nominal annual GDP growth. Since it could happen here as well, it's not simply a European problem. And most assuredly it's not an academic issue---it's all too real.  Excessive debt is dangerous for lots of reasons. Rising interest rates end up being the economic killer.

Country A's GDP is $100 and its debt is $100 as well. If it is in recession and its interest rate for new borrowings is 2%, its debt will grow by at least 2% in year #1. That's because it will have to borrow at least an additional $2 to pay its increased interest tab. 

Now let's assume the bond vigilantes raise the interest rates country A must pay on new borrowings from 2% to 7%, similar to what's happening in Greece, Spain and Italy now.  And let's further assume that each of these countries enters a recession. Paying $7 in interest will necessitate that that country borrows at least an additional $7 just to pay the interest tab. In that event, the country's financial death spiral has begun. It won't be able to grow at 7% or greater and probably not at 2% or greater either. Game over.

And that's exactly what 's happening in Europe today. Economies aren't growing and countries' debts are already equal to or greater than their annual GDP. Potential lenders are worried about getting paid back, so they either don't loan or dramatically increase the interest rates they charge on renewed or new borrowings.

As a point of reference, Germany pays slightly more than 1% for ten year borrowings and the U.S. now pays less than 1.5% for its ten year government loans.

Meanwhile, Greece, Spain, Italy and others are paying ~7% and their economies are in recession.

They apparently have no way out unless some other country, such as Germany, writes a check and bails them out by loaning them even more money, which for obvious reasons Germany is extremely reluctant to do. They have limited resources, too. As do we all.

Summing Up

We can't be sure what will happen to Greece, Spain, Italy or many other countries in Europe. Not even in France and Germany.

Will they effectively address their problems or is it already too late to do so?

In any case, the European entitlement welfare state is entering the end game stage.

To avoid disaster, a sovereign's economic growth must be sufficient to service a country's debt load.

Otherwise that country will fall off the proverbial financial cliff.

Many European countries may already be over that cliff and simply experiencing a Wile e Coyote moment right now.

It doesn't have to play out that way in the U.S. but it's definitely headed that way.

We need to change direction NOW.

Thanks. Bob.

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