A Summary of the European Debt Crisis
At CameoWorks, we work with companies that are seeking our advice on global expansion. The current events in Europe dominate the headlines, but it can be hard for executives to get a big picture of what is going on there from reading brief articles in the business press. My purpose for this article is to give business leaders a succinct overview of the crisis, the players, how it started, what is happening right now and what could happen in the near and distant future. That way you can understand how these events across the Atlantic can affect your business and what to watch for.
You may have noticed that people use a lot of terms interchangeably - Eurozone, European Union, or even Euro Area. Yet, each means a slightly different thing. The Eurozone refers to the 17 nations in Europe that have adopted the Euro as their currency. The European Union includes those nations plus 10 additional nations that do not use the Euro (such as Great Britain) but are part of the economic and political union. This picture makes it clearer:
For those of you who are not flag-savvy, here is a rough translation:
While many of these countries may seem insignificant on their own, as a block the 27 countries that make up the EU represent 25% of the world’s economy. In comparison, the US contribution to the world economy is only about 20%. It's not surprising, then, that the Organization for Economic Cooperation and Development recently cited Europe's potential slump as the leading threat to global growth. This chart correlates Eurozone industrial orders to US orders:
Before we jump into the European economic crisis, I need to back up a moment and talk about historical economic trends in general. Here I used the ideas of Ray Dalio, founder of the Bridgewater Hedge Fund. He simplifies economic trends into three main cycles that - overlaid on each other - explain the pattern we see in economic activity.
First, there is the long-term productivity trend, which has been roughly a 2% annual increase in GDP for the US and Europe for the last 100 years. Second, there is the short-term credit cycle that takes place at intervals of about 5-8 years. The gist of this cycle is that as credit and liquidity expand, business activity expands, and inflation increases. To keep inflation under control, the central bank raises bank borrowing rates through open market operations and the discount rate reduce the amount of credit available, and business activity slows down. The primary tool in this cycle is monetary policy – changing the interest rates that banks pay to reduce the amount of money in circulation. It's important to note much of what economists call ‘money’ in the various definitions of the money supply is not cash and coin, but rather credit and the ability to borrow. That will become important later.
Third, there is the long-term debt cycle. This is much harder to identify because it comes at much longer intervals – about 60-70 years. The fact that this is seen only once in a lifetime helps explain why policy response can be so disjointed. For simplicity, we’ll say that there are two main sectors – private and public. Usually, debt builds up in the private sector first but private debt has a way of becoming a public debt issue as fiscal stimulus steps in for shrinking consumer spending. Debt gives purchasing power, so as it builds, economic activity increases and the economy grows. However, as the aggregate level of debt increases (either public, private or both), eventually it will reach a point where debt service payments cannot be maintained. Interest rates can be dropped (through monetary policy) but, at some point, even dropping interest rates to zero will have no effect. This isn’t a crisis of confidence because the core issue – inability to make debt payments – doesn’t go away even if the outlook is good. Spending has to be targeted at reducing aggregate level of debt as opposed to buying goods and services. This is what is happening in the US and Europe right now – it’s a structural deleveraging. That is vitally important to understanding the context of the day to day headlines for Europe.
Here is an illustration:
As you can see in the chart, once monetary policy is ineffective, floating currencies and government spending become an important part of the self-correction mechanism. Looking back in history, some clear deleveragings can be identified. They tend to end with overall debt reduction due to write downs, extensions, restructuring, or reduced spending/higher income (austerity)….or central banks print money by buying large amounts of financial assets to spur growth and increase the money supply to ‘monetise’ the debt or shrink its relative size. Deleveragings tend to become evident over 2-3 years and take 10 + years to sort themselves out. That is what happened in Japan as illustrated by this slide from Richard Koo at Nomura:
With that foundation laid, we can return to Europe. Many of us in the US have looked at Europe and thought it all seemed too good to be true – the land 35 hour work weeks, good wages, and long vacations (not to mention the food). However, there are always trade-offs and in exchange for those lifestyle benefits, and the Europeans have accepted lower growth, lower employment percentages, and government as a larger proportion of the economy. Even though the European nations are economically linked through the Europrean Union, it’s impossible to simplify the crisis by pointing to one thing that 'Europe' did as a cohesive unit. The starting point in each country was different. We've all heard stories about how people in Greece were paid '14 months a year' or how tax avoidance had become a national past time. In 2010, there was about $10B of uncollected taxes - 50% of the annual deficit. In Ireland, a private real estate bubble turned into a public debt issue after the Irish government bailed out equity holders and bondholders. Spain actually started with relatively low levels of debt, but has a real estate bubble that will require its banks to be recapitalised. The long terms trends in demographics and globalization can’t be ignored either.
In any case, the 2008 global credit crunch was the trigger to expose the beginnings of a de-leveraging cycle – debt service levels (private or public) became unsustainable even with lower interest rates. Also, the global recession caused by the credit crunch highlighted the structural issues of the Euro zone and the limitations of the European Central Bank (or ECB). Many commentators has said the attitude originally was, 'Let's get to the common currency, and we'll fix the other stuff later.' but after 12 years, the fixes still weren't in place.
This chart highlights the missing component of have monetary union without full fiscal union:
There are three primary tools that central banks and governments can use to correct a sluggish economy. First, central banks can drop the central borrowing rate in order to support liquidity and the provision of credit in the banking system. This increases the money supply and economic activity. In this case, dropping from its current level of 1% would help the struggling economies of Greece, Portugal, and Ireland but would also increase inflation for Germany and is strongly opposed by Germany's central bank, the Bundesbank . The ECB's mandate is only one sided – promote price stability - and not to target steady economic growth. Also, decline in a nation's currency due to falling demand for its exports can serve to spur economic growth by making its exports comparatively cheaper. However, that option isn't available for Greece and the weaker economies in Europe because they are tied to the Euro, which has been made strong by the robust German economy. All of this is augmented by centrally funded spending. In Europe's case, that doesn't exist as each country has to live with the same exchange rate and interest rate but the market forces them to borrow at different rates.
In the following charts, you can see how the European countries funded themselves at similar rates and the system operated smoothly. After the global recession however, the market started to differentiate funding rates for the weaker countries.
This chart which illustrates the national debt/GDP of Euro zone nations is very illuminating. The green bar represents 2000 levels and the blue bar, 2010.
60% debt/GDP is thought to be the maximum level of reasonableness and in the Maastricht Treaty, which formed the EU, penalties go into effect above that level. As a point of comparison, the US is currently close to 100%. As you can see, some countries, particularly Greece and Italy, were already highly leveraged in 2000 and became more so by 2010. Others, like Ireland, weren’t highly leveraged at all, but became so when a private debt problem became a public problem after the real estate bubble required a taxpayer bailout of their banking system. Spain still isn't that highly leveraged, but is currently facing a real estate bubble that could lead to a bank bailout.
Also, another wrinkle that complicates the European issue is the large amount of cross-holding of debt - much of it held by each country's banking system. This chart from Reuters shows the French and German bank exposure to Greek debt.
It's important to note that in Europe, banks account for about 30% of GDP, compared to 8 % in the US. Their relative size to the rest of the economy makes the cross-holding of weaker nation's debt a much more significant issue. Also, European banks play a much more important part in the provision of credit and liquidity than in the US since Europe does not have the deep securitization markets we do.
A common currency without cross border subsidies and fiscal union creates distortions as well. It's not as simple as 'good countries and bad countries' or ‘savers vs. spenders’. As an export economy, Germany has benefitted disproportionately from the devaluation of the Euro due to the weaker economies in southern Europe. Also, Germany benefitted from southern Europe's leveraged purchasing power because consumers in those countries bought a lot of German goods as we see in the chart below.
By comparison, here are similar fiscal transfers in the US:
Missouri and Tennessee receive more Federal money than they provide in tax receipts. This cross subsidization across states would be called a 'bailout' by one country to another in Europe, and it highlights a main problem with how the Euro zone was constructed – there is no central funding mechanism – no central budget if you like - to coincide with a central currency.
To summarize, each weak economy has to fund itself but live with an artificially strong currency and restrictions on the central interest rate. The ECB is holding rates at 1% because of inflation worries in Germany. Each country is limited in its ability to print money or to spend money to get them out of this deleveraging spiral. And we’re only a few years into it.
What has been done so far and what type of future cooperation might be necessary? Basically, some financial backstopping and liquidity has happened but no structural changes.
The European Financial Stability Facility can lend up to 440 billion Euros and has commitments up 780 billion. It will become permanent as the European Stability Mechanism in July 2013. The balance can be used to guarantee loans, intervene in debt markets, or finance recapitalization of banks. Also, the IMF just announced a 300 billion European fund. The challenge is that the size of the problem - liquidity, financing, debt forgiveness, and fiscal stimulus can be self-escalating with market instability/lack of confidence. As funding costs rise, the hole gets bigger as debt payments grow. Also, it could devolve into to a cross border bank run and liquidity freeze. Just as in 2008, the solution starts with creating confidence to prevent a massive capital withdrawls and making sure there is an adequate supply of working capital for commmerce. During the US credit crunch, Hank Paulson talked about having a 'bazooka' at his disposal to calm down markets and consumers. Basically, the term referred to a tool for government that was significantly more firepower than required. This became the TARP program. In the US that bazooka was $700 billion in TARP money just for recapitalization. In the end they only used $431 billion with only a $32B loss currently. There currently is no bazooka for Europe. Currently, Greece, Ireland, and Portugal add up to almost 300 billion of aid and they are really small economies. Italy alone could be 600 billion. The current size of the EFSF is not big enough to provide that sense of calm to the markets.
Next came LTRO's or long term refinancing operations. Last winter, the ECB got out of its normal purchasing of short term government bonds and provided really cheap 1%, 3 year loans to European banks . The banks used that money to buy sovereign debt and that debt was the collateral for the ECB loans (The ECB can’t lend unsecured). This was an important move because of the scale of the program and because it involved longer duration funding. Effectively, it was like a quantitative easing program in the United States. The ECB lent 1.3 trillion Euros of this over two tranches and it did calm things down from December to April 2012. Italy’s and Spain’s funding costs dropped. However, like eating sugar, as soon as the LTRO’s stopped and the bank buyer withdrew from the government funding market, borrowing costs for those countries began to increase again. Clearly, this is because the core issues have not gone away. The deleveraging cycle continues to roll on and a solution will require more cross border subsidisation and fiscal union, which is at odds with the current political structure. Where economics and politics clash, economics eventually wins.
A force towards keeping the Euro together is that no one really knows how to unravel a currency union and or how to avoid the disruption that could cause. There is currently a prize being offered for the best thinking on what would happen. There are no winners – Germany would pay in any case. Here is a simple diagram of scenarios:
Assuming there is a break up, an entry for the Wolfson Economic Prize for the best ideas on the breakup of the Eurozone estimated what the depreciation would be in various currencies. If you move The Netherlands over to the left, you could see where you could see a two-tiered currency possibility.
A future resolution will need to probably have a combination of the following:
- More ECB easing. Going to from 1% to 0 would provide almost a trillion in extra liquidity that a ‘bailout’ fund would have to provide.
- A shift towards growth.
- A larger rescue fund and Spanish banks will need to be bailed out
- And finally, some type of joint funding guarantees – Eurobonds. This will mean an increase in funding costs for Germany but a decrease for many of the countries. There is so much debt it would likely have to take form on a partial basis. That could take 3 forms:
- Differentiating by term and only guaranteeing the short term debt. However, that is the term where they find it easiest to borrow. It also creates a re-financing hump that is not far enough into the future for growth to take hold
- Focusing on the Maastricht treat cap for public debt of 60% of GDP and guaranteeing debt levels <60% of GDP. That seems logical and would amount to 5.5 trillion Euros. However, the debt in countries above the 60% cap would become toxic and rates on that would likely increase so much that the debt service problem would continue.
- They could guarantee debt >60% of GDP. This would amount to 2.3 trillion Euros. A great feature of this is that the fund issuing Eurobonds would eventually wind down as each country got below 60%. States being helped from the fund will have to provide collateral and earmarked tax revenue.
However, issuing Eurobonds would be a change to the treaty and would require the approval of 27 different parliaments. Unless there is a more creative solution around that, approval could take 5-7 years.
Of course, every election is a chance to derail this. Also, there is very little incentive for the German taxpayer to want to pay for 1-4 above. Even though the price of failure will eventually come back to their economy, it is not transparent to them whereas the costs of bailout are.
Markets are predicting that a Greek exit is a high probability. It is important to distinguish between countries that have a liquidity issue vs. simply being insolvent, and Greece is insolvent. Similar to Lehman Brothers bankruptcy, a Greek exit could likely lead to unforeseen complications for the other Eurozone countries (such as a run on Portugese or Italian banks) and be the event that crystalizes the cost of inaction. This could be enough to spur more action around a Eurobond solution, more LTRO's, and lower interest rates - basically more fiscal union. However, the way forward will likely be a very bumpy ride through the latter half of 2012. It could amount to enough of an external shock to derail the US recovery and lead to another round of QE and negative GDP growth.
---- Drew Wolff
May 24, 2012