Thoughts and Delusions: The EU Poker Game

Mar.18.11 | About: CurrencyShares Euro (FXE)

European leaders did not wait for the March 24-25 summit to deliver what they call acredible and comprehensive package." It's neither credible or comprehensive; it's just adding new shovels so it can dig itself an ever deeper hole.

Not a week goes by without governments and central banks bringing a new stone to the grandiose edifice they are building for posterity -- what might one day be remembered as the "great era of denial." We should all ask ourselves why there is so much research and so many summits for a problem that has unfortunately only one solution when one has lost the benefits of sovereignty long ago.

I take pleasure in debating the indebtedness and resulting outcomes for sovereign nations like Japan and the U.S., but there is really not much to debate for those under a single currency monetary union. Any back-of-the-envelope calculation exposes the simple truth of the situation and the endpoint it implies. Greece and Ireland have already been shut out of the markets. Portugal with its yields on the 5-year now at 8%,and Spains close to 6%, will be next in losing market access. Its not a question of "if," but "when." Once out of the markets' wisdom, it's just a political poker game.

Research is focusing on the latest EFSF changes (where the terms of the facility will be modified so as the full 440 billion can be available versus the 255 billion the collateral rules had imposed) and the reduction (100 bp to 4.8%) and extension (7.5 years) of the Greek loans. They have now sufficient funds to purchase all further debt issuance by Portugal and Spain for at least the next two years at some 200 to 500 basis points below market prices (a great investment indeed) as well as purchase these directly on the primary market (someone will have to explain to me the difference between providing loans to a government and providing loans issued by the government), hoping that investors will be fooled into demanding lower yields on peripheral bonds so that German and French banks can unload their exposure to these. Of course this is nonsense, as the secondary market is the only one laying out the truth politicians are so eager to hide.

You can throw as many numbers and ratios you want against a wall of debt, but there are some basic accounting rules that determine the outcome:

Change in govt = budget + ((interest rateGDP nominal) x debt)

Debt (deficit/surplus) on the debt growth

All the rest is smoke and mirrors, motivated by greed and fear. So let's take these one by one.

The budgets are all in deficits and by considerable amounts:

2011% Greece Portugal Ireland Spain Italy Belgium France

of GDP -7.2% -4.9% -9.5% -6.4% -5.1% -4.7% -6.9%

Source: IMF, National governments, EU Commission, SG Cross Asset Research/Economics

All
these figures already assume a pretty significant improvement from 2010. One knows that to lower the deficit one must either reduce expenditures or increase revenues (taxes) -- or, better still, both. It has been pretty clear ever since austerity measures on expenditures have been enforced that these tend to impact heavily the denominator of the ratio ((GDP)). There is clearly room to maneuver on expenses in countries like Greece, where the average government job pays three times the average private sector job and where the average state railroad employee earns 68,000 a year working for a state railroad company that is spending 400 million a year on wages with total annual revenues of 100 million.

Never mind that the Greek public school system employs four times more teachers than Finland, or that an audit of the largest hospital in Athens discovered that it had 45 gardeners on staff despite having no gardens. Still, a reduction in spending is the hardest to implement and is extremely sensible to mood changes amongst the population, as the recent riots in Greece have demonstrated.

On the revenue side, there are a few simple conditions that must be met for tax receipts to increase elsewhere than in the fancy Excel sheet extrapolations of government finance departments.

Above all, you must be able to enforce the collection of them. No use has a perfect tax code if no one is paying the taxes due. In countries where tax evasion is a national sport (think Greece and Italy), it will take years to reduce the level of fraud and restructure the tax collection system. In addition, the Greek governments revenue is a gigantic 40% of GDP already (versus 15% in the U.S.), leaving little room to increase taxes further without creating a street revolution.

The second condition is elevated wealth and income disparity (U.S. disparity is extreme, whilst Japans is very low). To be able to tax people, you must have a wealthy population of individuals and corporations to tax from. Extreme wealth and income disparity combined with a low tax rate is an ideal situation, as the government can raise the tax rate on the wealthiest without discontenting the majority.

In addition, the taxation of highly concentrated wealth will lead to a disproportionate increase in revenues. I personally dont believe that this has much of an impact on consumption, although I know that most discretionary spending is made by the top decile of earners.

The third condition is that you need a federal taxation (i.e. fiscal unity) which is a totally missing feature in the European Union and is a major reason for the current mess. All in all, none of the conditions are met in Europe, and it is therefore very unlikely that the optimistic deficit reductions will ever be met. Nevertheless, for the sake of argument lets accept the 2011 estimates above and continue our back-of -the-envelope accounting journey.

Here are the remaining numbers we need to understand the sustainability of the European house of cards:

Greece Portugal Ireland Spain Italy Belgium France

10y rate 12% 7.8% 9.9% 5.2% 4.7% 4.08% 3.5%

GDP g% -1.3% 1.25% 2.2% 1.9% 2.7% 2.65% 3.2%

Debt/GDP 151 86 110 72 120 100 87

Source: IMF, Bloomberg

This
last piece of the accounting identity simply states the obvious.
When a country approaches a debt/GDP ratio above 100%, its growth rate must be above the average cost of debt; otherwise, you enter a death spiral (and this assumes your budget is balanced, which is light years away from being the case here).

But let's put our rose-tinted glasses on and assume that all the above countries ultimately get the same Greek sweetener and the EFSF provides all further financing at the same 4.8% interest rate. Even under this scenario, which is the equivalent to providing EU bonds where all future debts are consolidates and backed by the European Union as a whole, the death spiral is not broken and each country continues adding to its debt load. It’s that simple.

The reason it's that simple is that the only other factors that could improve the situation -- control on the currency and control on interest rates -- have been lost by joining the European Union. Germany, which is seen as the remedy by providing endless financing to the periphery, is actually the illness. The euro is back to 1.40 precisely because of Germany. Long-term interest rates are moving back up, increasing the costs of new issuance, again because of Deutschland. Absent Germany, the euro would be worth a fraction of what it's worth today. Exports would fly, nominal growth rates would be in the double digits and the debt could gradually be inflated away.

So why are Germany and France so keen in pursuing this nonsensical and costly strategy? The banks, again. The banking system is the only one that has actually converged in the European Union whilst the economies are in full-fledged divergence. German banks' exposure to the PIIGS is 549 billion (17% of its GDP); Frances is 726 billion (28% of its GDP). European banks have an overall exposure to the PIIGS of 2.345 trillion. A debt restructuring of any of the peripheral countries would make the Lehman liquidity crisis look like a bank holiday.

But that is only the tip of the iceberg. The real insanity of these bailouts is the perverse reaction it has fueled amongst the banks of the periphery. As they watch the asset side of their balance sheets melt like snow in the sun under the weight of the deflating housing bubbles (Spain -20%, Ireland -43%), banks have been desperately trying to make up for the losses. And here comes in the unlimited liquidity provided by the ECB, basically providing cheap and unlimited financing to the banks to purchase their own domestic government bonds paying handsome yields. Kyle Bass of Hayman Advisors says that Greek banks have between 3-3.5x their entire equity invested in Greek government bonds, and notes that if these bonds took a 70% haircut, Greek banks would lose more than twice their equity.

What are the French and German doing? The exact opposite. They are actually slowly trying to unload their exposure to the periphery whilst the "Club Med banks" and the ECB are purchasing it. No wonder the ECB is trying to get out of the game; it knows perfectly well who are the fools at the table, and that the bonds will ultimately be worth a fraction of their nominal value.

Angela Merkel and Nicolas Sarkozy are out on a limb to keep the Union together, hoping that their banks will be able to rebuild their equity before they are in checkmate. Between the Greek government, which has sunk its banks with government debt, and the Irish banks, which have sunk their country with the mother of all real estate bubbles, the European Union looks more and more like a giant CDO where the periphery's government and mortgage debts (subprime) are held in the banks' balance sheets (investors and banks), which are then in turn guaranteed/repackaged under the AAA status of the ECB of the EFSF (mortgage insurers). This will likely end badly.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.