PIIGS To The Slaughter: After Greece, Portugal

Includes: FXE, GREK
by: Chip Krakoff

Let's just suppose for a moment that the Greek debt crisis can somehow be resolved without a disorderly default or the collapse of the Euro. As I have written previously, I very much doubt that it can, and today's news gives little cause for hope. Although the leaders of both of Greece's major parties agreed this morning to the latest round of austerity measures, the EU powers have backed away from ratifying the deal, demanding a further 325 million Euros in budget cuts.

The Greeks now know how the Turks must feel, constantly on the cusp of a final agreement with the EU, but never quite getting to the finish line. This latest wrinkle will no doubt be ironed out within days, if not hours. It requires a much greater leap of faith, however, to believe that this will resolve the crisis once and for all. But suppose it does. What then?

We read in today's New York Times that the future of Portugal, which has done everything the European Commission-European Central Bank-IMF "troika" has demanded of it, remains uncertain. In exchange for a 78 billion euro bailout package granted last May, the Portuguese government reduced its budget deficit by more than one-third with the introduction of cuts in spending, wages, and pensions, together with substantial tax increases. The Portuguese people, altogether less volatile than the Greeks, mostly accepted these stringent measures without taking to the streets, at least until last Saturday, when 100,000 people massed peacefully in Lisbon's Palace Square to protest the latest round of cuts.

Portugal's situation remains altogether less dire than Greece's, but the signs are not encouraging. On top of a 1.5% drop in GDP last year, a further fall of 3.0% is forecast for 2012. Unemployment, at 13%, is well below the Greek or Spanish rate, but newest budget cuts, which include another 1.2 billion euros in public pension payments, point to a worsening of all major economic indicators. Portugal's public debt, which stood at 107% of GDP last May, is expected to reach 118% by the end of this year, even as the budget deficit has been reduced from 9.1% of GDP to 5.6%. Further shrinkage is likely, as the Portuguese Prime Minister has pledged to cut the deficit still further, to 4.5% this year, which is more likely than not to accelerate the economy's downward spiral. Though the IMF predicts that the Portuguese economy will eventually grow enough to reduce the debt burden, few others believe this.

According to David Bencek, an economist at the Kiel Institute for the World Economy, Portugal would need to run a primary budget surplus of 10% of GDP to reduce debt to a sustainable level. This would require much more severe spending cuts than anything seen so far, but the rub is that such cuts will shrink demand and raise unemployment, with corresponding reductions in tax revenues, making that target unattainable. As the Times article points out:

Without growth, reducing debt levels becomes nearly impossible. It is akin to trying to pay down a large credit card balance after taking a pay cut. You can slash expenses, but with lower earnings it is hard to set aside money to pay off debt.

This points the way not only to a Greek default and exit from the euro, but a Portuguese one as well. After that, it could be the turn of Ireland or Spain, or even Italy - all of the countries known collectively as the PIGS. And although default is not even a theoretical risk for the United States, our legislators, in their budget-cutting zeal, could condemn us to highly indebted, no-growth fate similar to what Japan has experienced for the past 15 years. You cannot cut your way to prosperity.

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