This Euro Crisis

Includes: ERO, EU, FXE
by: Erik Dellith

I recently caught Gutone's article "What Euro Crisis?," which raised some very good points, but also left much unanswered. This got me thinking about the general situation in Europe. After examining some debt ratios, I am not as optimistic as Gutone if Greece defaults and leaves the euro.

Many have stated that Europe in general and Greece in particular will not cause another Lehman-style crash. To this point, many, including Gutone, have stated that banks are more prepared this time around. I would cautiously argue that some banks may be more prepared, but that does not mean that all are, nor does it mean that even banks with no direct exposure to Europe would remain unscathed. Richard Suttmeier also discusses the tenuous positions of many banks here.

Gutone makes a statement that should be reassuring, but I actually find it somewhat unsettling: "All the financial institutions and governments have had enough time to do their homework thoroughly on different scenarios." It sort of reminds me of that old joke: If you want to make God laugh, make a plan... I'm sure you get the idea.

This brings us to the crux of the issue, Gutone's statement that "even if Greece, Portugal, and Spain all eventually default and exit euro, we will not see the same kind of crisis as we had in 2008." I can safely say, after years of studying economics, I have only "some" idea of what would happen if a single-currency economic region the size of the eurozone suddenly fell apart. (Hey, what happened after Rome collapsed?) Oh sure, economic theory can give us some idea of what to expect. (It's not good.) And we have plenty of examples throughout the course of history of nations devaluing their currencies: Asian financial crisis, Mexican peso crisis, Russian ruble crisis - that list goes on. So, we have a pretty good idea of what will happen in Greece if that country leaves the euro and goes back to its own currency, if nothing else happens. (That's not good, either.) But what about the way Greece's departure and economic collapse would reverberate throughout the world?

A key factor with the 2008 crisis wasn't that companies had direct exposure to Lehman Brothers so much as that the corporate credit markets dried up to the point where they made Death Valley look like lush rain forest. Hyperbole? Yes. But you get the idea. And Gutone correctly points out this dynamic.

Will we see the same kind of crisis we saw in 2008? I have to agree with Gutone that we will not see the same kind of crisis we had in 2008. We will have a similar-but-still-different crisis, focused on sovereign debt instead of corporate debt. Alas, there is nothing new here, we have long known this. But that doesn't mean that things would be better. To the contrary, things could be quite worse. Countries have already tried the fiscal stimulus route to boosting economic activity. The result? Meager growth, if any, and massive deficits that set the stage for people like Peter Schiff to write books about the USA being broke. Moreover, with interest rates already very low, there is little more that monetary authorities could do. Hence, we see little room for any counter-cyclical fiscal or monetary policies to ameliorate collapsing economies. Consider what this means for standards of living for a moment. (Yeah, that's not good either.)

Greece is a relatively small economy, with GDP of about $303 billion in 2011. This puts it about on par with the state of Maryland, give or take. The problem is that many countries in Europe are in situations that are not much better. Today, we saw the EU warn of economic imbalances in 12 of its member states, with seven of those in the eurozone.

Thus, there is potential for spillover if Greece falls. Spain has clearly grabbed much attention lately, and understandably so. Miguel Angel Fernandez Ordonez's resignation is somewhat telling about the situation there. Another key aspect is that Spain, like Greece, is facing a recession that is turning out to be worse than forecast. Another problem is that Spain is a much larger economy.

To get a clearer picture of the debt burden of these countries, consider the table below, which depicts gross debt to GDP among the eurozone countries. (Yes, I am aware of issues related to looking at gross debt versus net debt, but this is just to get a quick idea of the situation here. We can explore the differences later perhaps.) For reference, I also include the region's average and variance, as well as the gross debt to GDP figures for Japan, the U.K. and the U.S.A. This data is from the IMF.

Greece's debt/GDP ratio is expected to hit 153.2% this year. With GDP falling short, we can expect that number to climb, thus putting additional pressure on politicians there to agree to bailout terms. It will be interesting to see how the Greek people actually vote in the upcoming election.

Notice that Spain's debt/GDP ratio, forecast to be 79% this year, is nowhere near as high as Greece's level, and it is somewhat better than France's reading. The difference? Spain's recession is intense, to say the least.

Notice Italy's relative position. There is little wonder why yields on Italian debt have crept higher given the concerns over Greece.

Examining this table, we see how quickly the debt/GDP ratios climbed for many countries that are currently in a relatively tough spot, such as Greece and Ireland. Further, the IMF forecasts indicate little improvement over the coming years. This suggests potential for spillovers in the event that Greece leaves the euro and defaults on its debt. (I can imagine a conversation between traders now: "If Greece couldn't handle its debt, then what's to say these other countries can deal with theirs? Dump 'em all.")

The National Bank of Greece (NBG) reported recently that per capita income would collapse by at least 55% if the country left the euro. Imagine a similar dynamic impacting other European countries, even if the magnitude of that dynamic is not as large. Now think about what that could mean for global trade, and the drag that could be on growth.

Again, I agree with Gutone that we will likely not see the same kind of crisis we had in 2008, in the event that Greece defaults and leaves the euro. I am a bit concerned that it could be worse.

Realistically, I have faith (not much, but some) in policymakers to arrive at a new lackluster remedy that will keep Greece in the eurozone. Until such a resolution is announced, however, domestic equity markets will likely continue to whipsaw with every bit of good and disappointing news. The focus lately has been on the disappointing news. Undoubtedly, if that remains the focus, and consumers act accordingly, we could expect to see U.S. GDP growth come in shy of the 2.1% the IMF currently forecasts for this year and the 2.4% it forecasts for next. In fact, I wouldn't be surprised if another recession hit. And that's with Greece remaining in the eurozone.

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