5 Things You Need to Know About the European Debt Crisis

Includes: ADRU, ERO, EU
by: StreetAuthority

by David Sterman

Here in the United States, the scary days of 2008 when Bear Stearns and Lehman Bros. collapsed, major auto firms needed to be bailed out and Uncle Sam injected $85 billion into a teetering AIG (NYSE: AIG) are starting to seem a like a distant memory. The bailed-out auto makers are looking stronger, the rest of Wall Street failed to buckle under as Lehman and Bear did, and much-reviled AIG is valued at more than $50 billion once again.

But from Berlin to Paris to Rome to Athens, the painful economic crises have never left the stage. Three years on, policy makers are struggling to come up with yet another plan to save the weakest economies in Europe without saddling the larger, healthier economies with open-ended liabilities. It's been a Sisyphean task, trying to get that boulder up the hill -- and Sisyphus is getting tired. If Europe can't reverse course and develop a better game plan, then a whole series of events will play out, with mixed implications for equity investors.

1. Why do the problems persist?
A number of European governments run persistent budget deficits, just as we do in the United States. The solution was to cut spending, raise taxes and let economic growth help maintain newfound momentum by bringing in ever-higher tax receipts as economic activity builds. It soon became apparent that budget cuts weren't deep enough, a tolerated outcome in the face of rising social unrest. Yet few officials anticipated that these countries' economies would get worse. Economic activity in Greece, for example, is weak and getting weaker, and the government is bringing in a lot less money than was hoped. So those massive capital injections from neighbors have been going down the tube.

2. What's next?
Tough choices are being looked at. Greece, with $500 billion in sovereign debt, needs even more money. Citizens in France and Germany are quickly tiring of seeing their governments send good money after bad, depleting their own national treasuries. Politicians are loath to say it, but Greece may eventually be left to fend for itself. And that's not necessarily a bad thing. Greece could follow Argentina's example and announce plans to only pay its lenders $0.30 cents on the dollar while exiting the euro and bringing back the drachma. And the value of the drachma would be much lower than the euro, quickly making Greece more competitive in terms of exports.

3. If Greece bolts...
If Greece pursues this course (which would be quite appealing to me if I were an average Greek citizen), attention will immediately turn to the other PIIGS (Portugal, Ireland, Italy and Spain). With all due to respect to Portugal, whose economy is fairly small, a defection from The European Union would not likely be devastating and could prove helpful. But those other three countries, with their larger-sized economies and deeper integration with the rest of the continent, cannot be tossed off the boat quite so easily.

4. Spain and Italy
A look at Italy and Spain highlight the landmines ahead. They have the world's eighth and 12th-largest economies and are key players in European trade. They have given and received so many gains from economic integration with partners such as France and Germany that any sort of divorce would cause a huge amount of pain. Trade flows would drop, exacerbating already-weak economic trends.

But a real test looms: banks in these countries used short-term loans to get through the crisis. Those loans are now coming due. In the next two years, for example, Spain will need to roll over about $200 billion worth of loans. Who will buy them? (And at how high an interest rate?) Northern European policy leaders have been on the fence. Even if they buy them, they are bound to place very restrictive terms on the loans, tied to even further belt-tightening. That's why some believe the worst of the social unrest we've seen in Europe has yet to come. Nobody's happy. French and German citizens don't want to shovel billions more to their weaker neighbors, and Spaniards and Italians are wearying of externally-imposed austerity measures.

5. The consequences
For U.S. investors, this can all play out in several ways. France and Germany can continue to expend their considerable financial assets shoring up their distressingly weak neighbors. This would also imply that all nations use a common currency, but it's hard to see how the weakling nations can start to rebuild their economies when they are so uncompetitive from an export perspective.

France and Germany can also waive the proverbial white flag, tacitly suggesting that the grand economic experiment has failed by tightening up the European Union to only the healthiest nations. In effect, you would have two Europes, largely along northern and southern lines, that could help each to emerge stronger. German and French banks (after a series of massive write-downs) would no longer worry about their financial strength (though those countries would have currencies as strong as the Swiss franc, which has nightmarish implications for exports -- think German cars are expensive now?) The weaker nations would likely default on their debt and devalue their currencies, which if Argentina is any guide, may not be a bad thing.

The longer-term implications for U.S. investors are not yet fully clear. If Europe slips into a much deeper crisis as a solution isn't found, then it could be quite messy and the United States could be sucked down in the global vortex. The long-shot scenario is that economic conditions start to improve in places like Greece and Spain, enabling governments to bring in materially higher tax receipts, and making their existing and future borrowings look more manageable. Right now, especially as they are tied to the euro, countries like Greece, Portugal and Spain hold many economic disadvantages compared with their northern neighbors.

I hold the minority opinion that we are indeed looking at the beginning of the end of the European economic union. Secession by some of the PIIGS (Portugal, Ireland, Italy, Greece and Spain) countries looks to be the clear path. It would be a disruptive process, but perhaps healthier for the global economy and our key European trading partners. And if France, Germany and other strong economies stay together, then their remaining currency could rise enough in value to make the dollar a relative bargain. And might that help the United States to finally re-emerge as an export powerhouse? Time will tell. But the best thing for investors right now might be to take a "wait-and-see" approach before making any major moves.

Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.

Original article

About this article:

Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here