The eurozone is in serious trouble and Greece is just a symptom. Whether or not it defaults on its debt may not matter as similar problems plague Spain, Ireland, Portugal, and even Italy. The European Monetary Union (EMU) is built on a house of cards and it doesn't have the time for needed radical reforms. Like all sovereigns that owe more than they can pay, it will resort to monetary inflation to bail itself out. This article explains how the EMU works, why it is failing, and why it will resort to fiat money printing to solve it.
It may not matter if Greece is bailed out by the powerful EU economies because it is just one of many problems that the eurozone faces. While George Papandreou's socialist government survived a no confidence vote, the country is just postponing the inevitable. For while Greece may be temporarily propped up with loans, it is likely that it will ultimately default on the massive loans the EU and IMF have poured into it. This may have the unfortunate consequence of spilling over to the other PIIGS and jeopardizing the entire eurozone.
The basic problem that the eurozone faces is the unworkability of the monetary system envisioned by the European Monetary Union. It is now paying the penalty of having a central bank that is subject to political pressures. Make no mistake: the purpose of the EMU was political more than economic, created to foster further political integration of the EU. Looking back on this faulty system the economically powerful countries perhaps regret having given up their monetary independence. It will be they who will pay for it.
The end result of this faulty system, the PIIGS' (Portugal, Ireland, Italy, Greece, and Spain) deficit spending, will result in the euro's devaluation against other currencies, including the dollar. While the printers of dollars have nothing to brag about, the U.S. has the benefit of being the world's reserve currency and having a semi-capitalist country that is still the most powerful economy in the world. The Europeans have not integrated as well as we, and have not achieved that monetary status. With all our faults, the U.S. and its Treasury bonds are still the preferred port in a storm.
What the EMU has created is a Europe loaded up with debt financed by a banking system that has been given almost unlimited credit by the European Central Bank (ECB).
The worst part of the system is that it has given profligate countries an almost blank check to spend. To use an analogy, it is as if the Fed were to bail out all the U.S. states that have spent too much. Greece came into the EU as a corrupt socialist country with a huge bureaucracy and a moribund economy. The political system, as we can see from the protests and riots, caters to a large public sector that keeps voting in politicians who will support their lifestyles. They don't care who pays for their benefits as long as it isn't they.
Contrast this with a well run fellow EMU country, Germany, with a large and productive private sector whose sovereign debt is relatively modest in relation to its GDP:
(Click charts to enlarge)
The socialist PASOK party run by Mr. Papandreou and his father and grandfather before him, ran a political model familiar to Americans: an expanded central government, a public sector that consists of about 40% of the economy, a perpetual majority in parliament that serves their bureaucrat voters, a decline in the economy, massive corruption and tax cheating, and deficit spending to pay for the benefits. Greece ranks 37th out of 43 countries in Europe in terms of economic freedom. IT has have run up about €360 billion in debt ($518 billion).
To put Greece in perspective, at about 11 million people it is comparable to Ohio, but with a GDP of about $330 billion it is smaller than Ohio (GDP of about $480 billion). Ohio's local and state governments spend about $106 billion per year. Greece spends $152 billion, but it has been running a deficit equal to 10% of GDP (down from 15% in 2009).
Now Greece needs another €100 billion or so on top of €110 already pledged to the country by the EU.
This need for a new bailout was a bit of a surprise to many European observers. They didn't count on the intransigence of the socialists and their rather half-hearted attempts at budget cutting. They didn't count on the stagnation of the Greek economy, which would further diminish government revenues. They didn't count on the backlash of Greek citizens who are famous for their inventiveness at evading taxes.
The big question about Greece is whether or not they can repay their massive debt even with bailouts.
"Euro-zone governments are still pretending that they are dealing only with a liquidity problem, and that Greece and Ireland will emerge creditworthy from their programs," says Thomas Mayer, chief economist at Deutsche Bank in Frankfurt.
"But what happens if these countries can't return to the capital markets? If more austerity programs are needed, will voters rebel? The message is missing that a country that can't pay its debts must restructure," Mr. Mayer says.
While he survived his no-confidence vote, Mr. Papendreou has to convince his party members to make €28 billion more in budget cuts by July 3 or the next installment of the May 2010 bailout money (€12 billion) will be held up.
The market is betting that Greece will default. Insurance on its debt has gone up more than 47 basis points. Here is the chart on credit default swaps for Greek bonds:
The picture for Greece is grim:
- Young people are still the hardest hit by Greece's deepening economic woes, with 42.5% of those between ages 15 and 24 without jobs in March—a sharp increase from 29.8% a year earlier.
- The decline in industrial output accelerated in April, falling 11% from the year-earlier level after an 8% drop in March.
- Greece has promised the EU and IMF that it will implement €28 billion in fresh spending cuts and new taxes to bring the country's budget deficit below 1% of gross domestic product by 2015, down from 10.5% last year.
- Although the final details have yet to be announced, the government is considering several highly unpopular measures, such as new taxes on the poor, an extraordinary 3% levy on all Greek wage earners, new property taxes and cuts in retirement bonuses.
- Spending cuts include deep cutbacks in welfare payments and possibly even layoffs in Greece's long-cosseted public sector.
On June 5, 2011, some 100,000 people gathered in front of parliament to protest spending cuts and reforms:
Protesters and even rioters appear every day to confront parliament. This environment will make it very difficult for the Papandreou government to survive to the end of the year.
There is a serious debate going on between Germany and the rest of the EU. You would guess right that Angela Merkel is getting a lot of heat from her fellow Germans about the bailout. The Germans want debt reductions (haircuts) from Greece's bankers. Or at least they would like an extension of the maturities. Which means they don't want to stick German taxpayers with the entire bill.
The ECB and the IMF do not want this because it would amount to a de facto default by Greece. This is not a small problem. It is a huge problem. If it were only Greece, then it would be a minor issue. They are afraid such a default would start a chain reaction of defaults (euphemistically called a "credit event") by Greece's fellow PIIGS, especially Ireland and Spain. The ECB said last week:
The risk of "adverse contagion" from the bloc's sovereign debt crisis, and its interplay with the financial sector, "arguably remains the most pressing concern." European-level efforts to contain the debt crisis "have not been sufficient," and European crisis management has been "fraught with some detrimental shortcomings."
In other words, if Greece defaults, the market for euro denominated government bonds would possibly collapse and the losses would be enormous. Here is a picture of the debt structure of major economies as a percentage of GDP, including the PIIGS:
What is the real fear behind this? The stability (and bailout) of the banks that have invested massively in government bonds of the PIIGS. Here are some charts on bank exposures:
This exposure concerns the ECB and national bank regulators because their banks are highly leveraged:
If these banks get into trouble, who will bail them out? The article from which the above chart was taken (Fortune) likened the problem to Lehman, which pre-Crash had 30:1 leverage. The German taxpayers would not only bail out their own banks but also would be on the hook for propping up Greece, et al. If you wish to see a list of the top 40 banks in terms of exposure to a Greek default see here.
So, what will happen?
The problem as I mentioned at the beginning of this article is the European Monetary Union and the concept of the euro itself. All the safeguards of the Maastricht Treaty establishing the European Monetary Union and the ECB have been tossed aside as they try to save the system. The "no bailout" rule, the ECB independence mandate, the prohibition of deficits of more than 3% of GDP, the prohibition of debt exceeding 60% of GDP, the prohibition on ECB purchases of member sovereign debt, have all been ignored during this crisis.
Instead the ECB has been a massive fiat money pumping machine that has served the needs of its client nations to borrow and spend. Here's how it works:
When governments in the EMU run deficits, they issue bonds. A substantial part of these bonds are bought by the banking system. The banking system is happy to buy these bonds because they are accepted as collateral in the lending operations of the ECB. This means that it is essential and profitable for banks to own government bonds. By presenting the bonds as collateral, banks can receive new money from the ECB.
The mechanism works as follows: Banks create new money by credit expansion. They exchange the money against government bonds and use them to refinance with the ECB. The end result is that the governments finance their deficits with new money created by banks, and the banks receive new base money by pledging the bonds as collateral.
This is what the Greeks did and as a result they exported inflation, including price inflation, to the rest of the eurozone. The Greeks ran a deficit financed by eurozone banks, the banks were allowed to use the bonds as Tier 1 capital, and the ECB expanded money and credit to accommodate them. The Greeks got something for nothing from the fiat money expansion, exported price inflation to the eurozone, and as prices went up, the suckers at the end of the money chain paid more for the same things.
The costs of the Greek deficits were partially shifted to other countries of the EMU. The ECB created new euros, accepting Greek government bonds as collateral. Greek debts were thus monetized. The Greek government spent the money it received from the bonds sale to win and increase support among its population. When prices started to rise in Greece, money flew to other countries, bidding up prices in the rest of the EMU. In other member states, people saw their buying costs climbing faster than their incomes. This mechanism implied a redistribution in favor of Greece. The Greek government was being bailed out by the rest of the EMU in a constant transfer of purchasing power.
This is a house of cards. The Maastricht Treaty established that the ECB cannot make loans to banks without certain defined collateral. Specifically, for this bailout they can't accept Greece's bonds as collateral if Greece has been declared to be in default. Thus the current argument between Germany and the ECB about haircuts and extensions. Both S&P and Moody's have said they would treat haircuts and extensions as a default. S&P just cut Greece from B to CCC, and Moody's to Caa1. Such ratings are defined as meaning that there is an even chance that Greece will default.
There are two ways out of this mess: default or monetary inflation. They could unwind the EMU and ditch the euro, but that is unlikely to happen in the near term.
My guess is that they will print their way out of this mess. Continental governments have very little stomach for mass unrest since it has a tendency to bring down governments, bring in more radical regimes, and create uncertainty in Europe. They have already pledged another €750 billion in stand-by bailout money to the other PIIGS. That will be used up and perhaps more.
The eurozone powers are crossing their fingers and waiting for something good to happen. With various economic signs pointing down in the U.S. and in the rest of the world, this only puts greater pressure on the euro and their debt problem. This week red flags were raised about the German economy, the powerhouse of the EU. There won't be an economic recovery to save them.
Relying on monetary inflation is a traditional way for governments to get themselves out of debt. A 7% rate of inflation could reduce the amount of debt owed by these sovereigns by about one-third in just five years.
That is just too tempting for the EU to pass up.
This article originally appeared in The Daily Capitalist.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.