The Eurozone: Zero Chance Of Break-Up But Caution Is Advisable

Includes: FXE
by: The Independent Investor

I must say, there have been few stories that have plagued the markets for as long as the various European debt issues which the press has collectively labeled "the sovereign debt issue." This seems to be the one event that can consistently keep moving the market without any new or market changing news. Every time a seemingly new but ultimately short-term bailout package or bond buying programs is put together by various EU governments, the ECB, or even monetary institutions like the IMF, the positive effect on the market has been short-lived, and the sell-off that has that has followed has been severe. Well, there has been a lot of noise in the press about the daunting size of a European debt problem that is severe, the massive counter-party risk between various European banks that certainly does exist, and the sometimes seemingly imminently implosion of the eurozone financial system that has seemed plausible at times, I think you have to step back and look objectively at the eurozone and its issues to see what the what scenarios are realistic.

In my opinion the main reason that the euro has been selling off on each attempted "solution" over the last couple years is because the ECB simply lack the real regulatory authority or liquidity to take an action on the scale needed to fully address the problem and the EU member nations lack adequate capital and political support to take any decisive immediate large scale actions either. The ECB cannot print money and EU member nations cannot issue cannot issue the kinds of Euro bonds that would provide capital to the PIGS without having to constantly put together annual new bailout packages. Since large scale actions are financially and politically difficult for the ECB and eurozone members to undertake are instead simply using temporary programs like the recent short-term bond purchases EU member nations authorized the ECB to make of Spanish and Italian debt to try and buy time.

Now given the complexity and often seemingly daunting size of the sovereign debt problem many have postulated that the EU simply can't stay together. Greece and Italy have different debt profiles than Germany and France. Europe has shown again and again that unified action is all but impossible. And, of course, ethnic and cultural divisions are rampant. All these seemingly good but I think ultimately irrelevant views of the Euro-zone problem are really nonsensical since when you look at what links nearly all of these European nations together - massive amounts of debt that nearly every nations' banks hold. What EU detractors fail to appreciate is structure of the European Banking system and the inextricable links between the banks of the PIGS and the fiscally stronger European nations like France and Germany. Most Greek, Italian, and Spanish debt is held by European banks, and some of the largest banks holding the debt of these respective nations is in Germany and France.

The reality is that if any of the PIGS left the eurozone it would solve nothing and make the problems faced by the eurozone only worse. Since the PIGS have no industrial base of any significance these debt ridden nations would not obtain any real benefit from leaving the EU and devaluing their currency. The reality is that the PIGS aren't export based economies like France and Germany, so delinking from the euro would provide little advantage to them and likely make their currency they would use to repay nations like Germany and France worthless and this would mean that countries using the euro would likely get cents on the dollar even if these countries could afford to repay at least a significant portion of the debt that they owe..

Germany and France are clearly calling the shots since they have the most capital and also the most exposure to the sovereign debt of the PIGS. All that would happen if the PIGS left the euro is that the fiscally stronger European nations would get paid back in a currency probably worth 50-60% less than the currency they lent to the 'sick men of Europe." This would also trigger a default since the European banks repayments of the debt owed them by the PIGS would be getting a currency likely worth 50-70% less than the Euro's they lent these nations, and would have to write-down the debt accordingly. The PIGS would then be left with a worthless currency they couldn't borrow in that would be of any benefit to them since they don't have any significant export industries to speak of. The fact that Germany and France are the creditors and holders of most PIG debt tells us that if these heavily indebted countries left the eurozone it would not improve the liabilities of banks holding the debt anymore than it would help the economies lacking any significant export industries that would be leaving the eurozone.

Since encouraging the PIGS to leave the eurozone and delink from the euro would solve nothing let's see if there is any reason to keep the these countries in the euro and what some more realistic scenarios look like. Here I think it's misunderstood what Germany and France's true motivations are in continuing to bailout these heavily indebted nations. These are the kind of industrialized economies that benefit from the weakness of the euro against many major currencies that exists since their exports benefit from that weakness. Given that both German and French political leaders have judged it to be in their economic interest to keep the eurozone together, what the political and financial cost of keeping the union together will be should be the more interesting question. If you look at the eurozone as one country or, it looks markedly better than Japan and similar to slightly better than the U.S. given that their total debt to GDP levels are slightly better than ours and the savings rates in Europe are much higher so their governments don't need to stimulated their economies as much. Europe's biggest problem is political. Also, despite cultural and ethnic difference that exist in every country like the U.S. China (which has 60 minority groups), and differences between the debt and growth of each economy, (kind of like comparing Michigan to Texas?), the eurozone is not that unique in its debt to GDP ratio. They are a continent with many strong exporters, consumers who lack significant debt, and a government that has a large but not seemingly relatively unique debt problem when compared to other large first world countries like the U.S. and Japan.

The biggest challenge facing the eurozone in my opinion is political since French and German leaders simply cannot justify large bailouts to their populations in this kind of weak economic environment without requiring the beneficiaries of these aid packages to impose massive fiscal austerity. This raises two problems. First, the PIGS begin to feel resentment and their political leaders have trouble justifying voting for these massive tax increases and reductions in benefit packages the fiscally strong nations of Europe demand. Second, the tax increases and other fiscal reforms Germany and France must demand to justify the bailouts politically within their own countries face the prospect of significantly weakening the already bad growth outlook in these countries and in the eurozone as a whole. Germany and France want the PIGS to bring their budgetary process in line with theirs, but that will cause the PIGS to have to put huge new taxes on production and spending in place in addition to further reducing benefits and raising ages in the short-term.

To conclude, countries are not companies and the EU's solvency issues are not really any more daunting than that of the U.S. or Japan when you look at the debt to GDP ratio as a whole in the eurozone. Longer-term the fact that the eurozone faces daunting debt problems that limit the capacity of many of its members to finance their debt backed credit line short of the now infamous "Euro Bond" will likely be needed as the EU moves closer to a more unified political and monetary system. Unfortunately, while a political and financial union across the European continent may be a reality because of necessity sooner than many believe, the process by which this will occur will still likely take years and involve lots of significant concessions by all of the eurozone member nations. Still, given that European economies are already strongly linked through their financial counter-party risk, such a union should be seen as the most likely way to substantively address the overall debt issue on more than a temporary basis. History may not be on Europe's side, but if the financial situation, labeled a crisis by many, continues to deteriorate, choices may quickly narrow.

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