The Simple Explanation Of The European Mess

Includes: DIA, EWG, QQQ, SPY, VTI
by: Carlos X. Alexandre

One day doesn’t go by without every man, woman and child hearing a wide spectrum of acronyms and complex exotic takes and solutions to the European debt crisis, further confusing the issue. And if they haven’t noticed, that’s the idea. Thus, for those trying to figure out what’s going on, here’s a simple explanation.

The creation of the euro in itself was not necessarily a bad idea, and the core problem lies in the existing economic foundations throughout the European membership. Back in the day, plenty of economists warned against it. Instead of trying to consolidate their differences prior to the new currency, they overlooked them for the sake of political expediency, just as if two people were dating over the Internet and then decided to meet face-to-face at the altar. Thus this marriage of convenience for some, and inconvenience for others, although they didn’t see it, turned out to be a reversal of conveniences where nobody wins.

Imagine that a German citizen married a Portuguese national, and at first they didn't quite know their respective finances, and wasn’t important because love was in the air. It turns out that the German had $1 million in savings and $1 in debt, while the Portuguese had the mirror image of the ledger - $1 in savings, $1 million in debt - and after the wedding party, the German/Portuguese couple had $1,000,001 in savings and $1,000,001 in debt. Problem is that the interest payments kept creeping higher, while the Portuguese spending continued to aggravate the situation, and the German couldn’t keep up with the balance sheet.

Should they get divorced? Well, if that solution is viable, the assets and debt will be split 50/50, and the Portuguese actually wins in the short-term, while the German is not willing to part with half the savings and assume debt that didn't exist before.

Thus another potential solution is for both to cosign a new loan – “Eurobonds” – but the German will be penalized with a higher rate while the Portuguese will enjoy cheaper credit, and the fact that they are married quickly becomes irrelevant. But the German wants to have the cake and eat it too, and higher rates or a credit write-down are not acceptable alternatives, and they choose to engage their friends, family and strangers, and borrow even more to support a lifestyle that will eventually come to an end. To add insult to injury, the paychecks look increasingly smaller in view of the newly accumulated debt. And that's the story.

Therefore the pundits can spew a plethora of unrecognizable words and complex strategies, but the problem is quite simple. However, politics are an integral part of the process, which complicates the issue, and as Americans, we also know how that goes.

Bloomberg reported that Angela Merkel, Germany’s Chancellor, wants the private sector to share more of the pain, and did so while addressing a blue collar constituency.

“We want and we have to make sure that banks and other investors share the costs of getting over the crisis,” Merkel said in a speech to trade unionists today in Karlsruhe, Germany.

Then MarketWatch reported the opposite, further highlighting the “disunion” that prevails.

The European Central Bank on Thursday reiterated a warning that forcing private-sector bondholders to take losses on sovereign debt could hurt the euro and the eurozone banking sector.

In addition, and yet another bright idea, France thinks that the European Financial Stability Fund should be turned into a bank, as reported by Reuters – and notice the word “Stability” which should be “Solution.”

France believes the eurozone's EFSF rescue fund should be turned into a bank to leverage its firepower and Greek bondholders will have to accept losses higher than 21%, a finance ministry source said on Thursday.

And the ideas will keep flowing only because politicians have this habit of believing their own erroneous concepts, while trying desperately to get out of the hole that they usually dug in the first place. But there’s money needed that the EFSF won’t even start to address, as an article by Bloomberg pointed out, further having to rely on the kindness of strangers.

At least 66 of Europe’s biggest banks would fail a revised European Union stress test and need to raise about 220 billion euros ($302.3 billion) of capital, Credit Suisse AG analysts said.

A billion here, a billion there, and before we know it, we’re talking real money. But what about the banks, from a simple perspective, that is? Well, for a very long time the banking industry looked at the word “risk” as a dinosaur and banks were more than happy to continue lending to governments around the world for the sake of short-term gains. Had they pulled back on easy funds, the tough choices would have taken place before the debt ballooned.

But how does all of this affect me, when I’m smack in the middle of Kansas? Although our nationalist sentiment is coming forth, we live in a global village where we watch Hollywood movies, while feasting on Greek olives, Ecuadorian bananas, Brazilian coffee and Belgian chocolates. And watch DVDs manufactured in Korea on TVs made in China, while wearing our favorite t-shirt made in Sri Lanka. And everyone knows that technical support comes from India, except for rotten food, of course. Thus, the fallout will reach everyone's couches - made in Mexico.

And as the markets find their good and bad days, and the “bear” and “bull” calls emanate from every direction – more on that latter -- the truth is that the underlying condition is extremely precarious, and even if politicians in Europe come to their senses, the journey between here and sunshine is hardly anything to celebrate. Furthermore, Europe is only the most visible piece of the debt puzzle.

The best approach is for the European bureaucrats to accept that a mistake was made, pay the dues, pick up the pieces, build a solid economic base, and look 5 or 10 years down the road and be able to envision a true European union. After all, when building a house, the roof does not precede the foundation – and that’s the euro, although the option to remove the roof may no longer be viable.

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