When looking at the eurozone sovereign debt crisis and comparing what’s happening there to other sovereign debt loads, people often ask why Japan for example can sustain such a staggeringly high debt to GDP ratio, now 253% and counting, while weaker eurozone countries start teetering when they get to 100% or even less?
There are two main reasons in my opinion. The first is that in other monetary unions, the central bank is beholden to a single sovereign bond issuer. The central bank typically accommodates its indebted sovereign by monetizing its debt as a matter of rote. Japan for example has one central bank and one sovereign bond issuer, the Japanese government. Colloquially that means Japan can print itself out of a debt crisis and through that, sustain much higher debt to GDP ratios.
Financial eiltes like to put up the façade that each central bank operates independently of the government that appoints it, and to suggest otherwise is to be a conspiracy theorist. However, cracks in that façade have been appearing of late.
For example, in a recent interview with Politico, Kevin Warsh, a finalist for Federal Reseve Chair before Jerome Powell got the nod, pretty much spilled the beans outright saying that the notion of the Federal Reserve being independent was “foreign to the President,” referring to Donald Trump. Is it just Trump though? Not quite. Politico’s interviews with other former Fed officials belies the fact that Fed policy being controlled by politicians in charge goes all the way back to Chairman Arthur Burns and the Nixon Administration. In 1972, Nixon reportedly pressured Burns to keep monetary policy loose into the election, which former Fed economist and current chief economist of Cumberland Advisors, Robert Eisenbeis, said led to the double digit inflation of the mid 1970’s.
As for Japan, the Bank of Japan currently owns 47.5% of all Japanese government bonds. To suggest that this isn’t purposely accommodative of the Shinzo Abe administration, which came to power on the promise (and fulfillment) of record-breaking monetary stimulus, is simply willful blindness.
It is not at all a stretch nor is it in the least conspiratorial to suggest that whoever wants to be Fed Chair, or head of any other central bank appointed by a single sovereign, has to appease the person who has the power of appointment. This is the purpose of interviewing candidates, namely to see if they will carry out the monetary policy that the politician in charge wants.
In the eurozone however, there are many different sovereign bond issuers, none of whom directly appoint ECB officials. The eurozone is a monetary patchwork. It is not a true monetary union. The ECB knows that printing money for one profligate sovereign harms the interests of the more fiscally responsible ones. It’s the same in principle for a true monetary union like Japan or the US in that printing money to accommodate debtors (the government) hurts the fiscally responsible (private savers) by harming their purchasing power. However, since it’s not sovereign vs sovereign in those cases, private savers have no recourse when it comes to Fed policy so they don’t generally influence it.
When one sovereign objects to the profligacy of another though like what happens in the eurozone all the time now, the ECB has to walk a tightrope. The ECB actually is independent of most of the sovereign bond issuers (arguably less so from the more dominant ones), so it doesn’t hit the print button at will. It can’t without stirring the wrath of the more fiscally responsible sovereigns in the patchwork, meaning Germany. In short, no single eurozone sovereign can print its way out of a debt crisis like Japan or the United States can, and so the debt burdens they can carry are much less.
But there is another reason, and that is market perception. This is an elusive concept that can’t really be quantified, but it exists. The Japanese yen is and has been considered a safe haven asset since the 1980’s when Japan’s economy and stock market were rising at breakneck speed. Because of that perception, it is one of the most powerful risk-off trades, trumped perhaps only by US treasuries and the US dollar. Since Japan and the US are home to the most widely recognized safe-haven risk-off assets in the world, this means that the rest of the world willingly subsidizes their debts when the global economy gets shaken up. For the US, this has also been the case since the early 1980’s as well.
The euro has no such reputation, and it has squandered its opportunity to build one. The debt levels of its member states cannot reach anywhere near those of the US or Japan without triggering a crisis.
Sovereign Debts Are Still Rising
Of the so-called weaker PIIGS states in the eurozone, consisting of Portugal, Italy, Ireland, Greece and Spain, not a single one has decreased its absolute debt burden since the European sovereign debt crisis first came to the forefront in 2010. Not one. Since that year, absolute debt in Portugal has increased 62%. Italy’s has increased 28%. Ireland’s has doubled though stabilized since 2012, Greece’s has increased 14.6% and appears to be heading higher now, having jumped 4.6% last quarter after stabilizing since 2012.
The counterargument is that debt to GDP ratio is what really matters and these ratios have been stabilizing. The problem with this logic is that it’s circular. The equation for GDP is C + G + I + NX. That is consumption plus government spending plus investment plus net exports. Aside from the fact that GDP is an aggregate of an aggregate or an aggregate and doesn’t show much about what’s actually going on in an economy, the number itself depends on government spending.
Debt to GDP ratios then have government spending in the numerator and the denominator. As long as interest rates remain negative due to ECB bond buying, and they still are negative on the short end of the curve across most of the eurozone, then more government borrowing and spending will lead to lower debt to GDP ratios. The dishonesty of this approach in calculating debt sustainability is clear. When sovereigns can literally get paid to borrow, then obviously debt to GDP ratios will go lower the more negative rate debt gets issued. Short term yields are negative for Portugal, Ireland, Italy until just last month, and Spain. The exception is Greece, which is barred from issuing short term debt. Not much of a quality exception there.
When rates rise across the yield curve, the artificiality of stabilized debt to GDP ratios will be revealed alone with the false stability that depends on these manufactured numbers.
The cracks in the eurozone are fast expanding again. Whenever one is temporarily sealed, another rises up a day later. The political crisis in Italy appears to be abating for now, at least until the current government falls, but we all know that spending in Italy will not be cut. Bloomberg has quoted estimates of the new government agenda costing upwards of €100 bilion. The new populist government there agrees on little except the need for more government spending. You can’t end a debt crisis with more debt, the ECB knows this, and will not allow it.
And now there’s a new political crisis in Spain, with Catalonian secession about to take the headlines again. They want more spending, too. Former Prime Minister Rajoy was just replaced with socialist leader Pedro Sanchez by a vote of no confidence. Sanchez also believes in more government spending to cure the economy, but not as much as the Catalonian left wants even more.
Sanchez is only Prime Minister thanks to the Catalan separatist parties. They are going to want their backs scratched in return, and if they secede unilaterally again, Sanchez probably won’t have the power to invade Barcelona as former PM Rajoy did. If Catalonia secedes from Spain without an agreement on who pays its debt, Spanish bonds will end up spiraling down. They will anyway. It just depends on when the trigger will be.
Another trigger possibility is weak eurozone banks. The bank failure in 1931 in Austria of Credit Anstalt is what ultimately triggered the Great Depression in Europe after the crash of 1929 in the US. BNP Paribas (OTCQX:BNPQY), France’s largest bank with$2.45 trillion in assets, has the single largest exposure of any non-Italian bank to Italian debt. It is also the eurozone’s largest bank by assets. Deutsche Bank (DB), the eurozone’s second largest bank, is at all time lows and is already on a Federal Reserve watch list for troubled banks. The Fed will this month subject the German bank to stress tests of its US operations for the first time. The results could have an outsized impact on its business.
Banco Santander (SAN) is another eurozone bank flirting with all time lows, and it has combined net exposure to Spanish debt of €62.6 billion (see page F-180 on the annual report) as of the end of 2017. This is up from €45.9 at the end of 2016. If political turmoil or secession in Spain causes Spanish bonds to drop, this bank could be in danger as well.
Nobody knows when or where the trigger will be, but one thing is patently obvious. The numbers are fast heading in the wrong direction to solve this systemic crisis. Shorting weak banks may be risky here because their price has fallen so far already, but if a weak bank fails, stronger banks will be damaged in the wake as well. Aggressive shorters may want to consider establishing a short position on one of the stronger European banks instead like HSBC (HSBC) or Barclays (BCS), which will likely be damaged when a banking crisis ensues in the eurozone, even though these two UK banks are not part of the eurozone and will soon be out of the European Union entirely.
As for myself, I’m just going to steer clear of Europe for now.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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