Editor's note: This is the first article in a three part series examining debt crises in Europe. Part one roughly outlines why the crisis is occurring from an economic perspective at a broad level.
Just as the market-shaking waves of the global credit crisis began to ebb, an older, and equally potentially damaging dilemma reared its ugly head. The phrase “public debt” has been on everyone’s lips for a while now, but with new emphasis recently.
Lately, you’ve probably heard the phrase in reference to Greece, and increasingly, Spain, Italy, Ireland, and Portugal — never mind the banking crisis in Iceland.
I’d like to give a little summary of the surrounding issues. My gut tells me the G-20 countries are facing a crisis that involves public debt and private debt — notably the decline of global housing values — and the one rational public policy decision is to allow sustained inflation.
In part, this explains why we formed my company — because we believe that in a secular bear market in bonds (rising interest rates), fixed annuities of all kinds will be wildly popular.
So, back to the European debt story. Ironically, many of the first recorded sovereign debt crises occurred in nations of classical Greece, but back then, nations could often sell citizens into slavery to pay back what they owed. The tables have turned, sort of.
Now, despite its paltry 2 percent of the eurozone’s GDP, Greece and its massive debt threaten to shackle the West by inducing a series of sovereign debt crises through contagion effects. George Soros is sounding the contagion alarm bell, and many economists are voicing concern that a global public belt-tightening could be reminiscent of the 1930s.
The goal of this article series is to explain how this situation arose and why the market is fearful now, and then show arguments from both sides of the debate on whether a Greek debt crisis could create a new global economic meltdown.
How we got here — And is Greece just the tip of the iceberg?
Mark Chandler, the chief currency strategist at Brown Brothers Harriman summed it up here:
While the Europeans didn’t have the subprime real estate problem, they had a similar type of issue, and that is, they were lending people money, not so much based on a proper understanding of risk. And they were highly leveraged …
First, I think people should understand that there’s a big distinction. The countries in Europe are no longer currency issuers … And also, they don’t have credible deposit insurance over there. So there really is no way, if bank runs were to begin to happen, there’s no way to really preclude that…
So the problem as identified expertly by Chandler was, among a dozen other reasons, all of the following: ignorance about risk; high leverage; inability to devalue to retain competitiveness due to the lack of control over currency; and no deposit insurance.
And you’ve got the countries like Greece and Spain and Portugal, which used to devalue to regain competitiveness. They can’t do that. So they were left with one way out, and that was fiscal excesses. And the interesting thing, I think, is that a lot of people wanted to believe this fiction. So then, for many years, I have to believe that the Greeks’ problems were well known. But then, what the Germans wanted, though, was to lend money to Greece so Greece could live beyond their means to buy German goods…
Let’s take a deeper look at the third point, which is strongly linked to the weakness of the Greek economy. Tyler Cowen, writing for the New York Times, revealed the following:
Greece is a relatively wealthy country, or so the numbers seem to show. Per-capita income is more than $30,000 — about three-quarters of the level of Germany. What the income figures fail to capture is the relative weakness of Greece’s economic institutions. They are not remotely comparable to those of Germany and some of the other better-governed European Union nations…
Greece’s non-competitiveness, highlighted by a Third World fiscal system, failure to collect taxes, and low productivity, has been compounded by its overvaluation due to the euro. This overvaluation, supported by German and French interests, created a false sense of security, most fundamentally demonstrated by the bloated pension system.
Greece has a malfunctioning fiscal system in which the shadow economy is estimated to be roughly 20 to 30 percent of the reported economy and tax evasion may run at $30 billion a year. Simply collecting taxes that are legally due would help bring Greece’s books into balance…
Greece’s currency, the euro, is stronger than that of its neighbor Turkey, so a holiday in Greece is more expensive. Yet Greece has not built enough luxury hotels, golf clubs and resorts to justify the cost difference. Overall, the greater expense of Greek goods and services, which are paid for in euros, lowers the country’s international competitiveness…
Over time, this problem will worsen if productivity in Germany and France grows at consistently higher rates and the value of the euro puts Greek exports increasingly out of sync with market realities …The Germans and the French have been complicit in treating Greece as a wealthier country than it really is. The strong euro keeps exports from the poorer euro zone nations noncompetitive and also makes it easier for Greece and other lower-income eurozone nations to buy German and French exports; both tendencies benefited German and French commercial interests…
Greece is not the only country with an oversized budget, aging population and dwindling tax revenues. In fact, it is a Western problem. Check out this graph from the NYT.
The old social model in Europe has proven unsustainable. The problems Greece faces are politically quite unique, yet economically common and perhaps harbingers of the future for other Western nations plagued by similar issues. For a fuller demonstration of these aging population and pension problems, go here. For a country-by-country graphic on public debt, go here (more on public debt later).
For an advertisement for private pensions and a universal movement to greater incentives to save and reduce public pensions, look to fixed annuities, variable annuities and indexed annuities as one leg of the stool. In 2000, I published a book on privatizing the U.S. Social Security system (I was wrong — the last decade’s equity returns would have been disastrous), but what was wrong was the solution, not the articulation of the problem, which is that the U.S. government has become an ATM for Social Security and Medicare.
Anyway, back to Greece. It might be useful to think of Greece as the Lehman Brothers of Europe. The Times explains:
The key lesson from the failure of Lehman was that, in the midst of a systemic financial crisis, no significant bank should ever be allowed to fail. When an entire financial system is in peril, the cost of offering unlimited government guarantees and taxpayer bailouts will always be much smaller than the losses from allowing any significant bank to collapse. Such bailouts and guarantees may, in the long run, encourage excessive lending and other irresponsible behavior, but that is an issue to be addressed by regulation after the crisis is over…
Allowing Greece to renege on its debts could be catastrophic, because the cynically labeled PIIGS (Portugal, Italy, Ireland, Greece, and Spain) have economies intricately connected. This graphic illustrates the inter-connectedness, not only of the PIIGS, but France and Germany as well.
From the same Times article highlighted above, Anatole Kaletsky writes:
Today exactly the same analysis has to be applied to the risk of Greece or any other European government defaulting on its debts or dropping out of the eurozone … Yet the possibility of a Greek debt default or restructuring is being positively promoted by many of the world’s most respected economic and financial commentators…
These were exactly the sort of veiled threats, in some cases from the same authorities, heard before Lehman was allowed to collapse. It is hardly surprising that investors are starting to question the solidity of the guarantees against any kind of default that were supposedly provided recently by eurozone governments and the European Central Bank…
The fact is that if Greece were allowed to renege on its debts, the foreign banks that held €338 billion of Greek debt at the end of 2009 would immediately move to dump their additional €333 billion of Portuguese debt and probably their €1,500 billion of Spanish debt. And who knows how well over two trillion euros of Italian debt would be treated? The plunging value of Greek and Iberian bonds would immediately threaten several of the main French and German banks with insolvency, requiring government guarantees that would run into trillions of euros.
However, simply providing a one-time gift to Greece could be a source of great moral hazard:
Since the Greek economy accounts for only about 2 percent of the eurozone gross domestic product, in theory, it could be made a permanent recipient of largess. Yet that’s hardly an appealing solution, both because Portugal, Spain and others might want the same deal, and because Europe doesn’t have much social solidarity across national boundaries.
Cleaning up this mess will be a generation-long challenge. And there is no simple solution.
In part two of this series, I will take a closer look at why CDS spreads are rising lately.