By John Mauldin | July 21, 2011
This week we start with the latest version of the solution to the European Crisis, the details of which are now coming out. Then we look at the global economy, and some signs that seem to point to a softening. And then there’s some data on US employment from a friend who has some thoughts about what we really need to do to get unemployment to come down. There is a lot to cover.
But first, we have posted the latest of our Conversations with John Mauldin on the website. It is with Dylan Grice of Societe Generale in London, and he is just brilliant. Subscribers will love it. Basically, Conversations with John Mauldin is my subscription service where you can “listen in” on my conversations with my friends from around the world talking about the topics of the day. Subscribers give it rave reviews, and of course we do transcriptions. You can go to http://www.johnmauldin.com/conversations/ and type in CONV as the code to get a $50 discount off the $199 price. And, of course, you’ll get the past conversations as well, with all sorts of well-known analysts. To learn more just click on the link. And now, let’s turn to Europe.
Kicking the Can Yet Again
My friends at GaveKal point out that this is “… the sixth time in 18 months European leaders have announced a definitive solution to the Euro crisis. Should this version of the final bailout be taken any more seriously than the first and second solutions to the Greek crisis in May and September 2010 or the Irish bailout of December 2010 or the Portuguese rescue package of March 2011 or the breakthrough vote in the Greek parliament of last month? The supposedly good news for markets was that the -21% haircuts to be imposed on Greek creditors (as estimated by banker groups) were less than half those suggested a few days ago.”
A 21% haircut is a bad joke. If you assume that Greece can afford to spend 10% of their revenues just to pay the interest, which is what they will need to be able to do to get out of their crisis, then the haircuts look more like 75-80%. Sean Egan, the most credible credit analyst in the country, estimated this week that the eventual haircuts on the Greek debt will be 90%.
You can read the release from the EU leaders in its entirety, if you like, at http://www.foxbusiness.com/markets/2011/07/21/read-eu-leaders-full-statement-on-greek-bailout/. I really have no idea what you should drink as you read it.
Here is what it really says: We are going to keep throwing good money after bad and work as hard as we can to transfer the debt that is on the banks to the ECB and European taxpayers as long as the voters will let us. This first tranche will be another €109 billion. That will last a few years, and Greece will only have to pay about 3.5% on that debt and the rollover debt, and people who expected to be repaid in that period will see payment extended to either 15 or 30 years.
You can call this what you like, and they call it “selective default,” but it is a default. There will be government guarantees on the debt, so the ECB can take it from the banks.
Let’s see what the “voluntary” debt rollovers will look like and what the likely debt destruction will be. This is from Global Macro Monitor.
First, notice that the plan claims haircuts will only be 21%. But that assumes you can sell the new bonds at a 9% interest rate. If the interests rate demanded by the market are 15%, which is closer to reality, the haircuts are closer to 67%, after what appears to be an initial 20% cut. Will any institution not immediately try and get those bonds into the hands of the ECB? This is just ugly.
I have to quote what may be the most laughable part of the whole document:
“4. We call for a comprehensive strategy for growth and investment in Greece. We welcome the Commission's decision to create a Task Force which will work with the Greek authorities to target the structural funds on competitiveness and growth, job creation and training. We will mobilise EU funds and institutions such as the EIB towards this goal and relaunch the Greek economy. Member States and the Commission will immediately mobilize all resources necessary in order to provide exceptional technical assistance to help Greece implement its reforms. The Commission will report on progress in this respect in October.”
Ok, the Greek economy is in a depression, so let’s fire up a jobs program. Run by socialists and bureaucrats. The entire Eurozone is slipping into a slow-growth recession, and these guys are just focusing on Greece.
It’s Not Just Greece
And that’s the problem with this latest patchwork fix. It assumes that Greece is the problem and if we solve Greece everything else will get solved. The document analyzed above promises that bondholders of other nations will not suffer any haircuts. It does say that the Irish will get lower rates. But why won’t the Irish ask for haircuts? And it is my contention that the Irish will eventually reject the ECB loans they took on for their banks. And that will be a 100% haircut for the ECB. Not to mention that the Irish can point out that they didn’t do anything wrong or cheat to get into the Eurozone. They just built too many houses and ran up huge bank losses.
It’s just simple math. The Irish can’t afford to pay that debt. It should have never been taken on to begin with, and Irish voters threw the government that did it out of power. It cannot be lost on the leaders in Ireland that when the Greek prime minister called the EU’s bluff, the EU blinked. Trichet agreed to take on Greek debt after saying “non” for months, but with guarantees, kind of, sort of. Merkel caved. Ireland has to be paying attention. (By the way, I am going to go to Ireland in late September on a fact-finding mission. More below.)
Is Portugal any better off this week than last? Italy? Spain? Italy and Spain have barely any nominal growth in GDP, and the nominal growth of both these countries is below their debt-service growth. That is basically Ponzi-level finance. They have to issue new debt just to finance the old debt. And that is why interest rates are rising in both countries. Spanish banks have huge holes in their balance sheets from real estate loans that simply have not been written down. If Spain were forced to underwrite their banks, they would quickly be insolvent. To be sure, Italy introduced a new budget that, if followed, will make real headway on their deficit; but it also means a slower-growth economy for the next year.
To get an idea of the relative size of the problem, Germany has a GDP of about €2.5 trillion. The Italians have issued DEBT of €1.9 trillion. Italy’s debt-to-GDP ratio is approaching 120% (if it’s not already there) and is the second highest in Europe, following Greece. There is not enough money in Europe to help Italy, should the markets start to really run up their interest rates, as they must roll over debt. And higher rates mean that the debt costs and interest payments will be even larger. Their latest budget deficit was 4.6% of GDP, which means they need to borrow rather large sums of money
Italy does have a few things going for it. Much of its debt is of longer duration, so they have some room to maneuver for a few years if interest rates can remain kind, but they must find a way to increase growth or they too will become a Eurozone problem. The latest budget and austerity measures may give them a surplus, which they can use to pay down debt; and that would placate the markets.
And don’t forget France. The French may talk a good game, but their budget is in a shambles and their entitlements are unsustainable. There is a French day of reckoning coming.
Who is Going to Buy that Debt?
I had a conversation with my good friend Lord Bridport, who runs a major bond trading house in Geneva, selling bonds to pension and insurance funds in Europe. The plan is for the Eurozone to issue eurobonds and sell them into the private market to back the various bailout schemes. I asked him whether he thought his clients would buy. He said very clearly he would recommend they do not buy until it is quite clear who and what will back them. Otherwise, buy German and other solvent-country bonds. This is going to be a tough sell in Europe, gentle reader, if Alex is saying “no”; and he is not alone.
You Have to Admire the Commitment
You simply have to admire the commitment of European leaders to ignore common sense, simple arithmetic, and their voters in pursuit of the goal of a United Europe at all costs. It is really quite astounding.
I would remind my American readers that if you go back and read the history of the 1780s and our original Constitutional Convention (1787), it was the same determination on the part of our founding fathers that gave us a constitution. The convention was originally just supposed to be for amending the Articles of Confederation. Alexander Hamilton and James Madison never had any such intentions and argued forcefully for a full-blown change, with George Washington presiding. They got their way. There was no great clamor among the people for a United States of America and the loss of sovereignty of the 13 original states, which happened over time, by the way. The founding fathers would be aghast at the lack of state sovereignty today.
Can Europe do something along these lines? Possibly. They will need to move toward more fiscal consolidation, acknowledge that the European Central Bank is going to have to take on at least €1 trillion in debt by printing money, and that governments will have to run balanced budgets, much like our states; but the transition will be costly. And it will take time. And the obstacles are many, and not just monetary.
We at least had just one language (more or less) and the shared experience of a successful revolution. Plus a growing economy and plenty of opportunity and relatively free land in the west for pioneers, as well as some real visionaries as leaders.
John F. Kennedy once held a dinner in the White House for a group of the brightest minds in the nation at that time. He made this statement: "This is perhaps the assembly of the most intelligence ever to gather at one time in the White House, with the exception of when Thomas Jefferson dined alone.”
Who commanded the respect of the nation like Washington, or Adams or Hamilton or Madison? Would that we had such leaders today. We can’t even agree on cutting the deficit when almost everyone says we need to. Well, except for Paul Krugman.
I hope Europe pulls it off. I really do. They have done the US a huge favor by adopting this latest plan, as it keeps their banking system from imploding; because their banks are essentially insolvent with all the sovereign debt on their books. Such a banking crisis, which would be worse than 2008, in my opinion, would no doubt plunge a world already slowing down back into recession and pull our own slow-growth economy down into recession with them.
How long can they kick the can down the road? My guess is that it will be longer than we suspect. Will European voters go along with the continual lurching from crisis to crisis and piling more and more debt onto taxpayers? Will Germany allow the ECB to destroy its balance sheet and the euro with it? Can they keep their Bundesbank mentality in check and put to rest the ghost of the Weimar Republic?
I continue to predict the euro is going to parity against the dollar if it survives with all the current members intact. Parity may be optimistic. Stay tuned. I will follow this closely, gentle reader, and keep you updated.
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