A Comedy or Tragedy ?
In the ancient Greek theater, the difference between a comedy and tragedy was that in a comedy the participants discovered their lot before it was too late to do something about it. As the European debt crisis unfolds it is still not yet clear what type of drama we are watching. What is certain is that the outcome will serve vital lessons in the myriad of sovereign debt crisis that are sure to develop as we push into the new decade.
The Greek situation has developed into a major problem, not necessarily because of the size of their budget deficit, but because of the stipulations delegated by their monetary union with the rest of Europe. The interesting fact is that the Greek budget deficit is roughly 13% of GDP. Yet the U.S. budget gap is 11%! The difference is that our central bank has a printing press and thus can create money to pay its bills if it so chooses. Therein lies the irony of this drama; the European debt problems are a direct result of an attempt to maintain some semblance of fiscal responsibility.
One of the difficulties that European leaders face is not just simply the economic instability, but the political ones as well. It is no surprise that most Europeans are not happy about bailing out Greece for their fiscal indiscretions; especially the Germans. But what they don’t understand is that to not bailout Greece will inevitably lead to defaults that will hurt their banking system even more. Therein lays the dilemma; if Europe were to allow Greece to default, a pan European financial disaster would occur. However, there is no guarantee that a bailout will solve the problem either. And there are other political problems as well. Who knows if the Greek government can pull off the draconian measures that achieving fiscal stability will require.
Then there is the economic and moral hazard issue of other countries such as Spain and Portugal. European leaders face another challenge in figuring out how to firewall other EU nations that have gone astray and thus prevent them from falling into the same lot. That situation is not as bad as some would portray. No EU country “other than Greece is manifestly bust. Portugal is in the greatest danger, but it has a history of better fiscal adjustment which …. could allow its debt to stabilize at a manageable level.(1)” Spain and Italy could be thrown into the mix if interest rates remain high, but are not as surely to falter as Greece. </p>
In the bigger picture, the so called PIIGS (Portugal, Ireland, Italy, Greece, and Spain) of the European monetary union are not the only fiscal basket cases in the global economy. Indeed, there are numerous developed nations that have similar balance sheets; Japan, Great Britain, and the U.S. among them. But despite massive government debit issuance, bond yields in these countries remain historically low. That is in large part due to quantitative easing (read “money printing”) by the respective central banks. One has to wonder if, given recent events, the European Central Bank will not soon remit to that as well. Where will the new $1 Trillion EU bailout package come from? Raising that type of capital would certainly pressure interest rates at a time when Europe can least afford it.
As this drama plays out, there is also a very similar situation between the US and the EU that no one is talking about. There are individual states in the US that are in circumstances similar to Greece; they can’t pay their bills. It would not be surprising that in the not too distant future, states such as California or Illinois might require a bailout as well.
How will this global sovereign debt problem be resolved? Currently many of the central banks are monetizing their obligations. Printing money is a very effective way to payoff ones liabilities (I wish I could do that). The problem is that this cannot go on forever, and at some point the ramifications of these actions will begin to take effect through inflationary pressures. That’s what the gold market seems to be telling us. As Bill Fleckenstein poignantly points out, “In a social democracy with a fiat currency, all roads lead to inflation.” While individual sovereignties will resolve their debt problems along various paths, the ultimate destination will almost invariably be the same.
(1) The Economist