Over the weekend, the Europeans have come up with a much bolder and more aggressive package to save Greece and prevent the disease from spreading around the rest of the continent (well, beyond the continent as well — after all, Ireland is an island).
The package has three basic elements: a $750 billion Euro (apx $1 trillion) fund consisting of bilateral loans and loan guarantees, with about two thirds of that coming from the stronger European governments and about one third from the IMF. A decision on the part of the European Central Banks (ECB) has been to buy the bonds of individual countries in the Eurozone; in other words, to do some quantitative easing and create a lot more Euros, and the Fed has reopened the swap lines with the ECB that were put in place during the 2008 meltdown.
A Really, Really Big Package
Putting together a really, really big package was needed, since each small and tentative response so far has only served to make the problem worse. The idea is to make the fund so big that speculators will see that the institutions are not going to fail, and that the attacks on the institutions will fail. The more they were attacked the bigger the problem grew, and the more likely that the attacks would be successful. If the new defenses are massive enough that the markets realize they will hold, the herd will turn the other direction, reducing the size of the problem.
There are still, however, some very key structural problems with the Euro. Foremost among these is that the PIIGS, (Portugal, Ireland, Italy, Greece and Spain) are uncompetitive in trade terms while they are also running large budget deficits. Because they are locked into the Euro, they can’t devalue to make themselves more competitive. The only other way to get more competitive is massive wage cuts to bring down prices of goods and services that they might be able to sell abroad.
At the same time they need to make massive cuts in spending, and/or raise taxes significantly to get budget balances back at sustainable levels. That is not a very appealing plan to the voters of those countries, as witnessed by the riots in Athens last week.
Markets know these adjustments are going to be difficult, so the cost of borrowing from the weak countries soared, especially relative to stronger countries (very notably including the U.S., but the key is relative to the German Bund, since they are denominated in Euros, just like Greek or Portuguese government debt is). Higher interest rates cause local asset prices to fall. Banks are highly leveraged institutions, so this raises concerns over bank balance sheet increases.
By and large the big European banks have not done the sort of capital raising over the last year than the big U.S. banks have done. They will have to in the future, probably meaning significant dilution for the equity holders in big European Banks that have a lot of exposure to the PIIGS, like Deutsche Bank (DB). This combination was causing an incipient run on banks. If Greece were still on the Drachma it could reasonably devalue, but this is not an option within the Euro bloc.
Not a Very Popular Plan
It looked like the Germans were going to be unwilling to help out the PIIGS. This is not particularly popular with the German people, and evidenced by the ruling party losing big-time in a regional election (North Rhine-Westphalia) over the weekend. Just think how popular the TARP program was when it was up for debate back in the fall of 2008, and now imagine that the funds were not to be going to U.S. domestic banks — but rather to Mexico and Canada in an indirect way of helping out the big domestic banks — and you will get a sense of just how popular this program is in Dusseldorf and Munich.
The alternative would be for them (and most likely the French, who are the second biggest player on the donor side) to bail out their own banks. Indeed, it is not a loaf of baklava that has led Frau Merkel to agree to help out the Greeks — it is her love of her banks — and this package, from the German and French perspective, is really about preserving their banks, and preserving the currency.
It is this risk which is now resolved. The Germans have now really stepped up to the plate. The amount provided could probably provide both Spain and Portugal packages roughly equivalent to the one that Greece got, relative to the sizes of their economies. The real hope, though, is by having the defenses in place, they will not have to be used.
This graphic from the New York Times shows the size and complexity of the linkages between the various European countries, and it does not take a lot of imagination to see how if one part of the web were to be removed, that the other parts would quickly become unraveled.
There Remains the Issue of Solvency
While this package will (or should) take care of the liquidity problem, the solvency issue remains. The other troubled countries like Spain and Portugal will now have to make even more cuts in their budgets, and I will remind you that Spain already has 20% unemployment. The deflationary effects of fiscal tightening on the Iberian Peninsula is going to make it much worse. While they have promised to make cuts, it remains to be seen if they will actually be implemented.
This package could well be just a case of kicking the can down the road. You have the greatest incentive to default when you are running a balanced primary budget (revenues and expenses match excluding the cost of interest on the debt) and still have a large government debt outstanding. If you are still running a primary deficit, then defaulting on your debt is going to cause a world of hurt, since there will be no cash available at all to you. If after you make budget cuts so the only cause of the deficit is the interest on the debt, then a country is in a position to “win” by defaulting.
One of the keys will be to watch the behavior of spreads on longer-term European debt. The short-term spreads between, say, one-year Spanish paper and one-year German paper should drop because the liquidly problem appears to be solved. However, if the spreads on ten-year paper don’t come in, or even widen further, it will be a sign that this is not over yet, just a lull in the storm.
Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.
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