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Last year’s Thanksgiving weekend was an unusually active holiday news cycle.
Of course, it was when Tiger Woods had his bizarre car accident outside of his home. That saga would dominate the news for months to come. The lesser-followed news item of that weekend came out of Dubai when the emirate announced it would restructure its sovereign debt.
As we now know, both events would ultimately snowball. And both would result in the loss of a lot of money.
Dubai, once promoted to be the up-and-coming financial hub of the world, was warning of default. And as much as it was a surprise to global investors, it was equally underestimated.
At that point, the world markets were abuzz with ideas that the global economy was in a sharp, robust recovery. And Wall Street was telling Main Street that a return to normalcy was underway for global economies, i.e. put your money back in the market or get left behind.
Back then, based on the roadmap laid out from historical financial crises, I said …
“Expect more news like we received from Dubai. And expect markets to be surprised by the domino effect such news can create.”
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As it turned out, the next domino in line was Greece, the weakest member of the European Monetary Union (EMU). And Greece’s ballooning budget deficit and growing financial problems quickly spread the spotlight of scrutiny to the many other weak countries in the European Monetary Union — including Portugal, Italy, Ireland, and Spain.
All of a sudden questions were raised about the prospects and implications of a debt default … a departure of a member state from the euro … and perhaps even a break-up of the euro.
That uncertainty quickly took the high-flying euro back down to Earth. In fact, from the date of Dubai’s announcement, the euro plunged 21.5 percent in six months.
With the lifespan of the euro in jeopardy, European officials stepped in. They tossed out the rule-book on the euro that prohibited bailouts, and presented a shocking response … a threat to throw $1 trillion at the problems.
The Euro Leaders Had No Choice
The European banking system was (and still is) too exposed to the sovereign debt of its weaker brethren. Consequently, a default of a euro member country would deal a crushing blow to European banks and likely set off another wave of global financial crisis — only this time, it would have been even worse.
In 2009 the European Central Bank was flooding the banking system with unlimited loans for a paltry 1 percent interest. What did the banks do with all that money? They bought government debt — most specifically, debt from the PIIGS (Portugal, Italy, Ireland, Greece, and Spain).
In all, European banks owned $1.5 trillion worth of debt from fiscally challenged euro-zone countries. So the strategy was to buy some time until the banks shed some of the threatening debt.
Now, at the anniversary of last year’s kick-off event in Dubai, the euro zone’s timeout is expiring. The myth that the Greece rescue might have been enough to ward off the sovereign debt crisis in Europe has now been dispelled.
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This time it’s Ireland that’s requiring a handout from its neighbors. And it’s becoming increasingly evident that the $1 trillion bluff that European leaders crafted earlier this year will be called.
With the amount required to curb the bleeding in Ireland still yet to be determined, once again other candidates are lined up to be next, namely Portugal and Spain.
But with political tensions growing, the question is: When will backlash in the euro zone take over?
When push comes to shove, we’ll likely find that all of the $1 trillion worth of promises made to stabilize confidence in Europe won’t materialize. And we’ll see the weak countries continuing to live with tough austerity and the strong countries, which have committed to transfer taxpayer monies to their fiscally less responsible brethren, saying “no more.”
We’ve already seen the cracks in the euro zone’s attempt at solidarity. Slovakia balked on its promise to give up tax-payer money to Greece. And Austria has threatened the same.
Flaws of the Euro …
Countries that have joined the euro currency have unique challenges when economic times are tough. That’s because the monetary union in Europe consists of a common currency and a common monetary policy. But fiscal policy is determined by each individual country.
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And to patrol those fiscal decisions, the European Union established its Growth and Stability Pact that, among other things, sets two criteria for member countries:
1) Deficit spending by its member countries cannot exceed three percent of GDP, and
2) Total government debt cannot exceed 60 percent of GDP.
These limits were shattered and disregarded long ago.
Now, the euro-member countries are in trouble for all of the reasons Milton Friedman, one of the most influential economists of the 20th century, cited prior to that currency’s inception a decade ago.
He said:
- A “one size fits all” monetary policy doesn’t give the member countries the flexibility needed to stimulate their economies.
- A fractured fiscal policy forced to adhere to rigid EU rules doesn’t enable member governments to navigate their country-specific problems, such as deficit spending and public works projects.
- Nationalism will emerge. Healthier countries will not see fit to spend their hard earned money to bail out their less responsible neighbors.
- A common currency can act as handcuffs in perilous times. Exchange rates can be used as a tool to revalue debt and improve competitiveness of one’s economy.
Friedman predicted the euro would succumb to these flaws and fail within 10 years. If Ireland represents the catalyst for round two of the European sovereign debt contagion, his timing may not have been too far off.
Regards,
Bryan
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Excellent article. I disagree only that core EU members such as Germany will cut off funding to the periphery members. The rhetoric from inside the EU has been adamant that the project cannot collapse – even if that means Germany and France shouldering trillions of euros of debt. But otherwise this is spot on.
I agree with your disagreement 🙂 I think that Germany and to a similar degree France are fed up with pumping money into the periphery EU member states. At the same time these two states still believe in the “EU Dream” and I think it is clouding their better judgment. I think it is by far better to have a smaller but financially healthy EU than to try to prop up wasteful and fiscally irresponsible EU states. Let’s face it some countries should NOT have been allowed into the EU at all. I do understand that having additional member states means that German and French goods can be flooded onto the markets of those member states, but you gotta wonder if all that is worth it?
Cannot collapse? Hmm, I always shudder when I hear that. I guess we shall see. I wish no ill upon the EU but at the same time I would understand completely if the idealistic EU dream fell apart.