Fiddling While the Euro Burns

By: John Browne
Senior Market Strategist, Euro Pacific Capital, Inc.

Last week, eurozone finance ministers postponed, yet again, the most difficult decisions on the Greek debt crisis. The assembled powers could have forced an orderly Greek default or they could have taken steps to push Greece out of the union. Instead, they simply bought time until the next major rollover of Greek debt – which comes due in November. I don’t expect much to come from the brief respite.

Much of the prevarication can be attributed to political disagreement in Germany, where some see the current crisis not only as a means to further European unification, but also as an opportunity to extend German influence throughout the continent. Other Germans, particularly those in the south, see the crisis as a means to roll back the flawed structure of the eurozone. The resulting indecision is allowing adverse sentiment to set a time-bomb under the euro.

In truth, recovery has no chance of taking hold without a clear idea of what Europe may look like politically in a few years. Today, there is a desperate need for a momentous decision by Germany.

Rest assured these are problems that can’t be swept under the rug. Greece now has a debt-to-GDP ratio of 173 percent. Simply put, it is hopelessly bankrupt. The ‘troika’ of the EU, ESM, and IMF are demanding that Greece accept more austerity in return for more funding. But, already, austerity is reducing Greek GDP and tax revenues while creating civil unrest and a greater demand for social security payments.

The austerity medicine in Greece is also creating similar problems for Italy and Spain, whose economies are much, much larger. Spain has twice the outstanding debt of Greece, Ireland, and Portugal combined. Italy has five times that amount. The sums needed to rescue Spain or Italy would stretch even Germany to the limit of solvency.

Already, the euro is falling fast even against the deeply flawed US dollar. As I see it, there are three possible conclusions to the crisis:

1. The euro splits into two parts: one for the cash-generating northern countries and one for the Mediterranean countries, possibly including France. This two-tiered system would take into account the differences in economic reality for the two regions and would provide much more financial flexibility.

2. Some of the Club Med countries are forced to leave the euro, re-issue their own currencies, and attempt to generate earnings to repay debt.

3. The euro ceases to exist. As the world’s second currency, this would result in a short-term stampede into other fiat currencies such as the yen, Swiss franc, Norwegian krone, Australian and Canadian dollars, even sterling, but predominately into the US dollar.

Any one of these outcomes is preferable to the unsustainable status quo. But an orderly Greek default combined with an exit from the euro would be the best strategy to move forward. Unfortunately, this option is unpalatable to internationalist politicians, who want to maintain the pan-European government, and the banking system, which is choking on bad sovereign debt. Still, talk is growing.

If a default does come, the big question is how much creditors could lose through debt haircuts. Recently it has become clear that the 21 percent haircuts for private holders of Greek debt, which had been agreed on in July, may have to be deepened to 40 or even 50 percent. However, calculations will need to me made as to how much losses can be accepted by the banks before their insolvency threatens the solvency of their own nations. Very few observers know for sure how much bad debt lurks on the balance sheets of the big European banks. This question alone threatens further and more dramatic contagion.

Eurozone governments, in particular Germany, France, and Belgium, have long ‘persuaded’ their banks to load up on PIIGS sovereign debt. Now, unsurprisingly, a PIIGS default threatens German, French, and Belgian banks. France has some of the largest banks, all carrying unknown amounts of these toxic assets. BNP, Credit Agricol, and Societé Géneral alone have combined assets (of all sorts) of some $7 trillion. This staggering sum is equal to about half the US Treasury’s massive debt. However, the French economy is less than one fifth the size of the US economy. If losses related to bad sovereign debt were to push any of these banks into default, the ramifications could be dire for France.

The world’s immediate economic future rests with a prompt decision by Germany to abandon its dreams of empire and cut off funding for the PIIGS. Such a move would protect Germans from unlimited bailout requests, save the people of the PIIGS from unnecessarily harsh austerity measures, and provide a needed reprieve for the euro and international fiat currencies. For an even more in depth look at the prospects of international currencies, download Peter Schiff and Axel Merk’s Five Favorite Currencies for the Next Five Years.