You can't turn on the news, read the morning paper, or peruse the Internet without running into some handwringing piece on the troubles in Europe or perhaps a chest-puffing diatribe saying, "Here's how to solve it all, you buffoons." So just how bad is Europe? Well, the smoke has pretty much cleared from the past few months of smoldering hope followed by flames of despair. The euro zone has just two options: break up or print money. At this point, it really is just that simple. The distinct scent of eau-de-contagion weighs heavy in the air.
For a welcome change of pace (note the wry grin), Greece is no longer Public Enemy No. 1 as Italy takes center stage, with Spain and France elbowing their way into the spotlight and Hungary waving from the wings. With the long-anticipated demise of the Papandreou government in Greece and the fall of Berlusconi in Italy, events in Europe are likely to pick up speed.
- Italian and Spanish borrowing rates are reaching levels the countries cannot afford, meaning the ECB or the IMF must lower rates or provide additional debt at below-market rates. Spain's first debt sale since the weekend elections to replace its government resulted in an average yield of 5.11% on the three-month T-bill, up from 2.292% for similar issuance October 25. Apparently, the market isn't in love quite yet with the new government.
- French 10-year bond yields have also risen dramatically from 2.6% to more than 3.6% in less than two months. That's a 38.5% increase! France may still be AAA rated officially, but the markets aren't pricing the debt as AAA. (Recall that when the US lost its AAA rating, Treasury bond yields fell!) If France officially loses its rating, the EFSF (European Financial Stability Facility) will be seriously impaired, further dimming the prospects for any sort of bailout.
- Third-quarter German GDP growth came in at a meager 0.5%. France had 0.4% growth after a second-quarter contraction of 1%. Spain and Italy were flat. Euro zone factory output fell 2% in September. Exceptionally high debt levels, rising borrowing rates, and stagnating economies make for a dangerous brew.
- Italy and Greece are now led by appointees, rather than duly elected officials. For the time being, there is no reason to believe these appointees will have any more success than their elected predecessors.
- Hungary has asked the IMF for help. Contagion strikes again as Eastern Europe desperately needs external financing for its banking system, with about 80% of the financing coming from European lenders and their subsidiaries. A banking crisis in Europe will leave Eastern Europe vulnerable to an enormous credit crunch.
- The pullback in lending by highly stressed European banks is being felt by companies around the world, making borrowing harder and more expensive. This is a headwind to global growth.
- Basel 2.5 implementation, with its more stringent capital requirements for banks, is due on December 31 for European Union countries. As if things weren't tough enough!
Why do rising interest rates matter so much for sovereign debt? Imagine a country that has $100 of annual GDP (its income), debt of $100, and a government that is spending 10% more of its GDP a year than it takes in from taxes. If its GDP were expected to grow at, say, 2% while it had to pay 6% on its debt, it would be in a downward spiral and would quickly become insolvent, because the debt would grow faster than the income at an ever accelerating rate. Ouch! (US debt is about equal to our GDP, and we are running large deficits.)
Year 1: GDP = $100*(1+2%) = $102. Debt = $100*(1+6%)+(10%*100) = $116.
Year 2: GDP = $102*(1+2%) = $104. Debt = $116*(1+6%)+(10%*102) = $133.
Year 3: GDP = $104*(1+2%) = $106. Debt = $133*(1+6%)+(10%*104) = $151.
(You get the point.)
Bottom Line: The fundamentals have not changed. The market is just now beginning to appreciate the reality of the situation. What makes this even more startling is that, even though all these yields are rising dramatically, the ECB is furiously buying up buckets full of all these bonds. Imagine what yields would be without this ECB wingman! There is a clear flight to safety into the German Bund and US Treasuries.
The most important question is not if the European leaders can muster the collective will to solve this crisis, but whether they have the financial ability to solve it. I believe it is unlikely they can solve it in any meaningful way, regardless of what agreements arise. Political will cannot make 2+2 = 5, despite what bureaucrats may claim!
Back home, things don't look too rosy, either.
- Tuesday's US auction on five-year Treasuries had the lowest yield in history. This indicated that the markets have a negative outlook on future economic growth.
- Unemployment is still exceptionally high at 9%, with the adult male unemployment level at a near-record 8.8%, a level previously seen only in the very deepest recessions.
- The youth unemployment rate is 24%.
- A quarter of homeowners are under water on their debt.
- The fiscal deficit (the amount the government spends in excess of tax receipts) is 9% of GDP, with interest rates at record lows and our national debt about equal to the annual GDP. Remember the earlier math exercise?
- Since 20% of our exports land in Europe, a slowdown there affects growth prospects here.
- Our "super committee" turned out to be not very super. Is anyone really surprised?
If that didn't get your attention, ponder this. These types of conditions are what you see coming OUT of a recession. And, as I'm sure frequent visitors of this Website are well aware, we are likely heading INTO one. That's like heading into an all-nighter at work after spending a three-day weekend in Vegas without seeing your hotel room once.
The US and the global economy as a whole are heading into some exceptionally challenging times. But before you head to the hills with that 50-gallon bucket of dehydrated food, remember that the worst of times often can serve as a catalyst for meaningful and powerful change.