FYI | Feb 04 2010
By Greg Peel
To recap, the European Union is comprised of 27 sovereign nations in a common trading bloc, the purpose of which is to compete as a collective more effectively with the world’s economic powerhouses of the US, Japan and now China. It was born of the old “Common Market”.
Of those 27 nations, 16 have chosen to also band together under a common currency – the euro. Responsibility for the euro falls to the European Central Bank, and “euro-zone” membership comes with the requirement to satisfy various economic criteria in exchange for central bank protection (such as lender of the last resort insurance). One of those criteria is that members must maintain a level of public sector deficit of no more than 3% of GDP. In order to finance deficits, individual members issue their own soveriegn bonds. There is no single euro-zone bond. Excessive debt issuance from one member state incrementally impacts on each member state via the devaluation of their common currency.
Any sovereign nation can also go cap in hand to the International Monetary Fund for financial assistance, as that is what the IMF is there for. But the IMF also imposes strict criteria itself when it bails out an economy, and one of those is a forced devaluation of that nations’ currency. In the case of euro-zone members, clearly this is not an option. Thus the ECB must respond first.
> In 2009, the ECB was forced to bail out euro-zone member Ireland.
One of the euro-zone’s biggest problems is economic disparity. The CIA World Factbook (yes, the US charges the spooks with the task of measuring everyone’s economy) puts the European Union’s total GDP in 2009 down as US$16.0 trillion, ahead of the US on US$14.2 trillion. China’s economy is now assumed to have exceeded that of Japan’s but for the sake of comparison, the CIA suggests Japan’s GDP was US$5.0trn in 2009 and China’s US$4.7trn.
On an individual basis, in fourth place is Germany with (the numbers are all in US$ trillions from here) 3.2 and then France with 2.6 in fifth. Of the euro-zone members, Italy’s GDP is 2.1 (7th) and Spain’s is 1.4 (9th). We then descend through the Netherlands, Belgium and Austria before we get to Greece on 0.3 (28th), and then Finland and Ireland before we get to Portugal on 0.2 (38th). For comparison purposes, Austalia’s GDP is 0.9 in 13th place, only 64% as big as Spain’s.
We would not like to think of the consequences of Australia defaulting on its sovereign debt.
Last night the European Commision used new EU treaty powers to impose strict measures upon the Greek government and economy. Greece has vowed to reduce its deficit from 13% of GDP to 3% by 2012 but the EU has given the government only one month to actually come up with a viable plan to achieve the target and has ordered public spending to be slashed. The new socialist government is already meeting opposition from its trade union support base and a general strike has been planned. The EU is under pressure from the ECB and from dominant member Germany to bring a profligate Greece into line.
The measures are intended to prevent money flowing out of Greek government bonds for fear that Greece may not be able to meet its interest payment obligations. Previously the Gulf state of Dubai had announced a freeze on interest payments, sparking fears of default, but since the neighbouring United Arab Emirates agreed to underwrite Dubai debt, the danger has subsided for now. The ECB cash rate is set at 1% and the benchmark German bonds are yielding around 3%, but last week Greek bond yields blew out to 7% as funds quickly departed.
The panic has now subsided over Greece. And nobody honestly expects that the EU member will default. However, the austerity measures now being imposed on Greece will not be well received by an angry electorate.
It is the nature of such default risk episodes that contagion is a feature. When Thailand’s currency began to falter in 1997 the Asian Currency Crisis, affecting all the Asian “tiger” economies, followed. The following year Russia defaulted, bringing down the world’s biggest hedge fund. When Iceland became the GFC’s first major victim, Ireland soon followed. No sooner had Dubai hit the headlines, Greece was not far behind. And with the pressure now somewhat off Greece, the attention has turned to Portugal. Last night bond traders shifted focus to the next perceived victim and began selling out of Portuguese bonds.
There is, of course, a level of self-fulfillment about such flights of capital. When Bear Stearns went down, Lehman Bros was not far behind. And then the US government was forced to bail out all major US banks.
The Portuguese economy is smaller than the Greek economy, but much larger than the Greek economy is that of Spain – the ninth biggest economy in the world. Spain is considered to be the next domino, and beyond Spain even the larger Italian economy is drawing attention. If Spain were to default, the ramifications would be enormous. It would be another Lehman Bros as far as some commentators are concerned.
Economists suggest the reason why Greece and Spain in particular are in serious trouble is due to the lax collection of taxes. In the property markets in particular – and Greece and Spain are both popular rental destinations for foreigners let alone the local population – landlords are estimated to be collecting more than half of all rents as cash and thus avoiding tax payments. This is leaving public coffers short by billions of euro. Clearly a serious shake-up is needed among the so-called Club Med nations and austeritiy measures will have to be complemented by some aggressive crack-downs.
Fortunately for Spain, it entered the GFC with a budget surplus which provided an initial buffer against deflation. In response to criticims from other EU members, Spain has boasted that not one Spanish bank has needed an injection of public capital, and indeed one Spanish bank has bought into the crumbling British banking system. (Is the UK next?). But Spain has since suffered a huge bubble and bust in its property market, and quickly it is becoming more Greece-like every day.
Standing on the sidelines is the huge economy of Germany, which is the only major EU member still in surplus. As a world exporting powerhouse, Germany has long run a fiscal surplus which has formed a large percentage of the offsetting US deficit. Germany is the senior member of the EU and the only member with any real capacity to come to the aid of Club Med and, for example, bail out banks. But Germany refuses to do so.
> Which is quite understandable. Germans are renowned for being a nation of strict savers unlike their frivolous Club Med peers. Why should Germans have to stump for Mediterranean profligacy? But at the end of the day, Germany agreed to be a member of both the EU and the euro-zone and hence the survival of both may depend on German intervention.
Critics of Germany point out the underconsumption of Germans is just as much to blame for EU disparities as is excess consumption elsewhere. Germany is selling goods into its EU neighbours but buying little in return. This is a microcosm of the wider world malaise, which sees Japan, China and Germany on the one hand failing to spend on imports to balance out the rampant spending of the US, the UK, the rest of Europe and Australia etc on the other. The world is trapped with the pendulum having swung too far in the one direction.
> The Chinese government is currently making aggressive attempts to stimulate China’s domestic economy to address the imbalance which has been exacerbated by China’s currency being pegged to the US dollar. Germany’s currency is also pegged to its neighbours in that they share the one single currency. For the current European economic situation to be eased, critics argue, and for the sheer survival of the euro and the EU, Germany needs to come to the party.
> Otherwise what we have building is a crisis of confidence in the euro which could get out of hand. The pound would not be far behind. The irony is that once again the world is seeking sanctuary in the safety of short term US debt despite the US boasting the biggest deficit of all. The devaluation of the US dollar, as a reflection of this deficit, appeared to be underway late last year, but the trend has now reversed as the other side of the world appears in more dire straits. Nevertheless, the longer US bonds have begun to creep up again in yield as investors again begin to fear inflationary pressures.
>The collapse of Lehman Bros and subsequent ramifactions showed that one investment bank had the power to bring down the world. Such a catastrophic collapse was nevertheless prevented by coordinated government intervention across the globe. But what happens when national economies start going down?
