The Price of Malinvestment

As the European Union's  statistics office reports, cumulative government debt among euro area members has reached a new record high in 2010. It increased in all 16 countries of the euro-zone. As Bloomberg reports:


„Euro-area debt reached a record in 2010, making it harder for the bloc’s better-off countries to bear the costs of the fiscal crisis triggered by Greece.

Debt rose in all 16 countries that were using the euro last year, lifting the bloc’s average to 85.1 percent of gross domestic product from 79.3 percent in 2009, the European Union’s statistics office in Luxembourg said today.

Greece’s deficit topped expectations and debt ballooned to 142.8 percent of GDP, the highest in the euro’s 12-year history. Ireland’s debt surged the most, by 30.6 percentage points to 96.2 percent of GDP.“

We have remarked before on the problem that Greece can not possibly reach its deficit reduction targets. This will make it increasingly difficult for the IMF/ESM combo to give its nod to further disbursements of bailout loans. Evidently the markets are well aware of the situation and are pricing Greek government debt and credit default swaps accordingly.

What is also a remarkable and important point revealed by these latest data is that it is fairly irrelevant whether a country started out with a small government debt to GDP ratio or not. The case in point is Ireland. The amount of capital malinvestment and unsound credit supporting it during Ireland's housing boom was vast. The decision by Ireland's government to bail out its insolvent banks on the taxpayer's dime has shifted the massive losses these malinvestments have produced onto the government's balance sheet. Concurrently the bust has dramatically cut into government revenues – with the result that a former model of fiscal propriety has turned into a bankrupt nation that has become a ward of the ESM. If this does not vividly illustrate how severely damaging the  boom-bust cycle can be, nothing will. One would do well to remember at this point that the boom-bust sequence that laid Ireland and other nations low was a product of the irresponsible policies of Western central banks prior to and during the boom phase. Had not the Fed and the ECB lowered rates to extremely low levels and pumped up their respective money supplies in the wake of the tech bust of 2001, the boom in Ireland would never have gotten so extremely out of hand.

As always, those who are now tasked with picking up the pieces are asking the wrong questions and implementing the wrong policies all over again. The monetary roots of the boom and bust are ignored by all and sundry, at least those in positions of power and their advisers. The interventionist status quo must be upheld at all cost, so it appears. We can therefore state that the manic-depressive behavior of the economy (as J.H. De Soto refers to it) will remain with us and in the process consume ever more capital. It is no exaggeration to say that the Western industrialized nations stand on the cusp of a civilizational decline if they continue down this path. There is no need for this to happen. By returning to honest money, by gradually cutting back the enlargement of the State of the past several decades and by once again adopting the principles of free market capitalism the problems could be easily solved, as daunting as they may currently appear.

The modern economy is without a doubt capable of delivering rising living standards and growing wealth – if only we let it. Consuming the capital amassed by our forefathers is akin to heating our house by burning the furniture. It is not going to get us to where we want to go.


German Economic Adviser Urges Greece to Restructure Debt

It is now becoming more or less official – the inevitable Greek debt restructuring is approaching. The latest indication that this is the case was given in a Bloomberg interview by Lars Feld, who is a member of the council of economic advisers to German chancellor Angela Merkel. While Feld stressed that a Greek debt restructuring does at present not yet officially enjoy the support of Germany's government and remains vehemently opposed by the ECB, the fact that yet another German official is giving us his 'private opinion' on the matter is probably significant.  Let us also not forget that official denials are completely worthless. The governments of Greece, Ireland and Portugal all denied until the very last moment that they would have to accept bailouts. The closer the day of the bailout came, the more strident their denials were. Thus the recent barrage of denials regarding the prospect of a debt restructuring emanating from the Greek government can not be taken seriously. In any event, if Greece can not convince the IMF/ESM combo that it deserves further loan disbursements in spite of not meeting its deficit reduction targets, it will be all over but the shouting.  According to a report at the SF Gate concerning Feld's comments:


“Greece will have to restructure its debt and should avoid waiting too long to do it, Lars Feld, a member of German Chancellor Angela Merkel's council of economic advisers, said in a Bloomberg Television interview.

"I don't think that Greece will succeed in this consolidation strategy without any restructuring in the future, or perhaps also in the near future," Feld told Bloomberg Television's Nicole Itano in Frankfurt. "Greece should restructure sooner than later."

While there's consensus among most economists that Greece has to restructure, policy makers in Germany are divided and the European Central Bank isn't ready to back such a move, Feld said. Greece's debt will swell to 150 percent of gross domestic product, meaning the country will have to pay as much as 9 percent of its GDP in interest, he said.

Greek government bonds fell, pushing the yield on the two- year security up as much as 64 basis points to a euro-era record of 23.65 percent today, reflecting mounting investor expectations that Greece will renege on its debts. The government in Athens has ruled out a restructuring, saying it would devastate domestic banks and hammer the economy.

Germany "is currently not willing to support a Greek restructuring and when you look at the ECB and also the German representatives in the ECB, they're not supporting a Greek restructuring as well," said Feld.


We feel fairly confident in predicting that the German government as a whole will eventually come around to the idea. As Feld notes, even under the present much easier financing arrangements provided by the ESM, Greece will end up paying 9% of its GDP in interest alone. It can not possibly pay the current market rate – which means a return to market-based financing is impossible. That leaves only the IMF/ESM financing option, which in turn means that Greece must meet the prescribed and agreed upon targets – this is however also extremely difficult to do, as the Greek economy keeps contracting. The Greek government can not be expected to get any more blood out of a dried up turnip.


Restructuring – How Bad Can It Be?

As we have previously noted, a debt restructuring harbors a lot of risks for the euro area's banking system, which is probably the main reason for the ECB's opposition to the idea. No doubt the Greek banks themselves will find it difficult to survive a very large haircut on their estimated  € 40 billion in government bond holdings. We have detailed some of the corresponding data on the interconnectedness of euro area creditors and debtors on Friday.

Reuters published an IFR comment today that mentions a warning by the ECB that sounds extremely pessimistic regarding the outcome of a restructuring. While we think it probably overstates the case, it is still worth considering:


The ECB is against a debt restructuring from any Eurozone country but they now have a new warning from the ECB's Gonzalez-Paramo in the form of a restructuring being more damaging than Lehman's bankruptcy of Sept 2008.

Financial markets continue to price a Greek debt restructuring with the 2-year yield now around 25%. Officially Greece does not need a restructuring but it is easy to see that, given the state of the economy and an inability for tax revenues to recover, Greece will not be able to access the bond markets in 2012. Sourcing funding from the market was one of the conditions of the bailout and without it Greece will need to strike a new bailout deal with their Eurozone partners.

Politically this is difficult with growing opposition to bailouts most evident in Finland (election result) and Germany (Bundestag against giving up power on ESM disbursements). The net result is Greece will be forced into a debt restructuring but the big concerns remains over the channels of contagion.

There are two channels at work here:

  1)    just as the market did not treat Greece in isolation during the bailout focus any debt restructuring for Greece will drag Ireland and Portugal closer to a debt  restructuring end game and more importantly

  2)     the European financial sector remains exposed to a restructuring of peripheral debt.

More stressful stress tests last year would have helped to mitigate concerns over the financial sector but given the continued uncertainty the markets are likely to take the stance of "shoot first and ask questions later" when dealing with portfolio risk.


(our emphasis)

As mentioned above, we think the ECB  overstates the case somewhat. A restructuring of Greece's sovereign debt need not be as damaging as they make it out to be. After all, Greece isn't the first country forced to take this step. In fact, Greece itself has been in default as often as it has been out of it over the past two centuries.

However, we would definitely warn investors not to underestimate the risks the situation poses. The main risk is actually given by the fact that so-called 'risk assets' are all trading at the upper end of their range of the past two years, with market participants holding excessively levered net long positions. Margin borrowings have exploded as we have previously mentioned. It probably won't take much upheaval to upset the apple cart, so to speak.

We would therefore continue to recommend to exercise the utmost caution – risk remains exceptionally high.


The Charts:


1.    CDS, Europe  (prices in basis points, color coded):


5 year CDS spreads on Portugal, Italy, Greece and Spain – all remain in their recent short term uptrend – click for higher resolution.


5 year CDS spreads on Ireland, the senior debt of Bank of Ireland, France and Japan. Japan's spreads continue to come in, while Ireland's are only a few basis points away from a new record high – click for higher resolution.



5 year CDS spreads on Austria, Belgium, Hungary and Romania – flat after the recent bounce – click for higher resolution.


2.    Euro Basis Swaps and Other Charts


One year euro basis swap – still looks benign – click for higher resolution.



5 year euro basis swap – click for higher resolution.



5 year CDS spreads on Saudi Arabia, Bahrain, Qatar and Morocco – all going sideways more or less, in spite of the recent upheavals in Syria – click for higher resolution.



The SPX, T.R.'s VIX-based proprietary volatility indicator and the gold-silver and gold-commodities ratios. Note that while gold-silver made a new low yesterday, this has reversed rather violently in today's trading, after a margin hike for silver futures precipitated a sell-off. Gold-commodities is no longer confirming the rally in the SPX – click for higher resolution.



The SPX vs. the AUD-JPY cross rate – as we have already pointed out, there are now numerous consecutive divergences in evidence – click for higher resolution.



A short term chart of Greece's 2 year note yield – it has reached at yet another new high – click for higher resolution.



A longer term chart of the Greek 2 year note yield – a new crisis high – click for higher resolution.




The Dallas Fed's business survey has turned out to be yet another rather weak data point for the US economy.  Once again expectations were greatly disappointed. A summary can be found at Zerohedge, and we don't have much to add to it, except to say that we continue to hold that the recovery is probably  much weaker than is apparently widely believed. In light of this, any additional shocks  – whether from a further oil price rise or a deepening crisis in euro-land – may finally end up having an impact on the stock market (evidently not yet, as the SPX has just made a new high for the move). There is also an FOMC decision coming up that will inform us about the Fed's intentions regarding QE.  At the very least, we expect a pause – and that could  be fatal for various bubble activities in the economy that have sprung up on the back of this extraordinary monetary pumping exercise.



Charts by: Bloomberg



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2 Responses to “Euro Area – The Mountain of Debt Keeps Growing”

  • Praxeologue:

    There is a lot of focus on gross government debt to GDP ratios which are then compared to comparable data points in history but surely one of the noveltys today is the enormous private debt and in some cases, offset of public savings.

    Japan is a case in point. Much is made of their 200%+ gross government debt/gdp ratio but net government debt is about half that, and private debt has fallen some 200% to GDP since 1989.

    My long winded point is that I suspect Europe and Japan’s net government debt + private debt to GDP is considerably lower than UK/USA.

    • This is actually correct as far as I know – in fact, even the government debt of the euro area as a whole as a percentage of both total economic output as well as tax revenue is far lower than that of the US. The problem is mainly with those euro area member nations that have been most severely harmed by the preceding inflationary boom.

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