how the EU got into this fix
1. For many years the EU ran a money policy that was just right for a Germany struggling with the integration of the former East Germany, which had been run into the ground economically during Soviet rule. But that stance was much too stimulative for peripheral countries like Ireland and Spain. The extra money sloshing around there found its way into highly speculative real estate. This ultimately resulted in lots of bad bank loans.
2. The big commercial banks in the EU served as a dumping ground for large amounts of toxic sub-prime securities from the US.
3. Rather than recapitalizing its banks in 2009, as the US did, the EU decided to paper over their losses and hope that economic growth would eventually restore the capital the banks had lost. That has proved to be a big mistake.
These factors have been well-known for years, however.
What’s relatively new is concern about the EU’s “bad boys,” Greece and Italy.
4. It took several years of truly heroic economic reform for Italy to meet the minimum standards for approval to enter into the Eurozone. The other members might have hoped Italy would continue to strengthen itself once it was in. But instead, Italy used the borrowing power of the euro to avoid any further adjustment to a fast-changing world, preserving an increasingly non-competitive status quo by running up excessive government debt.
In hindsight, Greece seems to have gotten into the euro only because all parties decided to pretend it met the minimum criteria. Once in, Greece borrowed up a storm and lied about it for close to a decade–both understating the amount of debt it was running up and overstating its economic growth. That deceit ended only when a new party took power in Athens last year. If that weren’t bad enough, the big EU commercial banks appear to be on the losing side of billions of euros of Greek credit default swaps.
where we are now
The EU and the IMF are trying to arrange a partial bailout of Greece. They’re doing so in a way they think will avoid triggering the CDS payout provisions, even though Greece will only have to pay back half of the face value of the bonds it has issued. This is not a move calculated to win friends (or trust) among those who have been betting on Greek default, implying that the amounts are large enough that the banks can’t afford to pay.
The big question is whether Greece will go along with the austerity measures the IMF is proposing in exchange for debt forgiveness. Another new government is in place. It’s made up of “technocrats,” which means roughly that they’re supposed to wield a cost-cutting axe and then withdraw from public life. But will Athens actually do any of the things it has promised? No one knows.
The EU is simultaneously preparing Plan B, which would be to expel Greece from the euro.
Greece is poor and too small to matter. Italy, on the other hand, is wealthy and too big to fail. Italy, too, has just installed a new government of “technocrats.” It has also successfully gone through a severe restructuring in the past, just to get into the euro in the first place. So history says Italy can (and will) do so again.
Good news on restructuring in Greece or Italy will be slow in coming, because political processes take time to work out. Bad news, on the other hand, like that Athens refuses to do anything, tends to surface right away. Because of this, I think the news flow from the EU for the next few months will be generally neutral to negative and will be a net drag on world stock markets.
My guess is that markets are now almost fully discounting the possibility that Greece will leave the euro and that Italian economic reform will be slow but ultimately successful. For what it’s worth, that’s also my base case.
I’ve argued in previous posts that the EU as a whole is already small enough in world terms that its likely economic performance isn’t enough to move the global needle one way or the other.
The real worry for non-EU investors is that failure of a large EU financial institution as a result of the EU’s cumulative problems will happen–and that this will have a Lehman-like negative effect on world trade. I think this outcome is highly unlikely.
If that’s correct, we have two potentially negative influences from the EU to deal with in the coming months:
–uncertainty about Italy, and
–bouts of panicky selling by Europeans, for whom the crisis is far more important than it is for the rest of the world.
On the other hand, I agree with Goldman that a self-sustaining economic recovery in the US is already underway.
My conclusion? …avoid the EU for now and watch for potential weakness elsewhere to upgrade your portfolio holdings.