Recent news has been set ablaze with fear over a potential collapse of the European financial system. The full depth, cause, and extended impact of the European zone’s financial problems are still opaque to many people. Jason Hartman’s analysis reveals the basis of the European crisis comes from two principal factors. These factors are the existence of united monetary policy with independent fiscal policy, and the impacts of devaluation, default, and de-leveraging on creditors.
United Monetary Policy
- The fundamental underpinning of the European economic zone is a unified currency that spans across multiple nations, and which is managed by a continental central bank. This model offers the allure of stability since the goods, services, profits, and debts of all the member nations will be denominated in the same currency. This removes many barriers to trade between nations on the continent and helps to encourage growth in commerce.
Independent Fiscal Policy
- The other side of the Euro-Zone economic model is that each nation maintains its own government policy, budgets, and public debt. In theory, the member nations are held to certain ‘guidelines’ of fiscal responsibility. However, the disconnect between a united currency and independent fiscal policy means that some nations can spend irresponsibly and benefit from the stability of the unified currency.
- In a way, this creates a ‘free rider’ problem where the impacts of irresponsible government policy are saddled on the whole Euro-Zone, instead of the country engaging in the profligate spending. Evidence of this phenomenon can be found by comparing the yield requirement of government treasury bonds in various member countries to see the risk premium that is demanded by the market in exchange for investing.
- The reason for this risk premium comes from fears that the nation will either leave the European Union or be expelled and either de-value or default on their debt. A very clear way to see investor sentiment of the economic health for Euro-Zone nations is to examine the yield trends for treasury bonds.
The most prevalent disaster in the Euro-Zone is Greece. The yield on their treasury notes has risen to nosebleed levels, indicating that the market is all but certain that a default or devaluation is on the horizon. A less intense version of the same fears has impacted the yields for treasury bonds from Portugal and Italy as well. The reason why these factors are important is because if a nation such as Greece leaves the European Union, it will presumably declare all of its debts payable in Drachma’s. The value of Drachma’s relative to Euro’s in the marketplace will fall precipitously, since Greece would now be able to print money and inflate away its debts.
The impact that this would have on the Greek economy is to dramatically increase the price of anything that is either imported or relies on globally traded commodities. Conversely, the currency devaluation will mean that goods manufactured in Greece will be more competitive in other countries and people coming to Greece from the US and the rest of Europe will enjoy more purchasing power from their Euros or Dollars. Ultimately, this phenomenon will erode the standard of living for people in Greece as the economy adjusts to a more competitive market-based system.
This event will also erode the value of bonds that people had previously purchased from the Greek government, as the Drachma declines in value against the Euro. This phenomenon is the principal roadblock standing in the way of Greece being expelled from the European Union, since the overwhelming majority of Greek government bonds are held by banks from other member nations of the Euro-Zone. Thus, when the central bank meets to discuss a “bailout” of Greece, it isn’t Greece whom they are bailing out. They are bailing out the people whom Greece owes money, since they will be impacted very significantly if Greece defaults or de-values their debt obligations.
The impact of devaluation, default, and de-leveraging on creditors
- Creditors are the people to whom all bailout initiatives are principally aimed, and the ones who receive the primary benefits. The majority of credit instruments such as government bonds are owned by banks. Banks generate profits from holding bonds when the yield exceeds the rates they must pay to either borrow from the central bank or to attract deposits.
- Since the banking business model revolves around capturing a “spread” between the rate at which capital is borrowed and the rate at which capital is invested, banks are highly sensitive to volatility in the returns of their bonds. If a high percentage of their bonds go down in value over a short period of time, it is very possible that they can become instantly insolvent.
- Thus, the powder keg of crisis is standing ready to ignite. Business confidence and unemployment in the Euro-Zone are both in unfavorable territory. The fiscal problems of nations such as Greece, Italy, and Portugal are presenting a very real possibility that many banks across the continent will be absorbing very large losses.
- This fear of absorbing losses is what has caused the member banks to pressure the European Central Bank to create assistance packages for the member countries that are having problems in the hopes of avoiding the absorption of losses by smoothing the problem over until the countries become solvent enough to continue paying their debts.
- Unfortunately, long-term solvency requires economic productivity and the nations who are experiencing the deepest problems are the same ones who have most deeply manipulated their economies through profligate government spending. In this way, most (if not all) of the ‘bailout’ initiatives being floated are nothing more than a stall tactic by those holding a thin hope that their own lack of prudence will not be brought to light.
The extended impact of this financial house of cards is that if some nations are bailed out, then it seems reasonable that other nations should be bailed out. When the stronger nations are forced to bail out the weaker nations, it will continue to drive up the total debt to GDP ratio within the Euro-Zone and will continue to drive the entire system toward a continental crisis. In this scenario, it is likely that the European Union will appeal to the United States for a bailout.
The problem that ultimately arises is that nobody is present to bail out the United States when the global financial problem ultimately spirals to a point where it cannot be brought back from the brink. If this scenario transpires, it is all but certain that rates of inflation not previously imagined will prevail as the central bank attempts to inflate away the many accumulated decades of imprudent fiscal and monetary policy.
Action item: Structure your personal finances in such a way that you will be able to withstand an explosion in global debt and inflation. The best way to do this is with fixed rate debt that is attached to real income producing assets. As the impacts of inflation ravage the economy, they will erode the value of your mortgage while inflating the amount of your cash flows. (Top image: Flickr | quapan)
The Jason Hartman Team
