Sunday, September 11, 2011

Is the EU Sunk?

Is it even possible to solve the European debt crisis?

An old adage goes, "lie to me once and shame on you; lie to me twice and shame on me." The financial markets seem to have taken that thought to heart, and now disdain the half-measures peddled by Euro zone leaders as solutions to the crisis. These leaders aren't stupid or uninformed. They know the score. The fact that they won't get to the bottom line suggests the bottom line is ugly.

A standard measure of a nation's ability to service its sovereign debt and still maintain healthy economic growth is that the debt be no more than 60% of GDP. Indeed, the EU theoretically requires new members to have a debt-to-GDP ratio of not more than 60%. What is the reality?

Today, the debt-to-GDP ratio of the EU as a whole is around 90%. Germany, which would be the locomotive for any true EU rescue of its spendthrift members, has a debt-to-GDP ratio of about 80%. Not the best starting point for a bailout. Moreover, Germany's GDP amounts to some 22% of the EU's GDP. With Greece, Ireland, Portugal, Spain and Italy all going the way of dominoes, it's doubtful Germany has the ability to uplift all the sinners.

These figures understate the extent of the problem. The European banking system is one of the largest creditors of the dodgy debtor nations, and would very possibly be insolvent if things fell apart. Indeed, the simple exercise of marking to market European bank holdings of EU debt would likely indicate that the major European banks are insolvent. So the EU would have to guarantee the indebtedness of the major European banks. That would include vast amounts of interbank borrowings, commercial paper, repurchase transactions, and other debt, and all derivatives liabilities (an almost unknowable quantity given the opacity of the derivatives market). How much more would that add to the EU's burdens? It's hard to say, but the amount could easily run into trillions (of dollars or Euros, take your pick).

Measured by typical standards, it would appear that the EU couldn't save itself even if it wanted to. There is, however, one way out. That would be for the European Central Bank to print vast amounts of Euros to create inflation, drive living standards down, and make the Euro zone more competitive worldwide. Such a course of action would violate the ECB's charter, which requires it to stabilize the Euro. Many Europeans surely realize now that the mandate to stabilize the Euro gave profligate EU members an arbitrage opportunity. In other words, they could take the path of expediency, and borrow at the lower rates fostered by a stable Euro in order to raise their living standards. These lower rates were available because the markets assumed all Euro denominated sovereign debt was implicitly guaranteed by Germany and the other economically strong EU nations. With access to unduly cheap credit, the spendthrift nations could live large without having to work hard for the productivity improvements that otherwise would have been required. Give people a choice between hard work and expediency, and what precisely do we think they will do?

Amending the ECB's charter to allow it to inflate the Euro would contradict the most strongly held German imperatives. Rampant inflation after World War I, coupled with enormous war reparations to the victorious Allies, put Germany economically in extremis and opened the door for National Socialism. Germans today would have to stop being German in order to consent to inflation.

The hard data shows the EU is swirling in the porcelain bowl. The political realities of implementing the only feasible solution--inflation--require that Germany, the most powerful EU member, cease being German. Where is there daylight at the end of the tunnel? The EU seems to be gradually realizing how deep in the septic tank it's sunk. The question now isn't how to get out, but whether there even is a way out. And the answer doesn't look pretty.

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