One of the biggest assumptions that fueled the sharp rise in the market on Thursday was that the European debt agreement was, well, an agreement, albeit one where there were still some important details to be worked out. There was some doubt as to if it would be enough to really do the trick and get ahead of the curve, but at least the feeling was that everyone was on board and working on the problem (and the can had been successfully kicked down the road).
Well it just goes to show what happens when you assume… Once again, it looks like things fall apart and the center cannot hold.
The whole ball of wax just fell apart yesterday afternoon when Greece announced that it will hold a referendum on going along with the deal. Given the riots in the street in opposition to it, almost bordering on civil war, it is FAR from a sure thing that the referendum will pass. I would say that passage of the referendum is probably a long shot, but I don’t pretend to be an expert on the Greek political situation.
Since Greek debt is at the heart of the situation, Greece has to be fully on board. We will now not know if that is the case until sometime in January. Until then, the European markets will twist in the wind.
Italy’s Debt Problem
The early indication that the deal was not going to work was seen in the Italian bond yield, which failed to drop in response to the deal. That worried me, but I still thought we at least had a few months of breathing room before the crisis would flare again. Now the Italian 10-year note is plunging in value and the yield is soaring.
Italy is up to its eyeballs in debt, and has been for a long time. That debt today is being quoted at a yield of over 6.3%, up from 5.85% on Thursday. The higher the yield goes, the bigger the primary surplus (tax revenues exceeding government spending excluding interest payments) that the government will have to run.
Austerity measures are not very popular in Italy, and the Berlusconi government does not have the political capital to push it through. In any case, austerity serves to slow the economy and thus suppress tax collections.
A backstop for Italian sovereign debt is not very credible if Italy itself is a big part of that backstop. Italy is both too big to fail, and also too big to bail out as it is the third largest economy in the Euro-zone. The fourth biggest member of the Euro-zone, Spain, faces similar issues.
…And It Doesn’t Stop There
For that matter, even France is not looking that great right now. Its big banks are very exposed to the sovereign debt of the PIIGS. Part of the agreement was that the European banks were going to have to increase their tier-one capital to 9% from 5%, and would first turn to the private market to do so, then to their National government, and then finally to the European Financial Stability Fund (EFSF), or Euro-TARP.
Raising that capital will not be cheap for the banks, especially in the private market. The existing stock is currently trading far below book value because the market realizes that it belongs on the fiction shelf. France itself it probably gong to have to supply most of the additional capital that Societie Generale (SCGLY.PK), BNP Paribas and Credit Agricole will need to raise. That, in turn, will put France’s AAA rating in doubt.
Here in the U.S. we have already had one casualty from the European Problems as MF Global declared bankruptcy yesterday due to its heavy exposure. While not a household name, it was a very big player in the Forex markets, and was one of the primary dealers for Treasury paper.
It looks now like it will be a relatively orderly wind up, unlike the fall of Lehman Brothers; then again, MF Global was not nearly as big. Still, if it can be wrapped up cleanly, that is a big success for the Dodd-Frank financial reforms.
However, I sincerely doubt that MF Global will turn out to be the only major U.S. player to end up with a lot of egg on its face from the European debt situation. In particular, Citigroup (C) and Morgan Stanley (MS) are considered to be highly exposed. Not saying they’ll go under — we saw a few years ago that the government is not going to allow that — but you don’t want to be owning either of those stocks. J.P. Morgan (JPM) was the biggest lender to MF Global, and is reportedly on the hook for over $1.2 billion. That is not going to sink that bank, but it might be a nasty hit to fourth quarter earnings.
Countries in Euro-zone Cannot Control Money Supply
With countries of Europe all sharing a common currency, from inside the Euro-zone it looks to them a lot like they are all on the gold standard: they do not have control over their domestic money supply, nor do they have the ability to depreciate their currency to make themselves more competitive.
The debt of each country is effectively denominated in foreign currency, even if that is the currency they are using for day-to-day transactions. That makes all the difference in the world. Look at it this way: the debt and deficit situation in the U.K. is as bad or worse than that of Spain or Italy, but it is still able to borrow at low rates; ditto for Japan. Any country that issues debt in its own currency, and controls the printing press, cannot default unless they make the insane political decision to do so.
That, incidentally, goes for the U.S. The reason we lost our AAA status from S&P is that making a decision to default on our debt was actively on the table just a few months ago in the debt-ceiling crisis. As long as the debt is in your own currency, you can print all you want to pay it off. Yes that could be inflationary, but inflation is not the same thing as default.
Those who argue that the U.S. needs to go back on the gold standard should realize that if we were on it, we would look a lot like Greece right now. Given our massive current account deficits, Fort Knox would have been emptied a long time ago. That is not an argument for or against gold as an investment, but against using it as the basis for our monetary system.
If the bond market really thought that inflation was going to be a problem, there is no way that they would be willing to lend to the U.S. government at under 2%, as they are today. If inflation works out to be more than that over the next decade, those are certificates of confiscation, not investments.
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