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Europe's Economies Face Triple Threat
Released December 27, 2011 The Investment Strategy Group of Contango Capital Advisors provides regular updates on economic and financial conditions. In this issue, we take a critical look at the recent agreement intended to resolve the Euro Zone’s debt crisis.
The Euro Zone summit deal, intended to strengthen financial discipline in the region while restoring global confidence, looks unlikely to have much impact. Encompassing all 17 nations that use the euro, but given a cold shoulder by Great Britain, the agreement went some way to address the structural problems behind the Euro Zone debt crisis. Unfortunately, it’s not likely to go far enough to mend the fiscal fissures that have spread from Greece to Ireland, Portugal, Spain and Italy – and which now threaten both France and Germany. A TARP of One’s Own The Euro Zone suffers from three related but distinct problems. The first is the credit crisis it now faces. The region’s banks simply hold too much debt. As they write it off (which they must do) – while at the same time struggling to meet recently increased capital standards – they will be forced to raise significantly more equity, shrink their balance sheets dramatically, or both. The European Banking Authority (EBA) has indicated that the banks, in aggregate, need a capital infusion of at least 115 billion euros. Others contend that the EBA figure represents only about one-third of the boost that the banks require. But whether the figure is 115 billion or 345 billion, who would want to buy equity in these banks? Right: No one. So the banks have been selling off what they can, while reducing lending. In 2008, US banks turned gratefully to the federal Troubled Asset Relief Program (TARP). Today, the Euro Zone could desperately use a giant TARP of its own, and soon. Battling a Hydra Unfortunately, no entity can inject $500 billion into banks and, at the same time, successfully combat two other key challenges that now loom over Europe. The first is government debt, which has spiraled out of control throughout much of the region. The second is an unlevel – to say the least – playing field when it comes to major economic drivers such as productivity and competitiveness. Some governments, such as Ireland (and the US) took on excess debt in failed attempts to rescue the private sector. Other countries, such as Italy, have long been too much in debt. There, government debt represents 120% of gross domestic product (GDP), while government revenues grow at roughly the rate of GDP. Suppose that Italy had a balanced budget and paid 4% interest on its debt. The government would need 4.8% of GDP (4% x 1.2) just to pay the interest. So, if the Italian economy grew at 4.8% per annum, government revenue would rise annually by 4.8%. The result: Enough to pay the interest without increasing debt. Doesn’t Add Up However, if the economy were to grow less than 4.8%, the government would be forced to borrow the difference just to pay interest, and the debt would grow. That would compound over time. In fact, Italy is paying a nearly 6% rate while its economy has experienced virtually no growth for a decade. If the EU accord succeeds and new austerity policies are imposed, the Italian economy would shrink rather than grow, prompting debt to compound rapidly. Governments like those in Italy, Spain and France need to have a lot of debt forgiven – perhaps as much 3 trillion euros – to escape the exploding debt spiral. The third factor that renders the success of a new EU agreement unlikely is a structural crisis of competitiveness. During the euro’s early years, much of the Euro Zone blossomed, benefiting from low rates and a buoyant global economy. But only one country saw past the temporary growth spurt, invested in capital and planned effectively for the future. Germany held down its labor costs during the boom, strengthening its competitive position. Other Euro Zone countries depressed the euro’s value relative to other currencies, which made German exporters even more competitive. Hence, labor productivity in Germany is now 30-40% higher than in the Latin members of the EU. Germany runs a big export surplus with these countries, indicating that they are uneconomic locations in which to create competitively priced goods. Locked into a single currency zone, the only chance for escape is direct cost action – forcing down nominal wages and investing to increase productivity. This would likely take a decade and maybe another trillion or two euros to accomplish. Rather than foot the lion’s share of the bill for change, Germany is trying to force Euro Zone members to restructure government debts, undergo years of productivity improvement and forego their feckless ways. The European countries are democracies so, at some point, voters have to agree with this plan. Sound likely to you? So what happens instead? We don’t know … perhaps a long restructuring process, bolstered by enough transfers and money creation to prevent collapse. If that’s the case, the Euro Zone is indeed destined to be a dead zone for a decade or more. Investors would do well to regularly assess their strategies and holdings as the European financial crisis runs its course. The opinions expressed above are solely those of Contango Capital Advisors and do not necessarily reflect the views of Zions Bancorporation, its affiliates or its management.
IMPORTANT NOTE: Wealth management services are offered through Contango Capital Advisors, Inc. (Contango), which operates as CB&T Wealth Management in California. Contango is a registered investment adviser, a nonbank affiliate of California Bank & Trust and a nonbank subsidiary of Zions Bancorporation. Some representatives of CB&T Wealth Management are also registered representatives of Zions Direct, which is a member of FINRA/SIPC and a nonbank subsidiary of Zions Bank. Employees of Contango are shared employees of Western National Trust Company (WNTC), a subsidiary of Zions Bank and an affiliate of Contango. |
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