One of the most common questions we are asked at the moment is “can you please explain what is happening in Europe”. So the article below attempts to do that in simple language.
Issues affecting all of Europe
Following a brief post GFC recovery, the European economy is weakening as a result of the high interest rates and austerity (government cost cutting) measures in some countries, and economic uncertainty across the board.
Most governments and central banks would solve this problem by reducing interest rates and increasing government spending to stimulate the economy. The exchange rate would naturally fall in response, making exports more competitive. This is exactly what happened to Australia in 2008 and why we recovered so quickly from the GFC – The government increased spending (eg on schools and pink bats!), interest rates were reduced quickly (from 7.25% to 3.00% in 7 months), and the currency fell from $US0.98 to $US0.61
Europe is unable to take these actions. The Euro, which entails having one currency across 17 different countries, makes this impossible because of the rules that were put in place when the Euro was introduced whereby those countries have a common currency but separate taxing/spending powers and inflexible rules on how interest rates are to be set.
European governments can’t increase spending to stimulate their economies because they have such high debt levels. The austerity measures being put in place are crippling the weakening economies, and the opposite of the most common government policy during weak economic times.
The Euro was always doomed to failure – which is why countries such as England and Switzerland never joined, and why Germany was so reluctant.
There are 2 other related issues brewing which receive little attention. The first is that most countries in Europe have ageing populations. As people retire the workforce shrinks and so does the size of the economy. But the debt doesn’t. So in relative terms the debt will keep getting bigger.
Making matters worse, most European countries have unfunded pension liabilities ie the government is on the hook for paying a rapidly increasing amount of pensions to those retirees when they retire. Typically the pensions are more generous than in Australia and are not supplemented by an equivalent of our superannuation system.
Putting the above together, it will be difficult for Europe as a whole to reduce its level of government debt. In addition, there are issues specific to each country. The issues affecting the most important countries are described below.
Greece’s fundamental issue is that its people don’t believe in paying taxes. The collection of tax has never been properly enforced. That’s what got them into this mess in the first place.
Greece is experiencing significant social unrest. The people are violently objecting to the notion that for the first time ever they might have to pay a reasonable amount of tax. They blame the foreign banks and in particular the Germans for imposing such harsh austerity measures, and are reminded of World War II where the Germans tried to take over all of Europe.
Debt currently sits at 160% of GDP. Nobody really believes Greece will ever be able to repay this debt.
The Debt/GDP ratio is increasing for 3 reasons – Greece has a budget deficit (its government spends more than it collects in taxes); It is paying high interest rates (over 20% p.a.) on any new borrowing, and the economy is in recession (less people are working so taxes are down, and more people are on welfare so spending is up). These 3 reasons are self re-inforcing.
The recent European Summit in late October 2011 agreed to reduce debt to 120% by 2020. This is a very slow fix to the problem, is based on optimistic assumptions, and requires lenders to Greece to voluntarily forgive 50% of their debts. In other words, these targets are unlikely to be met, so Greece’s debt will need to be further re-negotiated in the future.
The Greek Prime Minister, George Papandreou, unilaterally decided to put the cost saving measures to a public vote. Then he withdrew this promise. Now he has been forced to resign. This is causing further uncertainty.
There is one piece of good news on Greece – it is such a small economy that it doesn’t matter much. The concern is the precedent it sets for other countries such as Italy and Spain. If the rest of Europe bails out Greece, what incentive is there for Italy to tighten its belts?
Italy is the big issue. It is probably too big to be bailed out.
Debt is approaching 2 trillion Euro’s ($2.5 billion), ie 120% of GDP
Italy’s interest rate for new debt has soared to over 6.5% despite the European authorities buying Italian debt to keep the rate down. Without this activity the rate would be even higher. It is very rare that countries with large debt and such high interest rates are able to reduce their debt.
The government does not have a clear mandate to rule. The President, Silvio Berlusconi has been forced to announce an election early in 2012 as a compromise for passing austerity measures. He may even resign sooner. So there is further political uncertainty.
Portugal, Spain, Ireland
These countries have already been bailed out in the past 12 months
They remain in fragile positions
France has debt of 90% of GDP, less than Italy and Greece
However its banks are in a weak financial position. France’s debt could soar if it has to bail out its banks, which hold large amounts of Greek and Italian government bonds. France has already had to bail out one bank in the past 2 months – Dexia.
As the second largest economy in Europe, France is required to show strength by supporting the weaker countries. Doing so further weakens its own position because it is effectively guaranteeing loans to the weaker countries.
If Italy is probably too big to bail out, France is definitely too big. No question.
Ratings agencies (eg Moodys, Standard and Poors) have threatened to downgrade France’s credit rating. If they do so, it could kick off a chain reaction starting with increasing interest rates which would push up France’s debt further over time.
Germany has the largest economy in Europe and one of the strongest.
Germany could solve the European problem by bailing out all the other countries
However, it would create a moral hazard (dangerous precedent) to do so.
What’s more, it would be politically unpopular – why should the German people have to suffer due to the poor economic management of their southern neighbours?
The German economy appears to be weakening, adding further uncertainty.
Issues outside Europe
The media is very focused on Europe at the moment. We shouldn’t forget the issues in the 3 largest economies in the world – USA, China and Japan. These are a subject of a future article.
So where will this end?
In tears. Or at least that is the simple answer. It has now been a week since the most recent summit. Each summit is intended to solve the crisis once and for all. And none of them have so far, that’s why we keep having more summits.
There are really only 2 possible scenarios here – Scenario 1 is that Europe muddles through the crisis, with weak growth for the next decade however avoiding recession for most of that time. This option may require some form of centralised taxation system and/or printing of money, both of which have been ruled out to date. Scenario 2 is that the system collapses with a major economy defaulting.
Neither scenario looks particularly appealing and both would have negative implications for financial markets
Some would say there is a 3rd scenario – that growth in the USA and China pull the world through the current situation, with equity markets rebounding. Our view at Lime Super is that this scenario is extremely unlikely based on the situation described above.
General Advice Warning
The information in this article is of a general nature and may not be appropriate for your circumstances. You should consult a financial adviser or speak to us at Lime Super before acting on this information.