Some historical context

Hey guys-

As important as going forward is, and as we contemplate who should do what in the European debt crisis, it is imperative to understand what's going on, and what has happened to get us to this point.

Let's start with the basics. CBC published an article today which acts as a primer. Some notable points from the article are:

• The euro, a common currency was adopted by 17 of the 27 member states of the European Union ("EU")

• Any country that enters the EU must adopt the euro once it meets the necessary criteria (Denmark and the UK have opted out of the euro completely)

• The "eurozone" refers to the 17 states that have adopted the euro in replacement of their old national currencies

• The Maastricht Treaty in 1993 lays out five main criteria to join the eurozone:

1. Inflation: the rate of inflation may not be more than 1.5 percentage points above the average rate of inflation of the three EU member states with the lowest inflation over the previous year.

2.Budget deficit: national budget deficits must be at or below three per cent of GDP.

3. Public debt: national public debt must not exceed 60 per cent of GDP. A country can still join if its debt exceeds this level provided it is falling steadily.

4. Interest rates: long-term interest rates must not vary by more than two percentage points from the average interest rates of the three EU member states with the lowest inflation over the previous year.

5. Exchange rates: exchange rates must remain within the accepted margin of fluctuation laid out in the Exchange Rate Mechanism (ERM) for two years prior to entry. (The ERM is the mechanism by which EU members linked their currencies in order to prevent large fluctuations prior to the adoption of the euro.)

If you read (highly recommended) - Michael Lewis' Boomerang, or read any news articles, it is apparent that in reality items like budget deficit and public debt are not met by several nations. In fact, in Boomerang, it suggests that Greece never met these criteria, but rather did a little 'cooking of the books' in order to grant access into the eurozone.

The European Commission estimates that the average debt burden for the euro area will be 88% of GDP in 2011 and 90.4% in 2012 (umm... wasn't the limit 60%?) Germany, the eurozone darling is forecasted to have debt of 81.7% of GDP in 2011, with Greece coming in at 150.9% of GDP. In reality deficits for the euro area are expected to be 4.1% of GDP in 2011, and 9-10% in Greece.

• While not all countries in the EU are not part of the eurozone, they are all part of a common market (no trade barriers, custom tariffs, border controls, and other impediments to the movement of goods, capital, labour and services across national borders)

• Today, the EU has common policies beyond trade (has included social and environmental co-ordinated reform), but the economic and core political integration was never structured

The open markets have lead to increased reliance between the EU countries (not only in the eurozone). The problem with just letting a country default, is the contagion impact not only in the EU but around the world. Some economists predict that a serious chain of defaults could spur a deep world wide recession. So as time is ticking, the economy (globally) becomes increasingly more fragile. For example, the China is the EU's 2nd largest trading partner after the US (we'll talk about China another week).

Michael Lewis gave a great interview on Charlie Rose which highlights the ridiculous nature behind the events leading up the debt crisis, and how the debt crisis isn't a singular banking crisis, or corruption of the financial systems. Rather in each country (Greece, Ireland, Iceland etc.), the underlying issues that lead to inflated debt-to-GDP ratios were culturally rooted. This would suggest that since the reasons for the crises were cultural traits and values carried on since... well the Greeks have been around since... forever (if the date has BC in it, I consider it to be forever), and that perhaps the solution won't be solved overnight (heck, my dad's only in his 50's and still he is stubborn as truck - honestly, try to talk him out of doing something once he's already set it in stone in his head. I dare you.)

Anyway, the book not only gives a great background but is funny (yes, actually funny). To give you a little teaser, the word feces appears a lot. If that doesn't get you running out to the bookstore, I don't know what will.

Link below to interview:

http://www.charlierose.com/view/content/11924

Post 1: Inflation vs. Default

A friend of mine (who I may try to coerce to post along side me) has challenged me to find articles on current events and opine on them. I hope this is a good start to our series.

The article I chose is from November 17, 2011. Despite the fact that it was my birthday, which throws me back to feelings of euphoria and strawberry shortcake, I can’t help but feel that it is a wee bit dated for today’s discussion.

News/rumors/telepathic thoughts from Europe have been triggering the markets left, right, up and down. Any news is old news as I watch the headlines crowd my Bloomberg terminal. You want to look for news from yesterday? You’ll have to dig through 257 articles, and surely there are at minimum two newly elected technocrats in Europe, Iran will be threatening something, a new country will have an Arab Spring like moment, and Rick Perry will find a new way to make us giggle – and he still won’t be in on the joke.

What is constant, however are the issues that have been facing Europe over the last two years or so. Despite meeting after meeting, we’ve seen nothing but lip-service granted to the underlying issues. I digress- back to the article!

The article argues that there are two options we have on the table:

1)Print money

2) Let the Eurozone crash and burn

The Germans (who run shiz these days), are extremely opposed to the option of printing money. The thought of a printing press classically conditions a stomach ache as a reminder of the hyperinflation in the 1920s of the German Mark.

Normally, printing money isn’t as shock-and-awe as the German 1920’s experience. Bernanke has said it is still in the toolbox to boost the US economy if things go awry with Europe. QE1 and QE2 didn’t send anyone to buy bread with a wheel barrel full of cash. The Bank of England increased their QE program in October. The difference? History has allowed countries to inflate themselves out of debt disasters, paying back the debt with inflated money, then kick-starting the economy once it can get back on its feet. With the Eurozone, if one country needs to inflate, all the neighbours go down with it.

So the question becomes what is more harmful – sinking the whole ship while the Euro flag waves high, or forcing certain exits ending the attempted Euro unity. If inflation does occur and prices rise, the gaps between countries such as Germany where wages are higher than say, Slovakia will no doubt put pressures on income disparity. You’ve solved your debt payment conundrum for a moment in time – now what?

Forcing certain exits will of course cause much shame and embarrassment to Euro leaders. But the countries can undertake monetary policy to fit what is needed in their own economy. Over the 17 nations that share the Euro, each one with veto power entangles the debates further than necessary. Other than shame and embarrassments – oh yeah, the immense fears that defaults will trigger CDS markets off the charts. If sovereigns default (unlike the 50% ‘haircut’) in Greece, who will be the odd man out on those contracts? Most firms hedge their bets, but at some point in the exchange, someone is not going to get paid.

Since firms report net exposure, it is virtually impossible to know where this risk will lie. Enter more contagion fears.

Obviously I don’t have all the answers/considerations. The ECB has been persistent that they are not in the business of purchasing sovereign debt, but rather they take care of monetary policy and the banks, and the individual governments should take care of sovereign/fiscal problems. Essentially the ECB is trying to take the option of printing money off the table.

I think it will be interesting to get in a time machine and fast forward five years. But that's crazy - who wouldn't want to get in a time machine?

Original article:

http://www.cnbc.com/id/45344815/Why_Europe_s_Central_Bank_May_End_Up_Printing_Money