Here we go again. Stock markets were down Friday in Europe and the Americas. The culprit was renewed anxiety that Europe cannot get its house in order. Indeed, it’s looking very much like a house divided in Euroland, which leaves the adopted child of the Union—little baby Euro—in grave danger.
Will the authorities come to take him away? Or will he run away on his own, never to be seen again?
If the Euro were a child, it would be important to tell him that it’s not his fault that his parents are bickering. They were never in love to begin with. The monetary marriage of convenience always allowed for fiscal infidelity in the separate States of Europe. The currency itself was well kept and stewarded by some of its parents, and flamboyantly pimped out to finance generous (but unaffordable) social agendas by other parents.
And here we are with “extreme tensions” in the family according to European Central Banker Jean-Claude Trichet. He told Germany’s Der Spiegel magazine that, “In the market, there is always a danger of contagion like the contagion we saw among the private institutions in 2008.”
The contagion this time is among nation states like Greece, Portugal, Spain, Italy and others with large (and growing) public debt-to-GDP ratios. For one, with the threat of more protests by trade unions in Greece and Spain, markets are not convinced austerity moves announced governments will actually happen. But even worse, what if they do?
Austerity measures will lead to lower European GDP growth in the short-term. That’s what happens when you liquidate bad debts. But lower growth and government tax taking makes it even more expensive to service debt (especially when interest rates are rising). Damned if you do. Damned if you don’t.
Overall debt to GDP levels on the Continent are high. But the three highest annual deficit-to-GDP numbers are not on the Continent at all. The International Monetary Fund predicts that the U.S. will have a deficit-to-GDP ratio of 11% this year. The U.K. will come in second at 11.4% and Ireland first at 12.2%.
Why, then, if spending seems even more out of control in those countries, is the crisis hitting southern Europe first? Well, as Bill mentions below, Ireland had a smaller debt problem to begin with and has already begin cutting back. It’s effectively had its crash.
The main difference between the U.S, U.K and the rest of the Europe is obvious. There are central banks in London and Washington that can print money. They can monetise debt (print money to support government or other bonds). They CAN inflate away with monetary policies in ways national governments in Greece and Spain cannot.
So what will you get? You will either get a more federalised Europe with a truly common monetary policy and a fiscal regime that binds. Or you will get dis-intgetration.
As long as all this is playing out, equity markets are going to be under pressure. One big reason is that credit markets are again under pressure. And when credit to the corporate world stops flowing you again find out who is the most leveraged and vulnerable. Free-flowing credit is the first casualty of a loss of confidence in monetary authorities.
Bloomberg reports that, “Concerns have spilled into the market for commercial paper, debt used by companies and banks for their short-term operating needs. Rates on 90-day paper are more than double the upper band of the federal funds rate, about twice the average in the five years before credit markets seized up in mid-2007.”
By the way, remember last week when we looked at the deterioration in credit spreads? It was Aussie financials at the top of the list on that particular day, for a variety of reasons. But check out last Friday’s data. The top five largest increased in spreads are an intriguing mix.
You have a European defence conglomerate. You have Portugal. You have in Italian bank. You have a health insurance company. And you have AMBAC.
AMBAC? Hmm. AMBAC. And what does it do? According to its website, “Ambac’s principal operating subsidiary, Ambac Assurance Corporation, is a guarantor of public finance and structured finance obligations.”
Today’s extra credit question, then, is this: if the cost of insuring AMBAC’s bonds against default is widening, and AMBAC’s business is selling insurance against default in public sector debt, what does that say about AMBAC’s business and the chance of sovereign debt default.
Please submit your answers to email@example.com and as always, show your work for extra credit.
Seen on a bumper sticker of a caravan this morning on Fitzroy Street: “Property and hard work will make your fortune” and “Wealth for Toil.” Hmm. Wealth for toil? We’ve heard it enough times to know it’s a line from the Australian national anthem. We’re just wondering if it should be removed now, what with the introduction of the Resource Rent Tax.
Finally, we reported last week on the evidence of falling real estate prices in Beijing. But what about Shanghai? A friend who’s moved there recently said the city is bustling with tourists and business people there for the much-anticipated expo. The city is gleaming and shiny and industrious.
According to this article in the U.K. Times online, “Some economists dare to say the Expo may be a symbol both of China’s economic might and of flaws in its system. According to Fan Yongming of Shanghai’s prestigious Fudan University, the Expo has accounted for half of the city’s fixed asset investment over the past eight years. Nobody is sure what will take its place.”
You know our take on what’s going on. But if you haven’t seen it yet, have a look here.