Tuesday, March 15, 2011

Bring on the Debt Restructuring in Europe

Did you hear the latest one…94% of college professors in the United States believe that they are better teachers than the average college professor! Furthermore, the vast majority of college professors also believe that they are better researchers than the average college professor!

I just thought of this when a quote in the Financial Times this morning. The columnist Gideon Rachman writes of the European leaders: “European leaders do not know whether to be more frightened of the bond markets or of their own voters.” (http://www.ft.com/cms/s/0/38e83edc-4e70-11e0-98eb-00144feab49a.html#axzz1GaG5raM7)

In the first case, the European nations do not seem to be able to create any workable plan to bail out the sovereign nations whose debt is under attack by those nasty “speculators” in the bond markets. In the second case, more and more elected officials, like German chancellor Angela Merkel, French president Nicolas Sarkozy, and others, are under pressure from the voters in their countries to adopt “much harder-line policies on everything from immigration to European spending.”

There is a real possibility that Europe could move much more to the right, politically, than has been the case for a long time. Two countries provide vivid examples of this possibility: the Netherlands and England.

The reason I included the little bit of humor in the first paragraph above is that I needed an example of the fact that not everyone can be above average (except in Lake Wobegon). To be honest, there are a lot of horrible college teachers. And, there are a lot of horrible (peer reviewed) research papers written by college professors.

And, not every country (or business or individual) in the world can “pump up” its economy through fiscal deficits and create more and more and more debt.

Someone has to buy the debt and countries and businesses and individuals will not always be available to run fiscal surpluses so as to acquire this debt for their portfolios.

I know this sounds like heresy, but there ultimately comes a day of reckoning for those that issue excessive amounts of debt. I know that the meaning of the term “excessive” is in the eye of the beholder, but, how the financial markets decide what is “excessive” can be cumulative.

That is why we talk of a “debt deflation” and a “credit inflation.” In periods of “credit inflation” the taking on of risk accelerates during the buildup and leverage increases. In a “debt deflation” people cumulatively reduce their exposure to risk and they also de-leverage at such times.

We cannot “average” the amount of debt across nations and say that all these nations just have an average amount of debt outstanding: if we average the amount of sovereign debt in Greece and in Ireland with the sovereign debt of Germany and the Netherlands we cannot say that these countries combined will then have the “average” amount of debt outstanding.

Rachman provides the example of the current Franco-German relationship: “A senior EU official in Brussels says that this is not the old Franco-German relationship that was built on a basis of equality: ‘Germany needs France to disguise how strong it is. And France needs Germany to disguise how weak it is.’”

But, the people of Germany do not seem to be buying this and Ms. Merkel is in trouble. Because of this she has been taking stronger and stronger positions in the negotiations within the European Union. And, Sarkozy seems to be trailing the far right candidate in the buildup for next year’s presidential election and has, therefore, been more of a supporter of Ms. Merkel.

Within such an environment it seems almost impossible that a unified political settlement could be reached that would ultimately satisfy the bond markets in terms of a bail out financing package for EU countries. This would take a political union that I just don’t see happening in the present state of the world.

Some of the weak, like Ireland and Greece, do not appear to be willing to submit to the strong, Germany, in the ways the strong believes the weak must act. Thus, the bond markets will not be satisfied.

But, there seems to be a section of the voting public that are saying that they should not be paying for the undisciplined way others have acted in the past. This body of voters appears to be gaining ground as the coherence of their message grows and the confidence in their ability to succeed expands.

As I said yesterday, there seems to be only one path out of this dilemma: the sovereign debt of the fiscally troubled nations must be restructured. (See http://seekingalpha.com/article/258172-are-there-any-leaders-in-europe.)

Bring it on!

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