European Sovereign Debt Crisis Opera: Has the Fat Lady Sung?

Unquestionably, the economic and investing question of the last two years has been the European sovereign debt crisis opera.  Financial markets rallied in expectation of a plan to resolve the crisis and then orgasmed upon the revealing of the plan.  So the question now becomes: has the fat lady sung and is the opera over?  That is, does this plan end the drama?  In short, the answer is “no.”

Unfortunately the symptoms of this problem are what have been addressed by the plan, and not the disease.  What is the disease?  Fundamentally, the problem is the issuance of massive amounts of capital – in the form of debt – that far outstrips the underlying capital base’s ability to pay it back.

A well functioning financing mechanism recognizes that debt is issued against the value of a profit generating asset.  Instead, we have approximately 30-40 years where globally debt has been issued against the most corruptible of assets: a promise of repayment.

Normally this is not a problem so long as your credit can generate income high enough and consistently enough to meet the debt covenant’s repayment terms.  That is, so long as there is sustained economic growth that makes use of the capital purchased with the debt.   However, in Europe there is a lack of innovation, stifling bureaucracy, horrible financing decision-making and outright fraud.

Europe’s plan to escape this quagmire – too much debt issued against too few quality assets – does not address this fundamental problem.  What I am saying is that the real way to escape the quagmire is to have a meaningful bout of introspection and address core economic questions.  Questions such as:

• For capitalism to work doesn’t there have to be a fear of loss?  Therefore, shouldn’t investors of poor debt be made to accept capital losses?
• Shouldn’t debt issuers be held accountable to a modicum of ethical and prudent behavior?
• Shouldn’t outright fraud (Greece lied its way into the EU and the eurozone) be punished somehow?
• Shouldn’t the EU charter have addressed all of these potential problems in the first place?
• If economic growth outstrips debt growth and is more sustainable than debt maturities then you can issued debt ad infinitum.  Since that isn’t occurring shouldn’t we be talking about how to grow the economy and about how to shrink debt issuance?

I could go on.

So while the financial markets have rallied on the details of the most recent “plan” I don’t really see this as cause for celebration.  Let’s look at where we are at:

• Globally we have debt issuance that far outstripped economic growth on a percentage basis.  That means that a greater proportion of each additional dollar of economic growth was effectively siphoned off to make an interest payment or to pay off a debt’s principal amount.  Unfortunately, this happened for almost forty years.  Effectively this was like printing money and it is no surprise that consumers the world around have bought all kinds of crazy stuff from flat panel TVs to multiple personal computers to multiple houses to diamond encrusted Rolexes.  But these are not economic purchases – that is they do not generate much of a return.
• It is also therefore not a surpise that all of this printed money ended up generating multiple asset bubbles.  Bubbles eventually inflate to such a degree that collective delusion eventually gives way to reality.
• The solutions to the economic stagnation brought on by too much un-economic growth sponsored by too much debt all are talking about using more debt.  Put more simply: how can a debt problem be solved with more debt?  That is literally like telling someone who is obese to keep eating.  Yes, really.  Unfortunately, some version of this story is being proposed in the United States, Europe, China and Japan.  Here we are talking about the world’s very biggest economies all simultaneously facing a similar problem.
• Structurally, the EU is not set up to solve its problems.  There is a collision of economic, political and sovereign interests and no mechanism in place to resolve very real conflicting interests.
• In Europe, banks are over indebted so cannot bailout the governments of Europe.  In Europe, the public sector is over indebted so cannot bailout the banks.  Oops!
• In Europe, banks bought each other’s debts such that they are hopelessly interlinked with one another.  In Europe, banks bought each other’s governments debts such that they are hopelessly interlinked with one another.  Normally the backstop against a meltdown would be a powerful, well-funded entity outside of the system that could bailout the system.  Unfortunately, the U.S., China and Japan are all in similar situations.  Oops!  What about private entities like the IMF?  While they are well funded and have excellent financial discipline the capacity of their bailout mechanism is small compared to the size of the problem.  Normally in this circumstance you would then look at the amount of equity on a banks’ balance sheets to see the amount of absorptive power.  In Europe bank balance sheets are woefully small in comparison to the size of the problem.  This means that if one nation, or one big bank in Europe capitulates then the first of many dominoes is likely to fall.  To me this is actually the biggest problem with the plan: too much correlation between the entities that are supposed to protect one another.  That means they are both susceptible to very similar economic shock waves.  Ouch!
• One of the proposals of Europe’s latest plan is to leverage the amount of money in the European Financial Stability Fund (EFSF) to turn it from a $200 billion fund into a $1 trillion fund.  This has taken on two forms.  One relies upon private investors to purchase sovereign debts in Europe and the EFSF will guarantee performance on the first 20% of losses – this is where the 5x leverage comes from (100% ÷ 20% = 5).  Unfortunately, private investors around the world have already been stung, and repeatedly, by credits that don’t pay their bills.  So who will buy these new debts to the tune of $800 billion?  That remains unknown.  Alternatively, the EFSF is also trying to drum up monies from other governments in the world, such as China and Russia to fund the other $800 billion.  Unfortunately, China finds itself proportionately in a bigger property bubble than did the U.S. or Europe.  Ouch!  Meanwhile, Russia does not have nearly enough in its sovereign wealth fund to purchase the full $800 billion.  What they do have they are willing to share with the Europeans.  Why?  Because Russia is looking to reassert itself in Europe and return to its Cold War status as superpower.  So Europe is necessarily cautious.
• Germany, the largest solvent nation in Europe has voted that they will not be contributing more monies to the EFSF.  So that means that additional monies must come from some other source.  The other big economies in Europe – France, UK, Spain and Italy – all are colossally indebted and are not going to be able to increase the size of the EFSF without tremendous strain on…guess what?…their ability to pay their own debts.

What we have here is an opera.  Not only that, but when the fat lady does sing and die at the end of the opera, she may actually die, unlike in an actual opera.

What can you do?  I refer to you my other piece where I recommended that you broaden your idea of what investment actually is: putting a surplus of capital into an idea that has a surfeit of capital.  So your own personal education might be smart.  Buying depressed property in a place like Detroit, Michigan or Dayton, Ohio might be smart.  Paying down your own debts is smart.  Etc.

What good news is out there?  The good news is, as I have been saying for many months, that U.S. businesses are doing very well right now.  That means that the U.S. economy just might start creating jobs.  That means the U.S. just might escape the European crisis vortex.  But folks, the odds look even to me.

Jason