Thoughts for the Weekend

Rising yields in parts of the EU.  The Spanish ten-year bond yields hit 7% on Thursday (yields finished slightly lower).   Italian yields were at 6.13% (they were below 5% three months ago) — they’ve increased as everyone thinks that they’re next (Greece, Spain, Italy).  (Think of it like Bear, Lehman, Merrill Lynch.)

 
Why Italy?  Italy is expected to only have a 3% deficit this year (as a percentage of GDP).  That’s great.  Unemployment (10.2%) is less than half of Spain’s rate (24%).  But, their 120% debt-to-GDP ratio is second to Greece (w/ respect to EU countries).  In addition, they’re in recession – expected to shrink 1.7% this year.  The bottom line is that once you have a high debt level, neither austerity nor “growth initiatives” provide an easy answer.

Not a good way to get rich quick.  It’s been reported that Italy has to put up 22% of the $100 billion bailout for the Spanish banks.  But, here’s the great thing…Italy is loaning the money to Spain at 3%.  So, Italy borrows at 6% and loans that money out 3%.  Pretty shrewd…

Sunday’s election.  Everyone is waiting to see how the Greeks will vote on Sunday.  Will they vote for anti-austerity politicians?  In the last election, 70% of voters cast their ballots for small parties that were opposed to austerity.  Politicians seem to be moving toward the middle right now (to try to attract votes).

What to watch.  Everyone is watching to see how the Syriza party will do.  They are the anti-austerity party.  If they win, everyone will try to calm the markets.  (The fear is that Germany may be done with bailouts for Greece; and this could lead to some chaos followed by massive worldwide central bank intervention.)  But, here’s the more interesting question…what if the New Democracy party wins?  That’s what the markets “want”.  You don’t seriously think that they’ll be able to fix anything, do you?

The most important question that I have.  Why do the Greeks schedule elections on Sunday?  Does voting on a weekday conflict with their strike schedule?

Slipping away.  Some amazing stats on Greece: GDP is ~15% below its 2008 peak; they expect GDP to shrink 4.7% this year; unemployment is ~22%; and the budget (fiscal) deficit was ~15% in 2008 and 2009 – this declined to ~6% in 2010-2011.

Greek exit.  If Greek exits the euro, there would be a bank freeze and the euros in the Greek banks would be converted to drachmas.  Then, the drachma would be devalued.  The fear of this happening explains why Greeks have withdrawn $875 million from their banks in the past month.

Some say the Greeks would never exit.  Many people argue that the Greeks will never withdraw from the euro because the drachma would be so much worse.  But, we may be thinking about this wrong.  The Greeks can no longer get credit (while using the euro).  As a result, while the drachma might be worse than the euro, it would be better than the barter system.

The common recommendation.  Many commentators are suggesting that three things need to be done in the EU:

1. Direct recapitalization of banks from the European stabilization fund.  This should be through preferred stock and should not be an obligation of each sovereign entity.  (In other words, one of the complaints from last weekend’s announced bailout of Spain was that this was simply adding to the sovereign debt.)

2. An EU-wide deposit insurance.  The idea is to prevent bank runs.

3. Fiscal union in order to impose restrictions on certain countries.  (It’s hard for me to imagine how these different cultures could unite in this way and overcome their distrust of each other.)

Deposit insurance.  Deposit insurance (point #2 above) seems like a no-brainer, but it’s not.  EU officials know that this would be very expensive if deposits were guaranteed in euros and a country exited (converting back to their own currency).  In addition, if the insurance is only in effect if a country doesn’t exit, this insurance will do nothing to prevent a bank run.

Another recommendation.  Some commentators are suggesting that the EU should guarantee all debt issued by countries that is in excess of some percentage of GDP (e.g., 60%).  In other words, if a country has a debt-to-GDP ratio of 90%, the EU could guarantee everything over 60%.  Again, I’m not sure why some countries are going to agree to backstop the weakest countries.  In the end, the euro could still fail and the countries that provided insurance could have significant losses.

Closing comments.  Investors seem to continue to take solace in the idea that the Fed will always add liquidity to our markets.  There’s not much more to be happy about…the EU is a disaster, the euro doesn’t work, bailouts don’t solve problems, our weekly employment numbers were worse than expected.  But apparently, in Bernanke we trust…

Have a great weekend.

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