The Financial Markets Are Protesting Austerity Insanity in Europe
By Justice Litle, Editorial Director, Taipan Publishing Group
Eurozone politicians are faced with the inevitable logic of sovereign bankruptcy – i.e. devaluation or default – but refuse to believe it. Financial market turmoil may yet force their hand.
Europe still doesn’t get it. By focusing on “austerity measures” in an effort to save the eurozone, they are padlocking the barn door after the horse has run clear across the continent. Trying to solve problems by “belt tightening” now will only make Europe’s problems worse – and thus the world’s.
This is why Mr. Market has been so aggressively disdainful of the euro (and why global markets tanked this week).
On the surface, there have been some rather sensational headlines, like the failure of CajaSur, a Spanish regional savings bank, and the rapid escalation of military tensions between North and South Korea.
But underneath that headline drama, there is a real fear that Europe will punch a hole in the global economic recovery with its impossible foolishness. It is too late for traditional austerity measures now – and that is the message nervous markets are delivering to obstinate eurozone politicians. Today we will try to explore why.
A Reason for Bankruptcy
In some ways, the financial problems faced by governments can be compared to those faced by ordinary households.
There is good debt and bad debt (i.e. productive and unproductive debt)… a need to invest and save… the possibility of becoming overextended… the temptation to put off dealing with a problem… and so on.
One big difference among many, though, is the willingness of households to accept reality – or otherwise have reality firmly thrust upon them – in situations where governments can go on acting blindly for extended periods of time.
When a household accumulates a certain amount of debt, for example, there comes a point where bankruptcy is the only logical option. Imagine a man with a $50,000 salary and $200,000 in credit card debt, racking up 24% interest at a compounding rate, trying desperately to handle the bills while supporting a family of four.
The math in such a situation quickly becomes impossible. Unless the man is willing to starve his children, move into a shelter, or some other drastic thing, the debt dynamics force him to consider bankruptcy… or to otherwise completely throw his hand in on paying back what he owes.
Meanwhile, the man’s creditors are free to exacerbate the situation by jacking his rates up even higher, tacking on predatory payment fees, and even making it hard (if not impossible) to get another job if the current one is lost (by way of the “bad credit” flag on job applications).
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At the end of the day, bankruptcy is a necessary function of the free market system. This is because, under any free market system in which credit is freely available, situations will inevitably arise where the compounding costs of debt service become too large for the debtor to bear.
The above is true for households, it is true for businesses, and it is true for governments. (Hence the origin of the term “exploding debt dynamics.”)
“What about the morality of paying what you owe,” some will retort.
To which your humble editor replies: “Yes, of course. But that is where horses and barn doors come in. Morality should have entered into the equation a long time ago, in respect to not borrowing more than one can pay back.”
“And sometimes, unforeseen disasters – like lawsuits or medical tragedies – can lead to mountainous debt burdens out of the blue. Even the virtuous can be struck down by debt.”
“So what happens when the deed has been done… the milk spilt… and paying off what you owe becomes functionally impossible? Should individuals be forced to bear the weight of sky-high interest rates and compounding debt burdens, as such de facto slaves to creditors, for the balance of their entire working lives? At what point does this stop making sense?”
Suffer the Little Children
Or here is another way to look at it. Imagine if debts were not only non-voidable, but also passable from one generation to the next.
Is it truly “fair” for one generation of gullible voters and greedy politicians to saddle their children, grandchildren, and even great grandchildren with the weight of their selfish and dumb decisions? Eurozone politicians seem to think so.
In saying “no” to bankruptcy – i.e. some form of organized debt default – Europe is saying “yes” to a diet of fiscal pain that could economically crush the eurozone. In this the sins of the fathers (i.e. the current generation of voters and politicians) are being invited upon the children and grandchildren.
(We can already see this in a literal sense in respect to youth unemployment rates. While Spain’s general unemployment rate is forecast to hit 22% in 2010, the rate among Spanish youth is actually much higher.)
Worst of all, Europe’s day-late and dollar-short “austerity now” attempts are being done for the sake of saving political face, moreso than out of long-term strategic interest or common sense.
Ireland’s Folly
If politicians had any sense, they would make more of an effort to learn from financial market history – especially when right there under their noses.
Ireland is a clear example here. Ireland has already put itself through the ringer of severe austerity measures in an effort to straighten up and fly right. And what have the Irish gotten for their troubles? Pain and anguish.
As John Mauldin recounts in a recent letter, “Europe throws a Hail Mary Pass:”
Notice that Ireland has the largest deficit, at 14.7%. This is in spite of (or more aptly because of) the enactment of severe austerity measures, far beyond what Greece, Portugal, and Spain have contemplated. And what has that gotten them? An economy that has shrunk by almost 17% in the last two years, 14% unemployment, and a country in the grip of outright deflation. Property prices have fallen by 34% and are still falling. Their banks are in shambles.
As Ireland shows: When it comes to accumulated debt, there is a certain threshold beyond which austerity no longer works.
To make another analogy, think of a failing business. What can you do to save a failing business? The first and most obvious route is cutting costs. You throw as much ballast over the side as you can to try and keep the business afloat.
But that alone won’t save the business if profits and revenues are falling. At the end of the day, you have to grow your way out. And you can’t do that if your cost cuts (i.e. austerity measures) run so deep that you no longer have the ability to grow revenues and profits.
At a certain point, the only way to save a debt-laden business is to renegotiate with creditors… to arrange for an orderly default, in such a way that the central elements of the business (workers, equipment, vendor and supplier relationships) can remain intact.
(By the way, the European debt crisis might be a current topic, but it’s not the only thing moving the market right now. If you’re looking for additional analysis, sign up to read fellow editor Adam Lass’ investment commentary.)
Devalue or Default
The best course for the eurozone now – and the course that the financial market itself is advocating, in your humble editor’s opinion – is one of aggressive currency devaluation, structured debt default, or both.
(An orderly default would not have to replicate the Lehman Brothers experience, by the way. The whole trouble with Lehman was a gross lack of order in the way the investment bank’s assets were unwound.)
Bankruptcy is a horrible thing to experience. It is a pride-sapping process and a humbling admission of defeat. But sometimes, it is also the right thing to do.
In certain situations, the avoidance of bankruptcy only makes the problem worse. Think of the family man with $200,000 in credit card debts again. Imagine if this man were to refuse bankruptcy as a point of stubborn pride, deciding he could cut back on expenses instead.
Then imagine if, as a result of this choice, the man’s children were forced to wear shabby clothes… forego dentist and doctor visits… shiver without heat in winter… and even go without medical insurance, all in the name of paying back an impossible debt. What a waste that would be if bankruptcy were STILL the end result.
In stubbornly denying the sovereign equivalent of bankruptcy – devaluation or default – that is the path Europe chooses.
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Damned if You Do, Damned if You Don’t
As with the inflation/deflation tug of war discussed earlier this week, there are two ways the eurozone can go from here, but only one true end game:
- In an effort to “save the euro,” Europe can move toward more austerity, more central authority, and a tighter coupling between northern and southern eurozone countries. Brussels can be given more power over the budgets of sovereign euro-member governments. This power can be used to make even deeper cuts, repeating the Ireland experience of humiliation and worsened economic contraction. And the Germans can be forced to embrace the Greeks, Italians, et al. with even greater bailout fervor. This route would save face for eurozone-loving politicians, at the expense of unleashing the hell of deep recession (or even outright deflationary depression) on the European populace.
- Or, alternatively, Europe can admit the impossibility of the current situation and allow struggling eurozone members to default, with the option of leaving the eurozone completely. This second alternative would also be a kind of hell… but it would be hell for the politicians, not the populace. There would have to be a readiness and a willingness to admit that the “grand experiment” known as the euro has essentially failed… that too much debt, mostly accumulated in happier times, has torn the union asunder… and that the idea of disparate countries holding hands and singing financial kumbaya was a pipe dream from the start.
Being the creatures of self-interest that they are, Europe’s politicians are naturally going for door No. 1, and will likely cling to the “austerity can save the euro” illusion for as long as they can.
But Mr. Market is firmly and loudly casting his vote for door No. 2… and in the long run, the market always wins.
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About the Author:
Justice Litle is the Editorial Director of Taipan Publishing Group, Editor of Justice Litle’s Macro Trader and Managing Editor to the free investing and trading e-letter Taipan Daily. Justice began his career by pursuing a Ph.D. in literature and philosophy at Oxford University in England, and continued his education at Pulacki University in Olomouc, Czech Republic, and Macquarie University in Sydney, Australia.
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