Thursday, November 25, 2010

Europe: It's even worse than it looks

Michael Pettis says it's almost certain now that Spain and Portugal will have to be bailed out. How do we know?
In one of my favorite TV shows, Yes Minister, the all-knowing civil servant Sir Humphrey explains to cabinet minister Jim Hacker that you can never be certain that something will happen until the government denies it.
And he has a point. Consider these statements in an FT story today:
"Absolutely not,” said Elena Salgado, Spanish finance minister, when asked in a radio interview on Monday whether Spain needed help from the European Union. “Spain is doing everything it has promised to do, with tangible results.”
 And now from Portugal:
“Portugal is regarded by bond market investors and economists as next in line for a rescue after the bail-outs of Greece and Ireland. But José Sócrates, Portuguese prime minister, was adamant that there was “no connection” between the Irish rescue and Portugal’s problems.  “Portugal doesn’t need anyone’s help and will solve its own problems,” he said.
I can't help but note that these statements are also reminiscent of the flood of reassurances by American bank CEOs in September 2008 that their banks were "well capitalized." And we all know what happened right after that.

In any case, here are Pettis's main points:
1. Greece will be forced to default and restructure its debt, and the restructuring will come with a significant amount of debt forgiveness.  The idea that it can grow its way out of the current debt burden is a fantasy.
2. Greece will not be the only defaulter.  Spain, Portugal, Ireland, Italy, Belgium and much of Eastern Europe will also face severe financial distress and possible default.
3. Political radicalism in these countries will rise inexorably as a consequence of rising class conflict.
4. Several countries, most notably Spain, will be forced to choose between giving up sovereignty to Germany, suffering extremely high rates of unemployment for several years, or giving up the euro.  They will almost certainly choose the third option.
I can't help but think we are coming to a very dangerous period in the global economy heading into 2011. As we have examined above, Europe is a mess and it is delusional to think there is a solution without some countries defaulting and/or leaving the euro. Meanwhile in the US, unemployment remains near 10% and the Fed is under fire from both the left and the right, undermining any positive impact that QE2 might have had. With the current anti government sentiment and the rise of the Tea Party Republicans, the prospect of passing any further monetary or fiscal measures should the economy take another turn for the worse is extremely limited. So we are out of bullets.

Meanwhile, China is on a crusade against inflation and is desperately trying to rein in it's unbalanced economy and chronic misallocation of resources. Against this highly uncertain global backdrop, Australia's economy is motoring along nicely, but our massive housing bubble is showing signs of collapsing under its own weight.

The property spruikers are already looking out for the best interests of the Aussie battlers, telling us that the modest falls in prices we have seen so far are an "excellent buying opportunity." But when Wayne Swan and the RBA come out with straight faces and start telling us that Australia's banks are well capitalised and there is nothing to worry about, be very afraid.

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