Gentlemen, Choose Your Disaster


With all of the above as a backdrop, let’s now see if I can outline the choices Europe faces. First, let’s take Greece, because it is instructive. Greece has two choices. They can choose Disaster A, which is to stay in the euro, cutting spending and raising taxes so they can qualify for yet another bailout; negotiating more defaults; getting further behind on their balance of payments; and suffering along with a lack of medicine, energy, and other goods they need. They will be mired in a depression for a generation. Demonstrations will get ever larger and uglier, as the government has to make even more cuts to deal with decreasing revenues, as 2.5% of their GDP in euros leaves the country each month. There is a run on their banks. Any Greek who can is getting his money out.

Greek voters will then blame whichever political group was responsible for choosing Disaster A and vote them out, as the opposition calls for Greece to exit the euro. Which is of course Disaster B.

Leaving the euro is a nightmare of biblical proportions, equivalent to about 7 of the 10 plagues that visited Egypt. First there is a banking holiday, then all accounts are converted to drachmas and all pensions and government pay is now in drachmas. What about private contracts made in euros with non-Greek businesses? And it is one thing to convert all the electronic money and cash in the banks; but how do you get Greeks to turn in their euros for drachmas, when they can cross the border and buy goods at lower prices, as inflation and/or outright devaluation will follow any change of currency. It has to. That is the whole point.

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So how do you get Zorba and Deimos to willingly turn in their remaining cash euros? You can close the borders, but that creates a black market for euros – and the Greeks have been smuggling through their hills for centuries. And how do you close the fishing villages, where their cousin from Italy meets them in the Mediterranean for a little currency exchange? What about non-Greek businesses that built apartments or condos and sold them? They now get paid in depreciating drachmas, while having to cover their euro costs back home? Not to mention, how do you get “hard” currency to buy medicine, energy, food, military supplies, etc.? The list goes on and on. It is a lawyer’s dream.

There is a third choice, Disaster C, which is worse than both of the above. Greece can stay in the euro and default on all debt, which cuts them off completely from the bond market for some time to come. This forces them to make drastic cuts in all government services and payments (salaries, pensions etc.), and suffer a capital D Depression, as they must balance their trade payments overnight, or do without. Then they choose Disaster B anyway.

The only real options are Disaster A or Disaster B. Whether they opt to go straight to the drachma (Disaster B) is only a matter of timing. They will get there soon enough.

Why then do they wait? What’s the point of going through all these motions? Because Europe fears a disorderly Disaster B. For the rest of Europe, it is the Abyss. The Greek hope is that Europe (read Germany) keeps funding them in order to keep back from the edge of the Abyss.

As one European diplomat noted, “There is a growing sense that despite the valiant efforts of Papademos … the reluctant Greek establishment is biding its time to the next elections, banking on the assumption that the world will continue to bail them out, no matter what.”

Europe is getting closer to the point where it must make a decision about what to do with Greece. In theory, the deadline is March 29 for the next round of funding. It is a game with very high stakes and deadly serious players. Can Sarkozy be seen as weak and giving in to Greece, with elections coming up in April? Can Merkel appear to give in and keep her troops in line? There are elections not long after that in Greece. Can Papademos cave in to further cuts and promises on future debt that will be hard to keep and intensely unpopular?

The markets are getting exhausted. There will be no private market for Greek debt at any number close to what is sustainable. Greece will be on European life support for a very long time if they stay in and there is no disorderly default. It will mean hundreds of billions of euros over the decade, debt forgiveness, etc. There are no good choices.

And Europe will all too soon face what to do with Portugal, which will want to dispense some haircuts of its own. Don’t forget Ireland, which is very serious about not paying the debt the previous government took on for its banks in order to pay British, German, and French banks. That is a default that is in the cards. I think “polite” Ireland is just waiting until its $60-billion default is seen as small potatoes, which will not be too long, as Italy must raise almost €350 billion just to roll over current debt. Italy projects that its deficit will be down to 2%, but if Europe goes into recession that projection goes out the window.

The bottom line is that Italy (and most likely Spain at some point) cannot raise the debt it needs at rates it can afford without massive European Central Bank involvement. Rates are already approaching 7% again. That is unsustainable from an Italian point of view. Germany must be willing to allow the ECB to take on massive balance-sheet debt, or Italy will not make it without haircuts. And a mere 10% haircut for Italy dwarfs what is happening in Greece – and doesn’t do much for Italy. If they go for a haircut, it will be much larger. French banks holds 45% of Italian debt. Italy is too big for France to save. They cannot even backstop their banks if Italy becomes a solvency risk. They simply cannot get their hands on that much money without destroying their balance sheet. The most recent downgrade of their debt was just the first of many.

Speaking of downgrades, Egan Jones downgraded Germany from AA to AA- and put the country on negative watch. This is important, as this is what I believe to be the most credible rating agency; and over 95% of the time the other “Big 3” agencies generally follow their lead, after a period of time. Part of the reason for the downgrade is all the debt that Germany is guaranteeing. Sean Egan was one of the first serious analysts to suggest that Greece would default. He was talking a 95% eventual default a long time ago. (Very nice gentleman, by the way. Or maybe he just left his Darth Vader mask at home when I met him.)

Europe will have to make its choice this year. Either a much tighter, more constrictive fiscal union with a central bank that can aggressively print euros in this crisis, or a break-up, either controlled or not. I don’t think they can kick the can until 2013, as the market will not allow it. Either the ECB takes off its gloves and gets down to real monetization when Italy and Spain need it, or the wheels come off.

The quote at the beginning returns to mind: “If we want everything to stay as it is, everything will have to change.”

Like any long trip, the drive (or flight) seems to take forever, particularly if you are very young or you are an investor. But then suddenly you are there. The LTCM crisis mentioned above took a long time to develop, but then it ended with a bang. One day Lehman or Bear is a big player and the next they are gone. I think this is the year the crisis moment for the euro arrives. Let’s hope they are ready.

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