Monday, May 23, 2011

EU Debt Crisis Growing; US Just Biding Time

The EU debt crisis continues to evolve. In the process, it provides us with a stark reminder that, eventually, all debts must be recognized and reconciled.

The sad truth is that the European debt crisis is really a global debt crisis.

There have already been four European bailouts: Greece twice, Ireland and then Portugal just this month.

Germany, the EU's biggest economy, has had to pay the largest single share of these bailouts. That is raising the ire of German voters who are tired of bailing out their poorer, financially distressed, neighbors.

Germans see these nations as reckless and undisciplined.

Though Germany has been able to borrow at 3 percent and then lend at double that rate to its ailing neighbors, the concern is that these countries could default, leaving Germany in the lurch.

The trouble for Germany is that German banks have lent several hundred billion dollars to other Eurozone governments. A series of defaults could trigger a German banking crisis, which gives Germany plenty of motivation to continue bailing out its neighbors.

The other alternative would be to bailout the bankers, which would prove even less popular with German citizens.

The Germans are bound to the euro. Pulling out and going back to the Deutsche Mark would jeopardize their economy and could prove disastrous. Exports are the backbone of the German economy. Any new German mark would immediately rise in value, making German exports more expensive all around the world.

The Germans are stuck between the proverbial rock and a hard place. They have little choice but to keep the bailout money flowing.

Fears of a contagion exist because banks all over the world are inextricably linked. European banks all own the sovereign debt of their neighboring countries and one default could cause a chain reaction.

So far, the troubles have been isolated in the relatively smaller economies of Greece, Ireland and Portugal. The worry is that some of Europe's larger economies may eventually ask for help, such as Spain and Italy.

Last week, Standard & Poor’s Ratings Services lowered its outlook on Italy’s A-plus sovereign-credit rating from stable to negative. Meanwhile, Moody's had previously downgraded Spain in March.

Both Italy and Spain could be characterized as "too big to fail". Italy has the world's 11th biggest economy and Spain the 13th. Yet, the cost of insuring Italian and Spanish government debt against default just keeps climbing.

Citizens of all the fiscally challenged European nations hold a deep resentment over the austerity measures their leaders have enacted to reduce government deficits. Most of Europe is still facing a recession and protests have sprung up all over the continent.

The irony is that even as European governments have made difficult choices and enacted draconian budget cuts, they continue getting hammered by the bond markets.

Meanwhile, the US — which has a $1.6 trillion budget deficit for this fiscal year, and which has reached its $14.3 trillion self-imposed debt limit — has done almost nothing to get its fiscal house in order.

Yet, the US continues to borrow at the lowest possible rates on world markets, and anytime the European debt crisis particularly fares up (like right now) there is a flight to the perceived safety of US Treasuries.

The US offers investors next to nothing for the 'privilege' of parking their money in US government bonds.

The perception of the US as 'safe' is simply a knee-jerk reaction based on past history, when the US was more fiscally stable than other nations. Clearly, that is no longer the case.

When reality finally catches up to the US — in other words, when the rest of the world recognizes that our fiscal position is no better than anybody else's, and that our monetary position may even be worse — that will be a grand moment of reckoning.

When everyone else's house is also on fire, where do you seek shelter?

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