To understand what is happening in Europe, one needs to first appreciate the context, the raison d’être for the Euro itself. One of the primary goals of the Euro was to prevent the kind of recurring conflicts that spawned two World Wars on the continent in less than a century.
This union joined the Teutonic North with the Club Med South under a unified currency but provided for neither a unified fiscal policy nor effective controls. The result was that much of the Eurozone enjoyed lower-than-market interest rates essentially subsidized by Germany’s financial track record and the belief that Germany would and could do what was necessary to ensure the credibility of the Euro. During the good years, this system appeared to work well, but just as we saw in the United States, providing a lower-than-market interest rate tends to induce more borrowing and more profligate spending than would have otherwise occurred – think Liar loans and home equity line funded spending sprees.
When the global economy was strong, the underlying problems were well hidden. I think Warren Buffet said it best, “It’s only when the tide goes out that you learn who’s been swimming naked.” The 2007-2009 global recession was quite an outgoing tide, revealing the economic rot that had developed within. The €110 billion bailout in May 2010 for Greece was intended to buy time for the nation to get its economic house in order, but in a story not unlike the too big to fail saga, corruption continued, taxes remained unpaid and government assets and jobs were not reduced as promised.
Germany and the other strong economies are left with two grim options. The first is to aid the struggling nations of Greece, Portugal, Ireland, Belgium and possibly Spain and Italy as well with little hope for a near-term end to the bailouts. The other option is for the Teutonic North to do nothing, resulting in a Greek default of some sort. This would mean large losses for German and other Teutonic banks, thus a bank bailout vs. sovereign bailout. Talk about being caught between a rock and a hard place.
This is all the more complicated by contagion factors. Let’s say Germany gives Greece a haircut on its debt. You can bet Ireland will be stomping its feet demanding a similar easing. Portugal and Spain and potentially even Italy might soon follow suit. If you are an Irishman, wouldn’t you be enraged to know that while your country is going to have to toil for decades under a massive debt burden, Greece got a handout, partially courtesy of your own struggling economy? So you pressure your Statesmen to fight for what just seems fair. Now we’ve got politicians under pressure from their own people to get as good of a deal on their debt write-down as the next guy. Where does it stop? Talk about a competitive death spiral of debt and asset, (on the bond-holders side) annihilation!
Thus one of the biggest challenges in both managing and assessing the magnitude of the Eurozone crisis boils down to human nature. No one likes to see the other guy get off with less pain for similar infractions. Wars have been started for less. There is no way to confidently quantify such a scenario as now we are in the realm of emotions and mobs – innately unpredictable. When this situation gets to a point where the photo-ops and meetings no longer satisfy the markets, when the reality of just how dangerous this situation has become is clear to all, the market panic could be intense. I recall with much frustration the endless assurances given to the market in 2007 and 2008 by various corporate and government officials, claiming that the problems had been contained. We’ve got essentially the same cast of characters in Europe right now who couldn’t get it fixed the first time around telling us that this time they’ve got it under control. Perhaps, as miracles do happen, but as the saying goes, “Hope is not an investment strategy.”
So here we are, back at the beginning of this little tale wherein the creation of the Eurozone was to prevent the kind of recurring conflicts that spawned two World Wars on the continent in less than a century. On that front it has been less than a resounding success. The wise investor acknowledges just how much of the path and timing for the Eurozone crisis simply isn’t knowable with any degree of confidence and protects themselves accordingly.