A common theme in our weekly posts is haranguing about the financial profligacy of our monetary authorities – the Federal Reserve – and from time to time we will extend some extra criticism of the Bank of Japan. This week we are extending our focus out to the situation in the European Union.
Periodic debt meltdowns/write-offs/jubilees – whatever you would like to call it have been a part of civilization since records began. The Old Testament has stories of rulers emancipating slaves, debtors and indentured servants. Historically it was commonplace and from a practical perspective it was probably necessary for rulers to keep stability in their societies. Some societies even developed cyclical timetables when debts would be alleviated…
In modern times we have no shortage of examples of debts going bad and some of the repeat offenders are almost comical. Our favorite example – since its liberation from Spain in the early 1800s, Argentina has defaulted on (or restructured) its debt NINE TIMES!! The most ridiculous part was in 2017 – after eight of the nine defaults – the Argentinian government sold a ONE HUNDRED YEAR BOND (about $10 billion worth) and it was over-subscribed which means that there was more money chasing the issue than there were bonds offered. The interest rate went off at about 7%. The investing world was starving for yield, and they took a leap of faith – and they have already paid the price. The bonds are now being restructured and valuations have been cut in half. Not a shocker…
For a now third-world debt issuance like Argentina, reasonable people can agree that it needs to be buyer beware – I couldn’t believe that they had actually pulled it off!
But when we get to Western Europe and the United States, we are talking about the world’s reserve currencies and one would hope that there is a very, very low risk of default or restructuring. The monetary system of the world is obviously built off the U.S. dollar. However, according to the IMF, after nearly 60% held in U.S. $, more than 20% of the holdings of the world’s central banks are denominated in Euros. Many other countries are fighting it out for a very distant third place at around 5%. Take a look…
Sadly, the debt situation in Europe today is FAR WORSE than it was in 2012 when there was an actual debt crisis. Case in point are Greece and Italy. In 2012 they were at the epicenter of an international financial meltdown as bad debt was teetering over the edge of the abyss and beginning to look like a “Minsky Moment” (no time to explain, we have to ask you to look that one up.) In 2012, Greece had a sovereign debt at about 150% of their GDP and Italy was about 126%. Fast forward to post-Covid-crisis 2022 and those numbers are more like 235% for Greece and 175% for Italy!! So, if the 2012 numbers were enough to ignite a crisis, how did we get so much further down the road of indebtedness without a complete Armageddon? We will oversimplify the answer and we will say it is the European Central Banks. The profligate governments of Greece and Italy (and others) have clearly been issuing bonds at a blistering pace – and the only buyer during Covid has been the ECB. Interest rates have been managed and the interest rate on Greek debt versus the European standard German debt hasn’t really been that different (2.29% on a 10-year note.) The ECB has amassed a mountain of member-country debts and they claim they are going to pull their bids. The million-dollar question is how do Greece and Italy sell their bonds now in a world-wide rising interest rate environment? The ECB is going to be forced into a very similar situation that we have described the Bank of Japan to be in. They can support the price of bonds (and keep interest rates down) or they can protect the value of their currency – but not both. If we aggregate Spain and Portugal into this analysis, the numbers get worse, and the entire Eurozone has government debt alone that aggregates to 100% of Eurozone GDP. Good economic history work from Reinhart and Rogoff shows that 90% of debt to GDP ratio is where things started to break down historically. That means that we should have expected restructuring on some of the world’s debt some ten years ago… and BTW – Interest rates are rising.
We don’t have time to go into the many facets of the European structure that render it less resilient than America from a political and more importantly monetary standpoint. For this post, just trust that we are reasonably accurate with that. Going forward, in the developed world it feels that Japan and Europe are in a race to the bottom – the price of their currencies relative to the U.S. $ on world markets will be the de facto color commentator on how the race is going. Race to the bottom means that they will keep printing money, ignoring economic reality and kicking the can down the road until a true meltdown occurs. China – with their Olympus Mons of debt – is the dark horse of this race…
Capital is flocking to America from overseas at a steady pace. We believe that that trend will STRENGTHEN rather than abate – so this is not a doomsday post from an American perspective – but we will still tell you to not sell your gold. If you don’t own any, buy some.
Life for the bottom 50% of the world has gotten better at a pace over the last 20 years so ridiculous that we can’t even find enough superlatives for it. But the story is different for a lot of the developed world largely because of unrealistic lifestyles financed by credit and exacerbated by absurd government spending policies.
It is sad that in our continued analysis of the world’s economy, we liken the US situation to being the prettiest girl in the leper colony – but that’s really what we see.
Regards and good investing,
Greyson Geiler