Active Volcanoes of Debt
“Markets rocked as debt crisis deepens,” proclaimed The Financial Times yesterday.
“Race against the clock to save the euro,” screams Le Figaro this morning.
The Dow fell 58 points yesterday. Oil rose to $97 a barrel, while gold went up $13.
What’s up? We don’t know. But we see a lot of banana peels on the financial sidewalks this morning. Be careful, dear reader; be very careful.
One headline tells us that the French plan has been abandoned. Another tells us that a new rescue plan is in the works. Still another contradicts the first two.
Germany doesn’t want a Europe where money is transferred from the ants to the grasshoppers; it doesn’t want Greeks and Portuguese using the Teutons’ credit card. France doesn’t want a Europe in which its banks are allowed to go broke because of nothing more than their own incompetence. And Italy doesn’t want a Europe without bunga-bunga parties.
We live in a world in which thinking people must be embarrassed by their own governments; still Italy is a special case. The country is the planet’s 3rd largest debtor, with debt equal to 120% of GDP.
In this situation, the Italians cannot allow any doubt as to their ability to govern their country responsibly and to make good on their debts. Yet, prime minister, Silvio Berlusconi, nevertheless fired the only person in Italy in whom investors had confidence, his finance minister, Giulio Tremonti.
“He’s not a team player,” said Mr. Berlusconi. “He thinks he’s a genius and that everybody else is a cretin.”
Meanwhile, the Telegraph reports that Mr. Tremonti lives in a house – rent-free – owned by a political ally who has just been arrested on corruption charges.
“The government ceased to exist months ago,” according to an editorial comment in La Republica. “We have a band of poltroons dancing under the volcano, and the volcano is about to erupt.”
Daily Reckoning readers have been watching the plume of smoke rising for months. But not just from the Vesuvius in Italy. We see smoke rising from the Krakatowa in Asia and the Mt. Saint Helens in North America too.
For sure, Europe is in trouble. George Soros says it needs a “Plan B.”
But the way we see it, the whole world needs a Plan B. And maybe a Plan C too.
In Europe, governments are broke. They have borrowed too much. They can only service their debts if interest rates remain low…or if they get bailouts. So far, the central authorities have come to the aid of the peripheral states. Greece, for example, is such small potatoes that the authorities can afford to make its troubles worse. That is, they can give it more and more credit so it can continue pretending that it is good for the money.
But lenders have recently begun to suspect that larger debtors – notably Spain and Italy – are going to be in trouble soon too. Compare both nations to the USA and you will find that they are not in especially bad condition. Italy, for example, has a deficit less than half the US deficit. As for its debt, it is about the same as the US, depending on how you calculate it. But while Italy’s government debt to GDP ratio has degraded by only 11% over the last 10 years, the US debt to GDP ratio has worsened by an unbelievable 45%.
Nevertheless, investors judge the US a good credit risk. This morning, they still buy US 10-year notes yielding just 2.9%. As to the Italians, investors aren’t so sure. Its credit default spread has gone up 92% since the beginning of May, putting its cost of borrowing near 6%, substantially raising the risk of a default. At about 7%, the game is over.
Italy faces a major refinancing challenge. Beginning in August to the end of 2013, it must borrow an estimated half a trillion dollars to keep going.
“Italy must itself send an important signal by agreeing on a budget that meets the need for frugality and consolidation,” said Angela Merkel. “I have full confidence that the Italian government will pass exactly this kind of budget.”
Whence cometh this confidence?
In our view, it is misplaced. The Italians will be as hopeless at controlling spending as the Greeks…and the Americans; governments do not accept austerity until it is forced upon them.
Our thoughts are focused on the big picture. What we see is neither an Italian problem, nor a Greek problem, nor an American problem.
In our view, the whole structure of modern, developed social welfare democracies is ready to topple. And not just because of the latest financial crisis. The crisis that began in ’07 is just a flashpoint…just part of a huge turnaround that has been underway for years.
Guess how much the Italian economy has grown in the last 10 years?
Guess how much net average wages in France have gone up since 1975?
Guess how many net new employees the Japanese have added to the workforce in the last 20 years?
Guess how many new jobs the US economy has created in the last 10 years?
Guess how much the average hourly wage in the US has gone up since 1975?
Guess how much the real, private sector economy of the US has grown in the last decade?
Guess how much US housing – and household wealth – has increased since the beginning of the 21st century?
It seems almost unbelievable, because it contradicts everything we thought we knew. Italy may be mismanaged. Greece may be a basket-case, but the US was supposed to be the most dynamic, adaptable, capitalistic, forward-looking, technology-absorbing, growth-oriented economy the world has ever seen. How could it go nowhere for more than a decade? How could an American’s labor not increase in value, while the economy becomes more efficient and more productive?
Mr. Martin Wolf, the influential strategist from The Financial Times, who has guided much of the world’s elite opinion for the last several years, has finally realized what you have known for years. We are in a Great Correction:
The fiscal crises we see are a legacy of the west’s private and public sector debt binges of recent decades. As the McKinsey Global Institute tells us in an update of last year’s study of the aftermath of the credit bubble, this is an early stage of a painful process of de-leveraging in several economies. “If history is a guide,” noted the 2010 report, “we would expect many years of debt reduction in specific sectors of some of the world’s largest economies, and this process will exert a significant drag on GDP growth.” So it is proving, with disappointment almost everywhere.
But Mr. Wolf is no fool. In his latest column he announces that he is going to do the smart thing – he’s taking a vacation! He’ll be back at the end of the summer.