The European Debt Crisis, Two Years On

No doubt, most Daily Reckoning readers are aware of yesterday’s shocking headlines: Mariah Carey lost 70 pounds…and Taylor Swift won the Country Music Award for “Entertainer of the Year.”

Meanwhile, the European Union continued to unravel faster than a Kardashian marriage.

Because the European leaders have failed to contain the crisis within the economic boundaries of the Peloponnesian Peninsula, it is now fanning out across the Ionian Sea and up the Adriatic like a toxic plume…and is washing ashore in Italy.

Investors are terrified to wade into the water. Italian bond yields are spiking higher and stocks are plummeting worldwide.

The crisis didn’t seem so worrisome when it was just a “Greek thing” — when the story was just about the “lazy Greeks.” But now the story is also about “Big Greece,” or Magna Graecia — a.k.a. Italy.

Going back a couple of millennia, Greek settlements were so prolific in Italy and Sicily that the region was sometimes referred to as Magna Graecia, or “Big Greece.” The name stuck, but its meaning evolved. Magna Graecia became a kind of slur, referring to the southern half of Italy — home of the “lazy Italians.”

This meaning of this term may be in the process of evolving once again. Magna Graecia might as well refer to the all the heavily indebted nations of the Western world. We are all Greeks now.

When the very first sign of a potential crisis sprouted in Athens nearly 2 years ago, most investors dismissed it as a minor blight on an otherwise fertile economic landscape. One rescue package — or two — would take care of the problem and we’d be on our way.

Here at The Daily Reckoning, we don’t mind saying, we provided a dissenting point of view. We warned early and often that the Greek crisis would not simply “go away.” We warned that it would metastasize throughout the euro zone and would imperil the euro itself. (It’s true; we said it. You can look it up for yourself).

Here’s a little something we wrote a year and a half ago. Seems like just yesterday:

Rome wasn’t built in a day, of course. So we should not expect Athens to be rescued in a week…or ever. The country’s fiscal condition is beyond repair. Either Greece slips into the Mediterranean, figuratively speaking, or the euro does…or both…

In a worst-case scenario, the ECB will exhaust its cash, credit and credibility trying to save Greece…and will destroy the euro in the process. Best case, the “fix” will persuade a few Wall Street strategists that the “worst of the euro crisis is over” and will suck a few more suckers into the European sovereign debt markets before the situation gets REALLY ugly.

And it will get ugly…one way or another.

Many investors behave as if sovereign defaults are like polio: eradicated forever. These investors are half right. Polio has been eradicated.

Greece may not actually default, depending on the rescue measures that come its way. But Greece is already bankrupt. The creditors to Greece should understand that history is not on their side. In fact, the creditors to every sovereign borrower should understand that history is not on their side.

“While a European sovereign default has appeared inconceivable in recent history,” a recent Wall Street Journal article observes, “defaults and debt re-schedulings were actually a common feature of the European financial landscape throughout the nineteenth century and up until the end of World War II, according to the economists Carmen Reinhart and Kenneth Rogoff.

“Greece has defaulted or rescheduled its debt five times since gaining independence in 1829…”

Governments default. That’s what they do. They tax; they squander the tax revenues; they default. This is the established unnatural order of the governmental world. The Greek crisis may be the first sovereign debt debacle of recent times, but it won’t be the last.

Our caution remains. But you don’t have to take our word for it. Just “listen” to what the markets are saying. For example, as we suggested in the September 7, 2011 edition of The Daily Reckoning, pay attention to LIBOR rates.

We observed:

The signs of credit distress are increasing.

These signs take various forms. But one of the most telling forms is the direction of LIBOR interest rates. LIBOR stands for “London Interbank Offered Rate.” It is the rate at which banks borrow unsecured funds from other banks in the London wholesale money market (or interbank lending market).

In most circumstances, LIBOR rates track short-term Treasury rates. But in the midst of crisis conditions, LIBOR rates tend to spike, while Treasury rates fall. That’s exactly what happened during the credit crisis of 2008, as the chart below illustrates.

The Spread of 6-Month LIBOR Rates Over 6-Month T-Bill Rates

In the depths of the crisis, LIBOR rates soared, reflecting the reluctance of banks to lend money to other banks. The more worrisome the crisis seemed to be, the higher LIBOR rates climbed. As such, the LIBOR rate functioned as a kind of “fear gauge.”

And so it remains…

The Spread of 6-Month LIBOR Rates Over 6-Month T-Bill Rates

During the last few weeks, LIBOR rates have been on the rise once again. They have not risen high enough to sound a distress signal, but they have risen high enough to raise an eyebrow.

Let’s call it an early warning sign.

This warning sign is still flashing amber. Since our warning in early September, LIBOR rates have continued their steady upward climb, which indicates that credit stresses are increasing.

Rising 6-Month LIBOR Rates

Meanwhile, government bond yields in the PIIGS nations of Portugal, Italy, Ireland, Greece and Spain are also surging higher — another clear sign of distress.

In the July 12, 2011 edition of The Daily Reckoning, we observed:

The euro fell to its lowest level since May, the Italian stock market fell to its lowest level since 2009 and Spanish bond yields jumped to their highest level since 1997. This small sampling of distress in the European financial markets would suggest that a credit crisis is beginning, not ending.

Greek two-year yields soared to 31% yesterday, but that ridiculous number hardly seems newsworthy. Greece is broke and everyone knows it…except the EU and the IMF. Greek bond yields might as well be one billion percent. Does anyone really expect to receive interest payments for the life of the bond?

The new news is not Greece; it is that the Greek crisis is now a genuine European crisis. Throughout the PIIGS nations of Portugal, Italy, Ireland, Greece and Spain, bond yields have spiked sharply since July 5. On that fateful day, the Greek parliament voted to accept the austerity measures imposed by the E.U. and the IMF, thereby opening the door to the bailout funds that were supposed to make everything all better. On that same day, however, Moody’s downgraded the Portuguese government debt to “junk.”

One week later, the financial markets seem to have decided that the cold, hard facts inspiring the Portuguese downgrade are of greater significance than the smoke, mirrors and empty promises that underpin the “Greek rescue.”

The situation in Europe is becoming so frightening that, ironically, investors are dumping the debt securities of Europe’s most indebted nations in order to buy the debt securities of the world’s most indebted nation.

Italian and Spanish 10-Year Government Bond Yields vs. US 10-Year Treasury Yields

While Spanish and Italian bond yields are spiking to multi-year highs, US bond yields are falling (i.e. bond prices are rising). This “flight to quality” move into Treasurys seems laughable… But we don’t make the rules, dear investor, we merely mock them. If a Treasury bond is “quality,” Thalidomide deserves a Nobel Prize in Chemistry… “Quality” rarely rolls off a government’s printing press.

Again, these trends have been intensifying for the last several months…despite numerous official pronouncements along the way that the EU had devised a potent and credible rescue plan. Investors continue to dump PIIGS debt and to flock into the US Treasury market.

Rapidly Rising Yields of Italian and Spanish 10-Year Government Bonds

Net-net, the crisis is not over. It is gaining momentum. Therefore, we would repeat the observation we made on July 12:

Treasury bonds are not the sort of “quality” an investor wishes to hold long-term. The quality worth owning long-term is much more likely to ascend up a mine shaft — like gold and platinum — or sprout from the soil — like wheat and soy beans — or spring from the mind of enterprising innovators — like RCA Victor and Apple Computer.

Throughout crises and depressions and all other forms of economic adversity, enterprising innovators somehow find a way to succeed. The 1930s produced some of America’s greatest success stories. Perhaps, the 2010s will repeat the performance.

Eric Fry
for The Daily Reckoning

The Daily Reckoning