Global Debt Crisis: Europe’s 50% Solution

Do you believe that last week’s agreement by European Union (EU) leaders will finally solve the Greek government’s debt crisis? It’s awkward to express exuberance about it; after all, the Greeks will continue to experience many years of fiscal austerity before their government’s debt is reduced to manageable levels. And if the bitter pill of austerity prevents economic prosperity, the Greek nation may not experience sustained growth for a generation.

At the moment, though, our global markets appear to believe that the agreement represents a huge step in the right direction. At the end of last week, the Dow Jones Industrial Average was on track to complete its strongest October in history. And many analysts hailed the agreement as an historic success, though some cautioned that investors should wait and see how the terms are implemented before celebrating its consummation.

Lost in much of the hoopla, though, was an important clause that had not previously appeared in similar government debt agreements. Interestingly, the clause illustrates how the European approach differs from the American approach on a fundamental level.

Let’s Make A Deal!

The challenges facing Greece and its EU partners are quite imposing. Each nation member is legally required to limit its federal government debt to 60% of its national GDP, but because of the ongoing economic malaise, the overall EU debt level has soared to 80% of GDP. And Greece’s debt level is the highest of all nations; it soared to 142% in 2010 and is forecast to remain above 130% of its GDP next year.

Because a Greek default on its debt would deliver a huge blow to its creditors, and because many of its creditors are European banks that are considered “too big to fail” by their governments, a Greek default is now considered an existential economic threat to the EU itself. European leaders have been struggling for months to devise a way to support the Greek government without taking the politically unpopular step of bailing out its profligate (and, arguably, fiscally irresponsible) member state.

Last week’s solution encompassed a commitment by the EU leadership to guarantee up to $1.4 trillion of the government bonds of fiscally weak European states. In exchange for this support, the Greek government agreed to new austerity measures that would reduce its debt load to 120% of GDP by the year 2020; furthermore, all European banks would be required to increase their capital reserves by $147 billion.

Perhaps most surprisingly, EU leaders convinced global private banks that have invested in Greek government debt to “voluntarily” forgive 50% of the outstanding principal on their loans. This clause was indeed a unique one; in contrast, the United States government failed to convince any of the holders of the debt of bailed-out American financial institutions to agree to any reductions in principal balances.

Merkel vs. Paulson

What are the accounting implications of a “voluntary” 50% reduction in principal by the private banks? Well, the firms will write off significant asset balances, which will reduce their equity book values accordingly. And because their capital reserve requirements are increasing in compliance with last week’s agreement, a larger share of their dwindling asset balances will necessarily be diverted to satisfy those requirements, thereby leaving fewer funds available for lending and investing activities.

On the one hand, some may predict that this will inevitably lead to less business activity and slower economic growth. On the other hand, skeptics may scoff that global banks have not been aggressively seeking out new growth opportunities any way, and thus the new regulations will not significantly impact growth.

German Chancellor Angela Merkel has been widely praised for demanding the 50% write-down from private sector banks. Her negotiating position, in fact, provides a dramatic contrast to that of former U.S. Treasury Secretary Hank Paulsen, who didn’t demand any such write-downs and reportedly sunk (literally) to his knees to beg Democratic legislators to fully bail out all “too big to fail” banks during the market collapse of 2008.

President Merkel?

It’s tempting to conclude that Chancellor Merkel did a better job of protecting taxpayer interests than Secretary Paulson. However, it will take a while for the long term results to become evident.

On the one hand, if the EU’s massive asset write-down cripples European banks (and thus the EU economy) for years, then Merkel’s victory may be viewed ultimately as a pyrrhic one. Conversely, if the U.S. government ever defaults on its debts, then Paulson’s decision to bail out 100% of the debt of the “too big to fail” institutions may be perceived eventually as a foolhardy choice.

At the moment, though, Merkel’s approach is undoubtedly the more popular one with voters in both the EU and the U.S. In fact, with such unproven candidates as Herman Cain riding high in the opinion polls at the moment, Merkel herself might have been able to win the American Presidential election if she had been eligible to run for that office.

The Dangers of the Global Economy

Eighteen years have passed since a youthful Al Gore successfully defended the fledgling North American Free Trade Agreement (NAFTA) on live television in a spirited debate against Ross Perot. Shortly afterwards, the pact was voted in law, and the free trade union between Canada, Mexico, and the United States began its highly successful run.

Or did it? Many critics complain that its track record over the past two decades has been anything but successful. Although NAFTA has indeed encouraged cross-border trade between the three nations, its original proponents promised that American manufacturers would move their plants from the fifty states to northern Mexico, which would then export their finished goods back across the border to American consumers.

In other words, although the United States would lose its “low technology” manufacturing industry, it would do so to a neighboring nation with close economic ties. Mexican consumers, rising into the middle class, would grow progressively wealthier and then purchase more expensive goods and services from the United States. In addition, as a result of their increasingly home-grown affluence, Mexicans would be less tempted to cross the border of the Rio Grande as illegal aliens in search of employment opportunities.

For a while, this vision appeared to come to fruition in accordance with the original plan. Maquiladora factories sprung up in Mexico, within easy trucking distance of the American border, and contributed to an emerging Mexican middle class. And the southwestern regions of the United States experienced an economic boom as well.

From China to Greece

So how did this vision go awry? Why aren’t American firms still manufacturing everything from toys to textiles within North America? And why does illegal immigration remain a challenge for the United States and Mexico?

Why? The reason is global interconnectivity. American buyers realized that the geographical proximity of Canada and Mexico isn’t very much of a economic advantage any longer, now that communication and transportation systems have made the world a smaller place. If goods can be manufactured more cheaply in China than in Mexico, despite the fact that China is half a world away, then factories can just as easily serve the American market from Asia as from Latin America.

For similar reasons, an economic meltdown in Greece — of all places — is now depressing the stock market values of American firms and exacerbating economic risks for American communities. Oddly enough, the path of economic danger that runs from Greece to the United States appears to be passing through — to reiterate, of all places — France.

It’s The Banking System!

Why Greece … and why France? This “strange but true” tale begins with the federal government of Greece, a culturally rich but economically small nation on the southeastern periphery of the European Union (EU). The government ran up a huge public debt, engaged in fiscal shenanigans to hide it from their fellow EU nations, and then turned to those same nations to finance a bail-out when faced with the prospect of imminent default.

The German leader Angela Merkel, head of the largest and most prosperous economy in the EU, initially balked at the cost of the bail-out. But French leader Nicholas Sarkozy, prompted by the pleas of the three largest French banks that invested heavily in Greek government bonds, convinced his EU partners that a bail-out would be required to prevent the economic chaos that would result from a governmental default of an EU member.

How does this European intrigue affect the United States? Apparently, the global ambitions of major American banks have exacerbated the risks facing firms and taxpayers in the United States. Unfortunately, American banks have sold securities to the French banks to insure them against losses in the event of non-payment by the Greek government. And a Belgian-French bank called Dexia SA, taking advantage of free trade laws with the United States, entered the American municipal loan market a few years ago, and is now raising interest rates on strapped American cities to compensate for its own loss exposure to Greek debt.

A Two Edged Sword

It is, of course, undeniable that the globalization of business and the economy has drastically improved the lives of countless millions of people. Within two generations, China has progressed from a nation beset by rural poverty to one boasting the second largest economy in the world. Its fellow BRIC nations of Brazil, Russia, and India have made similar strides as well, and various African nations are now hoping to follow the same path to prosperity.

Nevertheless, although the historically wealthy nations of the G-7 have certainly not slid into poverty during this time, they have learned that globalization can be a two edged sword. This is apparently why the United States Congress is now hesitating to ratify new free trade agreements with Colombia, Panama, and South Korea, and is looking warily at requests to continue pursuing new pacts through the World Trade Organization.

Anguish in the Euro Zone!

It’s the nation at the extreme southeastern end of the European Union, the one that borders Turkey and the gateway to central Asia.

It’s Greece, the cradle of western civilization. Although other nations within the E.U. can claim proximity to Asia – for instance, Bulgaria also shares a small border with Turkey, and the small island of Cyprus is geographically east of Greece – none can rival Greece’s claim as the birthplace of European culture and democracy.

Thus, the entire E.U. held its breath this week as Greece teetered on the edge of national insolvency. If it should collapse in a heap of debt, the entire euro zone – and perhaps the E.U. itself – might well collapse with it.

Fraying At The Fringes

The E.U. was originally an exercise in economic unity, a relatively small free trade zone of steel and coal producers that was established by a handful of formerly warring nations in western Europe. Its founding nations had seen their economies destroyed during the Second World War; they hoped that, by binding themselves together, they could prevent such catastrophes from occurring again. In other words, the E.U. was never originally intended to stretch across an entire continent and encompass 27 nations.

But the dream of a United States of Europe flourished, and the E.U. grew. Decades after the birth of the trade bloc, many of its nation states agreed to relinquish their national currencies and monetary policies by adopting a common currency, the euro.

The E.U. experienced great success during the economically flush decades of the ’80s, ’90s, and ’00s, celebrating the absorption of many former Soviet dominated nations, the reunification of greater Germany, and the emergence of a transcontinental system of government.  However, the 2008 collapse of the global economy brought troubling signs that nations at the geographical fringes of the Union – such as Iceland, Spain, and now Greece – might represent the canaries in a coal mine of a troubled geopolitical organization.

Iceland? A European State?

In a sense, the E.U. is already confronting huge challenges in managing economic problems within its own borders. The collapse of real estate values in Spain, for instance, as well as the monstrous increase of government deficits in Greece, would pose barriers to prosperity in any corner of the world.

But Iceland? Why is Iceland a European concern? Iceland is not a member of the E.U.; it is an independent island nation in the frigidly cold waters of the northern Atlantic Ocean. It isn’t even particularly close, in a geographic sense, to the continent of Europe.

In fact, Iceland lies beyond the shores of the isles of Britain and Ireland, which themselves represent economically troubled members that reside at the western fringe of the E.U. But Iceland may represent an even greater economic threat to the Union than these other member states, even as it flirts with the option of joining the Union outright.

A Matter Of Debt

But why is the E.U. so concerned about Iceland? Can it be because of political, cultural, and social habits that Iceland shares with the nations of Europe? Perhaps that is secondarily true, but more than likely, it is primarily due to the extent to which Iceland’s debts have wrecked the portfolios of European investors.

To put it simply, many Europeans invested their funds in the high interest offerings of Iceland’s high flying banks during the ’00s. And while the Icelandic economy roared, those investments paid off handsomely and focused global admiration and affluence on the small island nation. But when the world economy collapsed, the Icelandic banks collapsed as well, bringing down the entire island’s economy with it. Thus, although economic hardships in Reykjavik are usually not noticed in London or Paris, the defaults by Icelandic banks were sorely felt by investors in these great European cities.

In a sense, all of the economically troubled nations on the fringes of the E.U. share similar debt related burdens that threaten the region’s economic health. For instance, the decline in Spanish real estate values has caused much angst throughout the E.U. because investors throughout the continent have invested in Spanish property mortgage securities. Likewise, investors throughout the region have invested in Greek debt and now fear that a government default will deflate their own portfolios.

No Way Out?

So how will the E.U. address the debt conundrums that threaten its financial interests in places like Greece and Iceland? Because economic punishment for poor financial performance may reduce the likelihood of repayment even further, the E.U. is opting to assert its interests with a relatively gentle touch.

Thus, European finance ministers may be urging Greece to reduce its government budget deficits, but they are not yet calling for the nation to remove itself from the Euro currency zone. And European government ministers have even invited Iceland to join the E.U. in exchange for Iceland’s agreement to cover losses incurred by Icelandic banks, although Iceland’s president recently vetoed one such plan.

The great fear, of course, is that fiscal and monetary chaos at the outer fringes of the E.U. may spread to the economic heart of the Union itself. Such an event, if it occurs, may lead to greater shifts of economic power towards the emerging nations of the Eastern Hemisphere.