The End of the Line: Eurozone Crisis Hits Tipping Point
Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc., and
Michelle Gibley, CFA, Senior Market Analyst, Schwab Center for Financial Research
September 12, 2011
Key points
- The growing likelihood of debt default by Greece rocks markets and sentiment.
- Although the banking system is healthier today than it was in 2008, contagion risks are elevated.
- The grand experiment of a unified currency in Europe is facing its greatest test yet.
The inevitability of the eurozone crisis was foreshadowed by the late, great economist Milton Friedman. At the time of the euro's debut in early 1999, Friedman expressed concern that it would not survive the first major European economic recession or crisis. Prescient thinking.
Euro 101
The primary motivation for the creation of the euro was less economic than political. The goal was an integrated Europe that could more effectively compete with (and/or rival) the United States. The hope was that a single currency would also force economic restructuring in the more-wayward peripheral countries, requiring them to abide by the Maastricht Treaty rules that govern member countries' budget policies.
Things didn't work out as planned. Blatant disregard for budget policies among the "PIIGS" nations (Portugal, Ireland, Italy, Greece and Spain) brought on wage and price inflation greatly exceeding the eurozone average. In addition to the resultant diminished competitiveness of these peripheral members was the effect of burgeoning budget deficits as a percentage of their gross domestic products (GDP).
Fast-forward to today, and there's legitimate risk that these countries don't have the wherewithal to honor their debt obligations. The major problem is that European leaders don't appear (at least publicly) to understand either the gravity of the crisis or the impact that confidence has on the financial system. The very recent decision by Germany to begin contingency planning and shore up its banking system suggests perhaps they are just getting to this point of awareness.
Not contained to Europe …
The pressures emanating from the overhang of government debt in the eurozone continue to negatively impact trading in Europe, but why have US stocks also been taking their cues from the eurozone? Why does Greece matter so much?
Because the crisis is about more than just Greece. The problems in the eurozone are more about the health of the banking system in Europe, the long-term viability of the euro, Europe's contribution to global growth and the indirect impact on the US dollar.
… but Greece is unique in severity
Greece's deficit and debt levels (15% and 140% of GDP, respectively), lack of economic growth and commitment to austerity put it in a class of its own, and Greece is the most likely member to default on its debt. Greece's quarterly review for funding conducted by the troika of the International Monetary Fund, European Commission and the European Central Bank (ECB) broke down in early September. The breakdown was due to lack of progress on achieving fiscal targets, implementing structural reforms, selling off public assets (privatization) and a public debt-swap plan rumored to be short of the 90% participation goal.
In an illustration of Greece's struggle, the ability for Greece to generate the revenues targeted under the bailout is severely hampered: the economy contracted 7.3% in the second quarter and Greek officials have confirmed that they have cash for only a few more weeks. If this sounds familiar, it is: Greece was in the same position in mid-July of this year when cash was running low because the deficit was higher than expected.
This was partly due to lack of progress on austerity and reforms, leading to the second Greek bailout to cover higher-than-expected cash needs. Since then, yields on Greek two-year debt have skyrocketed relative to the other peripheral nations.
Greek Two-Year Bond Yields Go Parabolic
Source: FactSet, as of September 9, 2011.
So is forcing more austerity on a country already suffering from a lack of economic growth the solution, or will this just exacerbate the problem? It's clear to most observers that this is an unsustainable situation, with a restructuring of debt obligations ultimately needed.
