With Europe on the minds of so many investors over the last two
years, it's important to understand some basic truths about the
situation. As European leaders have now promised to backstop whole
countries with a continuous circle of debt, we are left wondering
if there is a solution to supporting an unsustainable system.
The euro was established in 1992, in accordance with the
provisions of the Maastricht Treaty. To participate in the
currency, member states are meant to meet strict criteria such as a
budget deficit of less than three percent of their GDP, a debt
ratio of less than 60 percent of GDP, low inflation, and interest
rates close to the EU average. These guidelines were widely ignored
soon after the creation of the Treaty. Many countries have since
been allowed entrance without meeting these criteria.
The euro is the sole currency of 17 EU member states: Austria,
Belgium, Cyprus, Estonia, Finland, France, Germany, Greece,
Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal,
Slovakia, Slovenia, and Spain. These countries comprise the
"eurozone", some 326 million people in total.
Lets start with some simple truths about the situation in
• EU Banks are leveraged at 26-1.
• One quarter of the ECB's balance sheet is PIIGS
(Portugal, Italy, Ireland, Greece, and Spain) debt.
• The ECB does not have ability to save all the
European countries because the 17 nations have agreed upon a
monetary union without embracing a political union or a fiscal
union. This creates unknown legal and constitutional issues for
• Unfunded liabilities are not being accounted
for on European countries balance sheets, which significantly
increases their debt to GDP ratios.
• The EU problem is not a liquidity problem; it's
an insolvency problem.
• Excessive debt leads to required deflationary
policy responses. These are incompatible with government targets of
re-election and financial market expectations.
• Nothing will get done in Europe without
• Greece, Portugal, Ireland, Spain, and Italy
have one aim and one goal and that is to get Germany to pay for
So, one would instinctually ask "where is the money for all
these bailouts going to come from?" The Europeans have dug deep
into their baffling skills to pull out the following programs and
groups: the IMF (International Monetary Fund), the EFSF (European
Financial Stability Facility), the ECB (European Central Bank), the
ESM (European Stability Mechanism), the SMP (Securities Market
Program), the ELA (Emergency Liquidity Assistance Program), and the
LTRO (Long-Term Refinanciang Operation), with talks of a European
Where we should be concerned is if our own Central Bank steps
into the fray. They have already opened swap lines that enable
European banks to borrow at very low interest rates… Here's a brief
overview of the current programs:
International Monetary Fund
The IMF is basically funded by the United States. Obama cannot
afford to propose a European Bailout during an election year, so
his hopes are that the EU can hold together for the next six
months. An EU breakup would probably dash any hopes of re-election
for Obama. So this ties the hands of the IMF.
European Financial Stability Facility
The EFSF is supposed to be a 440 billion temporary fund to provide
bailouts to Euro Zone countries only (i.e. not banks). No country
has actually contributed money to this fund. Yes, you guessed it
this fund actually borrows money to fund its operations.
Confused? All countries that are not getting bailout money
are responsible for the money borrowed by the EFSF. The European
solution to their debt problem is to borrow more money to pay off
their debt. Germany has voiced concern and has constitutional
issues over funding the EFSF to bail out other member states.
Germany is reticent to increase its exposure to a Eurozone fall-out
further inhibiting this ambiguous bailout program.
European Central Bank
The ECB administers currency, sets interest rates, and prints money
if the need arises. The ECB was funded with 5 billion euros. Mario
Draghi, the head of the ECB and former Goldman Sachs manager, has
stated "I don't think it would be right for the ECB to fill other
institutions' lack of action", but "we stand ready to act." This is
a complete contradiction and does not even begin to answer the
questions as to where the money will come from or how how far the
ECB is willing to stretch its balance sheets to aid the sinking
European Stability Mechanism
Ultimately, this leaves the ESM, the permanent European Stability
Mechanism, which does not even exist yet. It is supposed to be
funded with 500 billion in bailout money. Only four of the 17
countries have ratified the ESM. It needs all 17 countries in order
to be enacted. On top of this, six of the 17 countries that are
supposed to fund the ESM are themselves insolvent and currently
getting bailout funds in order to prop up their economies. Again,
we are faced with another ambiguous program and a European solution
to solve a debt problem with more debt.
Securities Market Program
Created by the ECB to directly bail out countries. The ECB has
already spent over 200 billion on Spanish and Italian bonds that
have rapidly declined in value. If the ECB were an asset manager
they would have been fired over this move, but because no one in
Europe can be fired the politicians are safe for now.
Emergency Liquidity Assistance Program
This is an ultra secretive program created by the ECB. It has
already provided over 140 billion to banks in Ireland, Portugal,
and Greece. In exchange for the 140 billion the ECB accepted Real
Estate and other illiquid loan arrangements as collateral.
Long-Term Refinancing Operation
This program is the most baffling of them all. This program was
actually created and lent 1.018 trillion to banks across the Euro
zone who promptly turned around and lent that money to their
respectful governments. The governments then turned around and used
a percentage of this money to fund their government programs, and
to pay the same banks back interest on debt they had already
borrowed from the those banks. You cannot make this stuff up.
European Fiscal Authority
There are talks of setting up a European Fiscal Authority that will
be composed of finance ministers in charge of the rescue
mechanisms. This would enable the ESM to issue treasury bills, set
up debt reduction funds, and buy up excess stock. Euro bonds are
not possible because Germany will not consider them until you have
a political union. The obvious problem would fall to investors.
Would you consider buying treasury bills backed by insolvent
countries? How would the market price these treasury bills? Europe
would need to become "the united states of Europe" and many think
this is impossible. Without this they will continue to address a
"insolvency" problem with "liquidity" measures.
All of this is confusing and baffling. Behind all the smoke and
mirrors we are left with a European solution of solving a debt
problem with more debt.
US citizens should be concerned. The United States Central Bank is
currently engaged in Monetary expansion of historic proportions in
order to prop up its own system, while millions of Americans are
unemployed. Would the millions of unemployed citizens be happy if
instead of helping them get back on their feet and back to work the
Fed and US government, already propping up TBTF (Too Big Too Fail)
banks with ZIRP, started bailing out Europe?
Welcome to a world of moral hazard and unintended