The Lull Before the Storm: What's Coming in 2011
This week—what with Christmas on one end and the new year’s celebration on the other, and everthing in between covered in snow—nothing much is gonna happen: It’s a week that’s about as dead as Dillinger. So I figured I should take stock of where we are—and more importantly, where we’re going.
To me, the biggest macro-economic story of 2010 was Europe: It’s falling apart, and there doesn’t seem to be anything that’s going to stop this collapse.
The second biggest macro-economic story of the year—though not by much—was the successful monetization of 75% of the U.S. Federal government deficit by Ben Bernanke and the Federal Reserve. I use the word “successful” in a morality-free, completely pragmatic sense: Bernanke achieved monetization with minimal market disruption. In fact, a lot of people would argue that QE-lite and QE-2 were not policies of debt monetization—that is how successful Bernanke has been. (Talk about “reality distortion field”! Steve Jobs ain’t got nuthin’ on Benny!)
This “success” has allowed the U.S. Federal government to continue to avoid making necessary, critical budgetary decisions—paradoxically accelerating the U.S.’s deteriorating fiscal situation.
The third biggest macro-economic story of 2010 has been the inexorable rise in commodity prices. Everyone’s been paying attention to silver and gold, but the real story has been industrial metals—especially copper—and agricultural commodities—especially grains—especially wheat—and corn, corn, corn!
To be sure, there were other important stories in 2010—the Mortgage Mess, Wikileaks, Wayne Rooney. But these three issues—auguries of EMU collapse, successful Fed monetization, and commodity price rises—are the ones that mattered on a macro-economic level this past year.
In 2011, every other financial story will be either a cause or consequence of one of these three issues: Guaranteed.
Now then—to specifics:
Europe is in deep s--t—there’s really no polite way to say it.
Back in the spring of 2010, Greece went down the tubes, as its sovereign debt collapsed in price, and its ability to borrow money from the open markets—and thereby continue to operate—for all intents and purposes ceased.
Then in November/December of 2010, the Irish sovereign debt also began to tumble, as it became increasingly clear that Ireland simply does not have the wherewithal to backstop its disproportionately large—and insolvent—banking sector. Angela Merkel’s less than clever words in an interview (to the effect that Irish debt holders might have to take a haircut) sparked a rise in Irish debt yields, squeezing Ireland’s ability to borrow fresh cash to keep its insolvent banks afloat—thereby creating the need for a rescue package from the IMF, the UK, the European Union, and the European Central Bank.
What was painfully apparent in 2010 was that the Eurozone and the European Union had no mechanism to handle a crisis in one of its member states. Nor is it moving forward to correct the single biggest weakness of the euro scheme—namely, the ability of each member state to issue its own debt.
In May of 2010—over a decade since the introduction of the euro—the EU finally came up with a mechanism to salvage the broken economy of one of its member states, the European Financial Stability Facility (EFSF). Stability Facility: Even its very name sounds cartoonish and silly—which fits with the general cartoonishness of the European crisis response, first to Greece, then to Ireland.
The concept of the EFSF—at least in theory—is for the member states to contribute to a €440 billion fund. In reality, the EFSF has no money, but rather, it will issue debt. Therefore, what’s really happened in the case of Greece and Ireland is that their bad debts were taken over by the EFSF—so in a sense, no one has been bailed out: Rather, the bad debts have been transferred to the European Monetary Union as a whole.
This is the European model of bailouts: In exchange for handing over their fiscal sovereignty and having tough austerity measures put in place—but without harming a single hair on the head of a single sovereign bond holder—Greece and Ireland had their debts taken over by the EU. In other words, collectivising the bad debts, in exchange for tighter central control from Brussels.
Which is fine—for the smaller countries with their smaller economies, and their weaker political pull.
But what about a big country? What about a country like—oh, I dunno—Spain?
☞ Possible EMU Collapse: What To Pay Attention To In 2011
After the Greek and Irish bailouts, it looks like Portugal and possibly Belgium are up next in this perverse game of musical chairs played to the tune of sovereign debt—
—but these smaller countries are dwarfed by Spain: Spain, as I argued here, is where the European game is really at.
As I pointed out, Spain is twice the size of Greece, Ireland and Portugal combined—Spain is roughly half the size of Germany—Spain has a fiscal deficit of over 11% of GDP for 2010, and a total debt of over 80% of GDP, data here (I am counting the accumulated debt of comunidades autónomas, which is so far 10.2% of GDP and steadily rising; data here)—Spain has an unemployment of over 20%—
—in short, Spain is trouble.
Not “Spain is in trouble”—that’s obvious, but that’s not my point: Spain is trouble. Trouble for the German banks that own so much of the Spanish debt. Trouble for Germany, which is propping up its insolvent banks (What, you think German politicians are any less craven than American politicians?). Spain is trouble for the European Union, for what a German banking crisis might mean for the EU as a whole and as an institution.
More than anything, Spain is trouble for the European Financial Stability Facility, because Spain is too big to be saved—and there’s really no way to finesse that hard fact.
You know what a lynchpin is? Actually, I didn’t—I had to look it up. According to the dictionary, a lynchpin is “a pin passed through the end of an axle to keep the wheel in position”. Hence the figure of speech: Without a lynchpin, the wheel comes off, and the whole vehicle crashes.
In the case of Europe, the lynchpin can come off awfully fast—think of Ireland. A few impolitic words from Angela Merkel, and suddenly the Irish bond market panics. Suddenly, Ireland is teetering on the brink of insolvency, unable to meet its funding needs. And that was Ireland—all due respect to those wonderful people, but we’re talking a GDP of a paltry $227 billion. Ben Bernanke takes a morning dump bigger than that. What’s Ireland’s $227 billion when compared to Spain’s economy of $1.5 trillion?
Spain: During 2011, Spain will be the flash-point—so you want to keep one eye on Spanish sovereign bond spreads, and one eye on Brussels:
When Spanish debt spreads over German bunds creep into the 3.5% to 4% range, you know trouble is coming. And when the Spanish spread decisively crosses 4.25% over the German 10-year, then you know trouble’s arrived—and it won’t be leaving town ‘til it’s had its chance to run riot in the streets.
How the EU and the ECB handle an eventual Spanish sovereign debt crisis will determine the very future of the European Union.
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