It’s been a rough few weeks for the Eurozone.
Portugal is still in trouble, Spain will be back on the coals after its Nov. 20 election, and if I were a bond trader, I would be shorting Belgium, which has serious deficit and debt problems, runs for months at a time without a government and is in some danger of splitting apart into its French and Flemish bits.
A bailout package for Greece has been agreed to, but the Greeks are struggling to form a government to implement it. And yields on Italian bonds are moving ominously higher, rising above the 7% that some think marks a point of no return.
So does this mean that a euro breakup and a Eurozone economic collapse are inevitable?
Not really.[ad#Google Adsense 336×280-IA]In fact, of all the European nations in crisis, only Italy has the potential to take down either the euro or the global economy.
Just take a look for yourself.
Getting Rid of Greece
At this point, Greece obviously is a goner as far as the Eurozone is concerned.
Really, it should have been pushed out 18 months ago, when it was first revealed that the country falsified its figures to gain acceptance into the Eurozone in the first place. Its government deficit at the time was 12% of gross domestic product (GDP) – not the 6% it claimed, let alone the 3% it had agreed to abide to on its entry.
French President Nicolas Sarkozy already has admitted it was a mistake to let Greece into the Eurozone, because the gap between its economy and the well-managed polities of Northern Europe was much larger than the area’s other members.
Former communist countries like Slovenia and Slovakia have integrated quite smoothly into the Eurozone, because their governments and people had already acquired the discipline necessary for membership. But since its entry into the European Union (EU) in 1981, Greece has lived on handouts, and raised its living standards artificially to a level two- or three-times the market value of its output. Exit from the euro is inevitable; Greece’s problem cannot be solved in any other way.
In fact, the sooner Greece exits the euro, the better. As it stands now, it’s rapidly becoming impossible for Greece to get its debt down to a manageable level, since the country’s official debt has been deemed untouchable.
Once the EU leaders acknowledge the need to remove Greece from the Eurozone, the country’s exit will be neither difficult nor damaging. The process of recreating the drachma will be similar to that followed in Slovenia, Croatia, and other ex-Yugoslav republics which abandoned the Yugoslav dinar in the 1990s.
Inevitably, Greece will have to default on much of its debt, but it’s already doing that now.
So if it’s handled correctly, Greece should not be a problem for the Eurozone or the world economy.
The PIIG Pen
The other smaller Eurozone weaklings aren’t major problems, either.
Ireland had a banking problem because of its immense real estate bubble, and the government got into trouble because it foolishly guaranteed the banks. However, Ireland’s current account is now in surplus and its economy appears to have begun growing again – despite draconian austerity measures.
Portugal, like Ireland, has replaced the government that caused the problem, which was largely one of public-sector overspending. However, it could run into difficulty again.
Portugal’s living standards (like Greece’s, but to a much lesser extent) are higher than justified by its productivity, and its balance of payments is still heavily in deficit. It’s in between Greece, which should definitely leave the Eurozone, and Latvia, which was able to bring its economy under control without losing its currency link to the euro.
If Portugal gets in trouble again, leaving the euro will be much easier, and in the long run, better for its economy than forcing further austerity measures. Because it is so small, Portugal won’t damage the Eurozone by leaving it. Instead, like Greece, it represents just a trimming at the edges.
Spain’s Nov. 20 election should produce a better government, committed to austerity. While it has a much lower debt level than Greece, Italy or Portugal, it combined a real estate bubble with government profligacy. If Italy stabilizes, the market’s attention will revert to Spain, but it can probably survive with a dose of austerity and good government.
Belgium is a basket case in terms of public debt, but the vast income it earns from the EU headquarters allow it to run a balance of payments surplus. It’s badly run, and for long periods of time not run at all, but probably not an immediate threat to the system – and it would be bailed out if it needed it.
The Eurozone’s Achilles Heel
Finally, we have Italy – the Eurozone’s Achilles heel.
Italy has slow growth and only moderate payments and budget deficits. Its high debt level is the result of decades of profligate government spending before Silvio Berlusconi came along. Berlusconi achieved less than he promised, but he cut government spending, raised the pension age and considerably improved Italy’s finances. If he’s succeeded by a capable center-right statesman, Italy should be fine, and the market panic should die down.
However, with Berlusconi’s coalition having lost its majority, and the president an aged leftist, there is a substantial chance of instability. If an election takes place that is won by the left, or if a “government of technocrats” that is in practice dominated by the left is appointed, then the corruption and special interests in the Italian political system may prevent necessary spending cuts and reforms, possibly imposing tax increases instead.
Since Italy is already overtaxed, and tax compliance is among the lowest in the EU, higher taxes result in revenue loss and economic downturn that could tip the country over the edge.
Also, since Italy is so large, the EU lacks the money to bail it out. Worse, its departure from the euro would destroy the currency and cause a major global recession. Our own economic health thus depends on the machinations of Italian politics.
Still, in any scenario other than a complete Italian collapse, most of the EU will continue to do fine, although the Eurozone’s growth will be constrained by bailout costs and austerity measures.
Of course, non-Eurozone EU countries that are capably managed and have a labor cost advantage over Germany, France, and Italy should continue to do fine, benefiting from not having to pay for bailouts.
For that reason, you might look at the Market Vectors Poland Fund (NYSE: PLND), which has suffered unjustified contagion from the euro mess and is trading on only 9-times earnings.
— Martin Hutchinson[ad#jack p.s.]
Source: Money Morning