Kicking the Can to the End of the Road

The Biggest Bubble of Them All

This week we turn from the crisis brewing in the US to the one that is coming to a slow boil in Europe. We visit our old friends Greece and Ireland and ponder how this will end. It is all well and good to kick the can down the road, but what happens when you come to the end of the road? The European answer seems to be to haul in the heavy equipment and extend the road.

I am asked all the time what my biggest worry is, and I quickly answer, the European Sovereign Debt Crisis. Of course, then we have to think about the Japanese Sovereign Debt Crisis, followed by the one in the US; but today we will focus on Europe. The biggest bubble in history is the bubble of government debt. It is a bubble in a world full of pins. It will take a great deal of luck and crisis management to keep it afloat, without wreaking havoc on the financial system and markets of the world.

The rumors have been flying all this week. Greek is going to leave the euro. No, it won’t. Germans are demanding debt restructuring, and then they say no. A German newspaper is reporting that the EU, IMF, and Germany want a Greek debt extension, while the ECB (holders of Greek debt) and France oppose it. Greek two-year bonds are now paying 25% if you care to buy them in the open market, which is effectively the market voting for some type of debt restructuring or outright default.

I sat down this week and read two lengthy reports on how Greek debt could be restructured in an orderly manner. One was from HSBC and the other from Roubini Global Economics. There are ways it can be done. But the costs of the various options may be more than the affected parties want to bear. It is not a matter of pain or no pain; it is a decision as to who will bear the pain.

The fundamental problem for Greece is that there is no sign of economic recovery, with GDP at -4.5% in 2010 and still likely to be -3.0% in 2011 (IMF). If your economy slows down by 10%, then your debt-to-GDP ratio rises by 11% without any new debt. And Greece is being asked to further reduce its deficit by what is in effect 15% of GDP, while taking on no more debt. Within two years…