On Europe, EU and the Financial Meltdown of Greece and Spain


The European Union (EU) came together, in 1999, after years of political, economic and ideological negotiations, as a somewhat of a monetary and fiscal governance union - a group of European (11 countries, originally) countries, led by Germany, France, Spain, and Italy, pushed for and got their wishes: 


The EURO: 
The EUR was adopted as the new currency for the entire Euro zone.   Parity rates were fixed for currencies of individual members of the EU club (remember the Italian Liras, Spanish Pesetas, German Marks, and French Franks?) for conversion into the new currency, the EURO.  In a carefully managed transition, the EURO replaced EU local currencies for all commerce (legal tender) across the EU zone on Jan 1, 2002.  It had become the accounting currency of the EU a few years earlier.  10 years later, the EURO is the world's second largest reserve currency (EUR 850 billion), behind the US$.  A 17 member EU zone (5 countries have been added since 1999), with a combined population of 330 million (slightly higher than US population, 2010 census) now use the EURO for all commerce.  In addition, the EURO is also used, around the world, as a "Peg" currency for countries still on a fixed exchange rate regime.  Most of these countries are in Africa.


European Central Bank
A European Central Bank (ECB) was also established in 1999.  The ECB little real monetary powers over the region's individual Central Banks (CB).  It was more of a coordination and governance unit, over each member country's CB.  The ECB's sole mandate was targeting EU zone interest rates, and not the EURO exchange rate.  So the BundesBank (German Central Bank), for example, continued to manage inflation (its sole mandate) in Germany on a day to day basis, but with a goal to remain compliant with EU’s agreed upon economic core measure limits. 


On a practical level, ECB's real purpose, and authority, to control and direct member states' monetary policy indiscretions was questionable right from the start.  The ECB is, in many ways fairly impotent.  But the ECB does have a public, quasi-political bully pulpit for exercises in financial rhetoric.  Oh, it does mint EURO coins, and prints the currency notes, though even that is effectively sub-contracted to member Central Banks.


Rules of Engagement
In addition to the EURO and the ECB, all member states agreed to be bound by a set of fiscal and economic criteria, for admitting new members.  Continued membership also required compliance with such criteria: fiscal deficit no greater that 3% of GDP, Inflation target rates, etc.
The EU zone today: Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain.  Greece joined in 2001, Slovenia (2004), Cyprus and Malta (2008), Slovakia (2009), and Estonia (2011).  Additions to EU membership are called “Enlargements” (readers are exhorted not to get any wrong ideas!).  10 countries in Europe are yet to join the Enlargement movement, with the UK, Denmark, and Sweden (de facto exemption) being exempt from the “mandatory” enlargement clause.


To be candid, I could not place several of the newer EU member countries, without the help of Google Maps (using an Atlas is so passé).  No shame there, I am fully Americanized.  I also accept the economic benefits rationale for the EU, without any reservations on the underlying economic theories, primarily those of Robert Mundell (Stationary Expectations Model, and International Risk Sharing Model).  Mundell, of course, won the Nobel Prize in Economics (1999) and is a celebrity Canadian economist (them Looneys!).  


The problem, instead is managing member countries’ vast differences in culture, politics, aspirations, laws and regulations.  In theory, the EU zone is about the size of the United States.  But the US has – one single government, Federal Laws, Central Bank (Federal Reserve Board), and despite regional cultural differences, the US is united as a republic.  Realities of how the US actually works are far from ideal.  Congress and the Administration (Executive Branch) somehow manage to differ on every issue – social, economic, etc. – but we Americans manage compromises allowing the country to remain solvent and the government functioning.  For how much longer, I cannot tell.  The key to the US economy functioning (albeit fiscal policies and performance is quite dysfunctional) is the political independence of our Central Bank.  The Fed has a dual mandate of managing inflation (stable prices) and growth (economic output, or GDP).


Across Europe, on the other hand, nationalistic fervor takes precedence over any constraints set by EU rules.  Every member country, since inception, has cheated – to advance its own agenda: prosperity, economic and political clout, etc.  


Furthermore, European financial institutions – Banks – were able to leverage to ridiculously dangerous levels.  Very high leverage (borrowings) creates opportunities for very high returns on Capital.  American Banks were doing essentially the same, in the pre-financial-meltdown era.  Lehman Brothers, for example, had a 37:1 leverage, or assets to equity ratio.  In other words, Lehman borrowed 36 dollars (to lend, or to invest) for every dollar of equity capital Lehman had.  Think about this – every % of profit for Lehman, at 37:1 leverage, is a 37% return on equity.  The converse, unfortunately, is also true – every % of loss is a 37% loss on equity.  So, a mere 3% loss (24 billion) in its balance sheet (800 billion) wiped out 21 billion in total equity (37:1 leverage).  That was the reason for the Lehman bankruptcy filing, the largest ever in US history.  Theoretically, the same is true for countries, but nation states do no file for bankruptcy.  They simply default on their external debt obligations – as in Russia (1997), and Argentina (multiple, repeat offender).


Europe was not immune from the US financial crisis of 2008-2009.  As US banks failed, and US Investment Banks were being sold for pennies on the dollar, banks across Europe received their own margin calls.  Ireland was first to step in, along with the UK, to organize state sponsored bailouts of banks, with equity infusions and outright nationalization (Royal Bank of Scotland).  The US bought preferred shares in a gross amount of 780 billion $, to try to stabilize the US banking system.  In addition, US banking regulators shutdown hundreds of regional and community banks (Washington Mutual’s sale to JPMorgan, Wachovia Bank’s sale to Wells Fargo were impending failures, forced into sale to their suitors).  While a government sponsored rescue and bailout of privately owned banks is a flagrant violation of “Free Market Capitalist Principles”, the markets have never truly been free, so why pretend otherwise, during America’s darkest financial hour?  Too-Big-to-Fail (TBTF) rhetoric was used to justify bailing out Citibank, Goldman Sachs, Morgan Stanley, et. al.  I am not sure anyone of them was truly TBTF.  If ever there was a single institution that was TBTF, we should all be very scared, and the Feds must not allow one to become a TBTF.  Hank Paulson, as Sec. of Treasury, and x-CEO of GS pumped the fear of biblical financial and economic calamity in to Congress; Wall Street obliged by dragging the DOW Jones Index down over 700 points in a day, as Maria Bartiromo, and other cohorts at CNBC (a CNBC only post is coming, someday) projected the end of the world was neigh.  Nice lips for screaming so, BTW.


In the mass hysteria that followed, public opinion was manipulated, overnight, into the corner of sympathy, and of self-preservation.  Congress passed TARP immediately.  And, let me tell you, lest you forget – NOTHING happens in Congress immediately!


But, and again, I digress.  Financial Markets are more connected that ever before.  You may have heard that before.  What that really means, is that almost every bank is taking the same risks, around the world.  European banks bought (or, were sold?) the same securitized mortgage crap that the US banks held on balance sheet in raw loan form, as yet to be securitized inventory.  US banks got caught sleeping at the wheel, not realizing in time, that a tsunami of homeowners were about to default on their loan payments.  Available for sale (AFS) is the accounting category for such loans on bank balance sheets.  AFS account is subject to mark-to-market regime.  Ergo, kaput went Wachovia, Citibank, Merrill Lynch, etc – but not without some shenanigans and machinations, as in not coming clean at the first opportunity.  US regulators clamped down on disclosures (it is a felony crime for CEO, CFO and BOD to not disclose what they know, when they know).  An insurance company, called AIG was also ensnared in this fiasco, and bailed out with a $180 billion infusion from the Feds.  AIG owed a large amount, by way of margin calls, to Goldman Sachs.  Way to go, Hank!  AIG, however, went down because of slightly different reasons – AIG wrote insurance contracts in the defaulted loans and Mortgage Backed Securities born off of such “Liar” Loans.


Easy money, as in lax credit checks, had fueled the US housing boom.  It was not different in Europe.  As European banks began to unravel their countries jumped to the rescue.  Unfortunately, a large number of EU members (the ones I cannot place on a map, with the exception of Greece and Spain, which I can!) are tiny economic powers.  Their banking institutions had become larger than their national GDP! How in the hell is a national government supposed to orchestrate a bailout of such relative proportions is beyond me.  So, Greece, and Spain, and other countries shoved their banking troubles under the rug.  Not unlike Japan’s denial of its own banking crisis, originating again in housing prices in Japan, in the late 1980s.  Many say Japanese people, and its economy experience the lost decades (2, actually).  Even now Japan has not come fully clean.  It’s a cultural thing, I suppose.


In the last few months, Greece has finally accepted and announced that the Greek financial meltdown is here.   And that they are beyond what Greece can manage.  Greece is literally on fire, and unraveling down to its core.  There is some hope of saving the cradle of civilization from civil war, but every day that goes by brings the world close to a Greece that no one would want to contemplate.  And more recently, the Spanish have finally acknowledged they need outside help.  Their banking troubles too are too big for the Spanish government to manage.  Portugal is not far away. I think.  Italy is close, but Italians are Italians.  Eat, Pray, Love was shot partly in Italy for a reason!


So, Germany and France are the only two EU countries with economies and resources large enough to put together a European Bailout package.  The Brits could help.  But the Brits are who they are.  I can see the crusty grin on many a British face, as they read of higher levels of distress across the channel, over morning tea and biscuits.  Not to mention, that the UK is still not out of the doldrums itself.  


As for the US – we could help, but we have a heap of our own problems.  And in this election year, Congress will do what Congress does – NOTHING.


Germany and France will put something together as a concerted rescue effort.  It will likely have unpalatable, perhaps even draconian conditions attached - condition that will be impossible to swallow, for the Greek people, or, for that matter, the proud citizens of any other European country.


The European Union itself is at risk.  In my mind’s eyes, that gig is up.