Why Europe’s Debt Crisis is Barely Getting Started

If you’re sick of hearing about Europe’s economic crisis, you’ve got a long hard slog ahead of you in coming years. The steady stream of good and bad news is ‘hiding the decline’, as climate scientists would say. But the decline continues nonetheless.

Countries implementing so-called austerity are still running deficits. Politicians say the crisis has passed while their economies shrink. Debt to GDP ratios are rising as debt grows and GDP falls. In short, everything is slowly getting worse.

But the gradual decline throws up some much more interesting and insightful day to day news. Let’s take a tour of the absurd before we get to the deep and meaningful takeaway.

Greek newspapers are reporting that 1,000 homes lose electricity each day in Greece. Not just because they can’t pay their power bills, but also because the commonly evaded property taxes are now included in electricity bills.

Maybe some of the disconnections are legitimate though. Der Spiegel is reporting ‘more than 120,000 professionals have left Greece since the start of the country’s financial crisis in 2010, according to a recent study by the University of Thessaloniki.’ The last time we were in Greece, we got stuck in a lift and it took forever for the technician to turn up. A country in crisis has very real consequences for the people there.

In Portugal, public workers may have to get paid in Portuguese government debt. The constitutional court ruled part of the country’s budget unconstitutional, so cash is tight. There is some truly beautiful irony in this. Public workers getting paid in dodgy public debt.

It turns out that Spain’s social security fund is 97% invested in Spanish government debt. Diversification anyone? But what happens when the fund reaches 100%? Who will be left to buy the additional Spanish government debt being raised? And if Spain experiences a bond crisis, what will happen to Spanish pensions?

In Italy, the CEO of Unicredit bank told thrilled depositors that confiscating their deposits to bail out a bank is OK if ‘everyone else is doing it’. Meanwhile, a car carrying a ton of gold (literally a ton) was intercepted at the Swiss/Italian border. Dan Denning wrote a fictional story about something very similar to make a point about capital flight in his newsletter. Now it’s coming true.

The German’s are no doubt rather annoyed about a new ECB study showing they’re amongst the poorer nations of Europe. Spain, Italy and Cyprus topped the wealthy end of the list. The reason for the surprising numbers lies in house prices.

In Germany, owning a house is less common and prices are much more stable, so rising house prices don’t drive national wealth. In much of Europe, owning a house is the major factor in personal wealth. Unfortunately, house prices in Spain fell 9.7% over the last year.

France is experiencing a political crisis of its own. President Hollande’s camel was stewed and eaten by a family in Timbuktu.  You can find the enjoyable details here.

Former German Chancellor Helmut Kohl has admitted he ‘acted like a dictator’ to get the euro accepted in Germany. A referendum would’ve overwhelmingly rejected sharing a currency with the French. Oddly enough, Kohl is proud of his legacy because he thinks the currency union will prevent war.

Meanwhile, the Greek government commissioned a report to total up the damages Germany owes the country because of the two world wars. The report was leaked and the owed amount comes to €162 billion. That would cut Greece’s debt in half. In other words, the Greek government inflicted twice as much economic damage on their own country as the Germans could in two world wars…

Slovenia has implicitly applied for a bailout from the EU. ‘We will solve our problems on our own,’ said Slovenia’s Prime Minister. She was leaving a meeting with the President of the European Commission when she said that. Put the two together and you get one conclusion. A bailout is already in the works.

News network Reuters released EU draft plans for Cyprus to sell most of its gold to pay for a small proportion of its bank bailout. Even though gold makes up a huge 62% of Cyprus’ reserves, selling most of it raises just €400 million.

That’s tiny compared to the EU’s €10 billion bailout, which just goes to show how undervalued gold really is and why no other European country has even discussed selling their gold to pay down debt.

Cyprus has since denied any discussions about selling its gold. But the size of the required bailout has increased 35% in the last month, with Cyprus expected to scrounge up an additional €6 billion euro from somewhere.

Saving the best until last, the EU is threatening to fine Spain if it doesn’t implement additional taxes. This is straight out of nincompoop land. Fining a country that can’t pay its bills because it can’t pay its bills?

As you can tell, Europe is descending into chaos. But this is just the beginning. Things are going to get much worse.

Stock And Flow

An important part of understanding Europe lies in the difference between a stock and a flow. For example, the government deficit is a flow, while the government debt is a stock. One is a measure of change in a given period, the other is a snapshot at one point in time. The government incurs a deficit during a given year, while its debt can be measured at any point in time.

So where does GDP fit in? Is it a stock or a flow?

The correct answer is that GDP is a flow. But most people think of it as a stock. That creates a gigantic misconception.

You see, last year’s GDP has to be regenerated every year just for GDP to remain the same. You don’t get to count what you did last year in this year’s GDP. You have to start over each year. Working hard doesn’t grow your GDP, just working harder than last year.

Some things counted in GDP repeat constantly, like food shopping. It will remain around the same level next year. But some forms of economic activity are different. Housing construction for example. Once you build a house, it’s done. Unless you can find another house to build, your house building efforts won’t be counted in next year’s GDP.

The parts of Europe struggling with a recession focused on the ‘once off’ kind of GDP. Housing construction, banking, setting up shell companies…all of these things are difficult to regenerate each year. There are only so many people willing to set up shell companies, buy houses and borrow money. Whereas demand for German cars, for example, is much more repetitive and stable.

One last factor to keep in mind before we get to the valuable bit. The government deficit is a flow, like GDP, because it’s a movement, not a snapshot in one particular moment.

Here’s why all this matters. Stocks and flows require different policies to improve them. A tax won’t solve the debt problem. It can only solve the deficit problem. A flow based policy like tax can only solve a flow based problem like the deficit. In the same way, a stock based policy can only save a stock based problem. Defaulting on debt reduces it.

Mismatching a stock and a flow leads to dangerous policies. For example, many economists say inflation reduces debt. But that’s a flow solution to a stock problem. To explain why inflation might not work to reduce debt, ask yourself what other effects inflation might have.

The deficit could rise as the interest bill on government debt rises. Unemployment could rise as economic chaos takes hold, increasing the government’s welfare bill. And inflation could interfere with saving and investment, leading to a new depression down the road.

Mixing up stocks and flows is a major reason why policies don’t end up working. Stimulus and austerity (flow policies) can’t improve your debt position, because it’s a stock. They can only improve deficits.

Here’s part of an interview of economist Carmen Reinhart, who co-wrote the book This Time Is Different. The book was really a study of sovereign debt crises like Europe’s, so Reinhart may be the world’s leading expert on the topic.

Spiegel: Do you think it is wrong for Europe to focus on austerity measures with inflation at such a low level?

Reinhart: No. Restructuring, inflation and financial repression are not substitutes for austerity. All these measures reduce your existing stock of debt. Unless you do austerity you keep adding to the debt. There is no either-or. You need a combination of both to bring down debt to a sustainable level.

Reinhart is referring to the fact that dangerous stocks and flows have different solutions. Confusing stocks and flows will lead to confused solutions. And those backfire…

Reinhart: There are no silver bullets. If central banks try to accommodate and buy debt, there are risks associated with it. Somewhere down the road you are going to wind up with higher inflation. That is a safe bet — even in Japan …

So what is Reinhart’s advice?

Reinhart: The best way of dealing with a debt overhang is to never get into one. Once you have one, what can you do? You can pray for higher growth, but good luck! Historically it doesn’t happen — you seldom just grow yourself out of debt. You need a combination of austerity, so that you don’t add further to the pile of debt, and higher inflation, which is effectively a subtle form of taxation …

Spiegel: … with the consequence that people are going to lose their savings?

Reinhart: No doubt, pensions are screwed.

It’s entirely beside the point, but there is a beautiful irony in every Spiegel interview. You see, Spiegel means ‘mirror’ in German. So to a bilingual person, the above transcript reads like some sort of split personality disorder, with someone talking to themselves in the mirror.

Anyway, in the end, it’s a question of who pays for this mess. Reinhart reckons pensions are ‘screwed’. We’re not so sure. Who else will governments rob to pay for their last gasp efforts to hold onto their power over the economy?

Do you think it will be the bankers they’ve been bailing out? Maybe it will be the pensioners who represent the largest voting bloc? No, the savers and workers will be clipped around the ears. Politicians will do what they’ve always done — go where the money is.

That’s why The Money for Life Letter  is focusing on a new kind of investment strategy. We call it ‘definancialisaton’. The idea is that the day you retire is also the day you become independent of your employer or employees, independent of the government and independent of the financial system.

That doesn’t mean buying a farm in Whoop-Whoop and getting a shotgun. It means small and enjoyable changes to your life today which allow you to benefit in retirement. We’re releasing a report on our best idea yet next week.

Nickolai Hubble.
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Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like.

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