The Twilight Zone
We have been silent on the Euro zone mess for quite some time. We get plenty of calls on this topic, and, yet, we haven’t been able to bring ourselves to say much in writing. Why is that?
The simple fact is that the trouble in Europe is in many ways unknowable. The news stories over the past months show that clearly: an Italian prime minister makes a pronouncement on afternoon, only to be contradicted by the German chancellor hours later. The German chancellor announces an accord with the Greek prime minister one day, only to have the Greek prime minister back away from the agreement and refer it to the Greek people. And what accompanies each of these news swings? Swings in stock and bond prices, of course. As we write, the latest news that a group of central banks have come together and agreed to lower the price of a type of inter-bank lending has pushed the DJIA up 400+ points. Never mind that the reasons that this type of action were needed are terrifying to contemplate (large European bank failure, anyone?), the market is desperate to hear that something concrete is being done to “fix” things.
The question, then, is exactly what needs fixing in Europe? We can nuance the issue, but the plain truth is that the Euro Zone (countries that agreed to use the Euro as a single currency) has participants who have not played by rules and others, people fear, may not be willing to play by the rules for much longer. Entry by countries into the Euro was contingent on having and maintaining certain acceptable levels of budget deficits (not more than 3% of GDP). The idea was that this would keep everyone in-line and countries would do what was necessary to keep deficit spending to less than the 3% of GDP limit. Unfortunately, the Euro entry committee failed to foresee two problems: no country’s deficit level was verified prior to admission to the Euro, and the political will of a country to live up to the 3% deficit limit was assumed to be solid.
Greece is the first example of a country that, so far, is failing on both those assumptions. Its deficits were revealed in 2009 to be not 3%, but, instead, approaching 14%. Cutting the budget to get down to the 3% limit brought into clear focus the nature of the second assumption. We have all seen the images of Greek citizens rioting and striking as the budget was cut, testing the political will of the Greek government to live up to the 3% deficit limit.
The simple truth is that the members of the Euro have just two choices: bail them out or toss them out. Both will be very expensive propositions. If you bail them out, how do you say “no” to Italy or Spain when they, too, want help? Toss them out and you risk unwinding the Euro currency altogether, along with a rush of capital from other shaky countries into safe ones (if you think a run on a bank is bad, wait until you see a run on a country). Either way, the costs will be enormous, and we simply do not have the ability to predict which path will be taken. Will German citizens be willing to shoulder a disproportionate amount of the burden to support floundering countries? What price might they demand for that support? Will Greece (and others?) be willing to pay that price? The questions are important ones and not solved overnight. Pundits abound with predictions for what this means to the US markets, but those predictions change throughout a given day. In light of this, we stay believers in a long-term investment strategy founded upon a prudent allocation in light of our clients’ goals and risk tolerance.