Thursday, May 31, 2012

Eurozone default losses are water under the bridge

Forget all the talk about PIIGS defaults and a possible Eurozone banking and/or currency crisis. The losses from lending to Greece, Portugal, Spain, etc., are water under the bridge. The real issue is that Eurozone economies have been doing poorly for many years, thanks to excessive and unproductive spending and bloated governments.


As the chart above shows, the U.S. equity market has been outperforming its Eurozone counterpart ever since 2001. 


This chart quantifies the outperformance, by showing the ratio of the S&P 500 to the Euro Stoxx index since 2001. U.S. equities have outperformed by an astounding 125% since the Eurozone glory days of early 2001. (Correcting for the fact that the Euro has appreciate vis a vis the dollar by some 37% since then, U.S. equities have still outperformed by an impressive 63%.) Europe's underperformance relative to the U.S. would be the equivalent of many trillions of dollars of foregone income. 


It's only been in the last year or two that this outperformance has really gathered speed. The chart above shows the ratio of the two equity indices from the beginning of last year. Here we see that U.S. equities have outperformed by over 40%. (And correcting for the Euro's depreciation against the dollar over this period, US equities have outperformed by over 50%.)

My point here is that the concerns over the eventual size and impact of Eurozone defaults is misplaced. The losses resulting from the profligate borrow-and-spend policies of Greece, Spain, Italy, Portugal, etc., have already occurred in an economic sense. The losses began to accrue from the moment these countries took advantage of the strong euro to borrow money that was used to support lavish lifestyles for public sector employees, corporate cronies, and other beneficiaries of income redistribution. Very little of the money went to productive purposes, so there is nothing to show for it.

It's wise to remember that debt is a zero-sum game in an accounting sense. When Greece declares default, its creditors must take the hit to their bottom line, but the Greek government wins because it has relieved itself of the need to make interest and debt repayments. In the real world, Greece's creditors began losing money many years ago as Greece squandered the money it borrowed. For many years, Europe collectively diverted massive amounts of scare resources to the Southern Eurozone countries, and the money and the resources were consumed rather than invested, so there is nothing to recover.

The real losses are shown in the charts above, and they have manifested themselves in more than a decade of serious economic underperformance. This is the elephant in the room, not the potential impact of PIIGS' defaults on the Eurozone banking system.

Given the degree of Eurozone underperformance, I would be tempted to buy Eurozone equities, but only if and when the PIIGS governments decide to address their true underlying problem. They need to radically cut back the size and scope of their governments, and at the same time eschew any effort to raise taxes to close their funding gaps. Raising taxes only serves to validate the size of government; instead, government must be shrunk to fit the ability of the private sector to afford. This will of course be difficult, since Europe has long been addicted to Big Government, and Big Government will not consent to go into rehab until it has exhausted all other efforts at reform. So I don't see it happening soon, but I'll be watching closely, as will all other serious investors.

And of course, all of this is a timely lesson for the U.S. Our problem is not a shortfall of revenues, it's an excess of unproductive spending.

11 comments:

Bill said...

If this were true then why would markets tank every time it looks like Greece might exit the Euro or Spanish banks might fail? Are you saying the markets are irrational? Isn't the problem credit default swap exposure and the potential for systemic failure similar to the concerns the world had with AIG?

Public Library said...

In a fiat world, debt never really decreases nor is a zero sum game. It keeps getting shuffled around until it ends up in the attic of sovereigns. Eventually the houses come crumbling down.

The only thing available to extinguish debt is gold...

William said...

If "markets" are going to enforce supply side economic theory where does this enforcement end?

Why not attack Japanese bonds and drive their value down - their government has engaged in wasteful public spending to provide employment for decades.

Then why not knock down the value of US bonds and many others. The US is the largest debtor nations and our deficit as a percent of GDP is higher than Spain and our spending on defense, "intelligence" and multiple wars were not productive.

Scott Grannis said...

Bill: markets react negatively to each bit of bad news out of the eurozone, but on balance our equity market has been moving higher. I do think it's likely that markets don't really understand how debt and debt defaults work. A default doesn't destroy wealth; wealth destruction occurs when borrowed money is wasted on unproductive activities. Banks can be recapitalized easily. These defaults are not going to bring down the global economy, no matter how much our market worries about it.

Dr William J McKibbin said...

I tend to agree with Scott that Greece is not going to topple the global economy -- likewise, neither will Spain, Portugal, and Califonria -- however, I would also argue that the source of pessimism in the markets is not solely the Eurozone, but rather the Eurozone combined with California combined with the totality of America's declining real wages, home values, and employment to population ratio -- add to all of that the existing debt and obligation to fund future entitlements of the Federal government, and well, there's some real grounding for pessimism, at least along Main Street USA -- now, let's not forget that pessimism spells "cheap" in equities, so those with means should not despair -- the future looks bright for long-term accredited investors -- now is the time to convert lazy dollars into equities of all kinds, including education in world-class skills -- in fact, the future has rarely been brighter for long-term investors with a 25-30 year investment horizon!

Gloeschi said...

Scott is right. Like Romney. ("It's a zero-sum game. JPM's losses are somebody else's gain. This is how capitalism works, folks").
I come to this blog merely for comic relief. Thanks for the entertainment.

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Egghead said...

As Gloeschi said, you are indeed funny. If debt is a zero sum game, why do we ever have financial crisis? The US can just default and let its creditors lose. Isn't that beautiful?

William said...

The more I think about what is happening in Euroland - the distrust of the southern tier of nations who were able to borrow vast amounts at significantly lower interest rates than they could have with their own currencies - I realize the fundamental problem is the adoption of the Euro. For Greece, Portugal, Ireland, etc. the natural market feedback mechanisms of the bond markets which would have limited their borrowing (because of a rise in interest rates) no longer existed and didn't work.

So the solution to their present problems would seem to be to correct the original flaw in the establishment of the Euro. Europe ultimately will have to come together to have all 17 nations guarantee the sovereign and bank debts of all nations using the Euro.

sturdeebeggar said...

This is so key:

"Raising taxes only serves to validate the size of government; instead, government must be shrunk to fit the ability of the private sector to afford."

Hans said...

Point well taken, Egghead.

I vigorously oppose the view points of, Mr Grannis...I believe his opinions about the EU crisis are much too sanguine, particularly when it comes to debt default..

Yes, EuroLand will not disappear, but the Black Plague has been replaced by the Red Plague...Oh, there will be a lot of pain and not only in Spain.

Despite a 70% debt forbearance, the Greeks still demand more...

Governments will have to shrink in scope, but also in philosophy...Without reformation a new redundant cycle will begin again...I currently see little hope on the horizon..

Economics, is simply an extension of policy...