The European Crisis Is Hopeless As Long As Leaders Don’t Understand The Problem

I was on RT last Friday talking about the European sovereign debt crisis with Liz Wahl. The video is below but i have a few thoughts to add here as well.

I am not at all optimistic about the euro zone in terms of policy makers fashioning a solution to the problem. The euro leaders have the diagnosis all wrong. They keep harping on government debt and deficits as if that’s the problem. And this has caused them to go all in for austerity without a backup plan. The reality is that the sovereign debt crisis in Europe is not about government debt; it’s about private debt and intra-euro zone imbalances.

Look at Spain, for example. The government’s budget was in surplus throughout most of the 2000s. In fact,Germany, which is a AAA-rated country had a fiscal record significantly worse than Spain’s over the decade leading up to crisis. Yet Spain is now facing crisis. And it’s been almost two years since I wrote how Spain is the perfect example of a country that never should have joined the euro zoneThe evidence is right in front of our noses. Yet euro area leaders still don’t get it.

Quoting from a post last week on Wolfgang Münchau and his analysis of the euro crisis, here’s why we see the debt and deficit fixation:

it’s because the government deficit story is an easier narrative to tell and simpler to attack within the existing institutional limitations of Euroland. That makes some sense politically, but it tells me that this crisis will continue to get worse.

So what is going to happen is that the periphery will swallow the bitter austerity pill only to find it doesn’t help. They will then all be forced one by one into the Greek death spiral. Portugal, for example, is seeing its CDS spreads rise alarmingly high – as if they will soon move into Greek territory. Spain and Italy are where the rubber will meet the road.

We do know that the Europeans won’t let Spain and Italy default. That much is now clear. So I think we will have to see another crisis which threatens either of those two nations before we get a more definitive policy response. This will probably occur sometime this year. Remember, we’ve been here before.

Meanwhile, as I say in the video below, the ratings downgrades are meaningless. Traders of European countries’ sovereign debt have long been signalling they see credit deterioration everywhere outside of Germany. And that means, politically that Germany will be asked to pony up. They will balk. But when the next crisis in Europe comes – and that will be Portugal in all probability – we’ll just have to see what the politics are. I think the ECB and Germany will step in with support as they have done before. But they will need to see another crisis before they are willing to do so. There is always the potential for policy errors depending on the political situation.

Bottom line: I am pessimistic about Europe right now. But I am always hopeful that policy makers eventually get it right when evidence of policy failure mounts.

I will be on CNBC this afternoon at 2PM talking about the FOMC meeting and other stuff like the euro zone. Tune in. If you miss it, I will post the video at some point later.

This post originally appeared on Credit Writedowns.