European Austerity and the Fate of the Euro

Last week, S&P downgraded Spain to BBB+.  Spain, Italy, Greece, Portugal, Ireland, Belgium, Denmark, and Holland, members of the Eurozone, have officially fallen back into recession. We are more than two years into the European Debt Crisis – the crisis that we have been assured by politicians has been fixed, and, yet, much of the continent finds itself in the shadow of recession, banking crises, higher levels of unemployment, and, perhaps of most concern, higher debt to GDP ratios.  Although the “successful” long-term refinancing operations conducted by the European Central Bank (ECB) bought the markets about 4-5 months of breathing room, undercapitalized banks are now more closely tethered to the overleveraged balance sheets of their respective sovereigns.  After a temporary period of relative calm, 10-year borrowing rates in Spain and Italy have re-approached 6%.  Simple math dictates that, when you are growing at negative rates and borrowing at 6%, you are unlikely to improve your overall long-term debt dynamic.  It is truly a pathetic state of affairs when financial markets celebrate “successful” auctions of 12 and 18 month Spanish debt as if it is a mark of strong financial health – be advised, the bar has officially been lowered.  Unfortunately, lowering expectations does not fix the long-term debt issues facing the Eurozone, even if it makes financial markets feel better in the short-term. 

And now, as if the Europeans didn’t have enough complications to deal with, the inconvenient matter of national politics is taking center stage.  Nicholas Sarkozy, who has stood shoulder-to-shoulder with Angela Merkel of Germany in trying to forge greater budget discipline into the Eurozone, is likely on his way out.  He looks to be replaced by Francois Hollande, who has run on a socialist platform that seeks to undo much of the “progress” that has, supposedly, been made.  The Dutch Government also resigned last week, as its populace has also become wary of the pain of austerity.  Spanish citizens, suffering a 25% unemployment rate, are taking to the streets in protest of further government spending cuts.  

The Eurozone has far more problems than potential solutions.  The imposed austerity of the last few years, in the absence of a restructuring of the competitive balance between Germany and everyone else, just reduces growth with little long-term benefit.  This reduction of growth makes debt service more difficult and keeps borrowing costs high.  Not making any structural or fiscal adjustments, however, is akin to continuing with the very policies that placed them in this situation in the first place.  In other words, more borrowing and spending with only the potential for future stronger growth is unlikely to assuage the concerns of potential lenders. Sharp spending cuts – austerity for the greater good – simply isn’t going to be sustainable; a nation’s citizenry simply isn’t going to sacrifice current lifestyle for an ethereal collective such as the European Monetary Union.  While I do not have the answer as to how these problems, ultimately, get resolved, this much is clear – nothing has really changed.  Investors can continue to wallow in denial or they can prepare for the continuing difficulties of the European conundrum. 

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