Comstock Partners, Inc.February 11, 2010
Greece Is Only A Symptom
The Greek fiscal crisis is just a symptom of world-wide credit problems that was signaled by the emergence of subprime loan disclosures as early as August 2006. The importance of subprime lending was not recognized until much later, but nevertheless evolved into a continuing series of economic and financial crises that continue until this day. The problem has now extended to sovereign debt, and, as usual, the weakest links are exposed first (Dubai and Greece) only to spread to stronger entities later. Not far behind are Portugal and Spain, then perhaps Italy and Britain. It's not just a localized minor problem to be solved by some sleight-of-hand by the EU, but a debt crisis that could envelop the globe.
In addition to excessive fiscal deficits by some of its weaker members, the EU has some special problems for which there are no good options. The Greek government can either undertake severe fiscal austerity measures, default, be bailed out by the EU or leave the organization entirely. Each of these has unwanted consequences. The result of enough fiscal austerity to relieve the debt pressures is a severe recession or depression. An independent nation generally offsets this with an easy monetary policy and devaluation of the currency, something that Greece cannot do as an EU member since they do not run their own monetary policy and share a common currency. Default would cause havoc in the EU banking system that holds most of Greece's debt. An EU bailout would only push off the crisis since other weak members would demand the same deal. While the Greek economy is relatively small and the Portuguese economy slightly smaller, bailing out an economy the size of Spain's would be an enormous or even impossible project. And leaving the EU would probably bring down the organization.
Furthermore Greece's debt burden is only slightly more onerous than those of an alarming number of other nations including Portugal, Spain, Italy, Ireland, Iceland, Britain, Japan and, yes, even the U.S. Globally, assets soared in price during the boom, supported by vast increases in debt. Now the assets are severely diminished while the debts remain and there is insufficient income to pay them off.
The U.S. is far from immune. Administration budget projections of the deficit indicate that the gross Federal debt held by the public will exceed 100% of the GDP within two years while the deficit will amount to 10% of the GDP. The CBO estimates enormous deficits for the next ten years, and it doesn't end there. And this is probably a best-case scenario that overestimates future economic growth, doesn't include GSE debt and doesn't account for the huge fiscal problems of the 50 states.
In addition the prospect of big deficits as far as the eye can see raises fears of default or currency depreciation leading to a rise in interest rates and a dampening of growth. So far interest rates have been held down by Fed purchases of Treasury bonds and mortgage-backed securities (MBS), purchases by China and a rush to safety. However, Treasury Bond purchases amounting to $300 billion ended on October 31st while the program to buy $1.25 trillion of MBS comes to an end on March 31st. At the same time, China, while not actively selling U.S. Treasuries have sharply reduced their purchases and will probably continue doing so.
It therefore seems to us that investors are making a big mistake if they assume that Greece is too small and unimportant to matter and that the rest of the developed world is somehow isolated from the turmoil. Greece is to sovereign debt what subprime was to private debt. It's the possible start of a vast tsunami that threatens to overwhelm the global economic and financial system. Investors should take heed.