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Craig Allen: Market Bounce on EU Summit Agreement a Tough Sell for Germany’s Merkel

With the world awash in debt, savvy investors must hope for the best but prepare for the worst

At the European Union’s Brussels summit on Friday, EU leaders agreed that euro-area rescue funds could be used to stabilize markets (read bail out troubled countries) without forcing these countries that comply with EU budget rules to adopt extra austerity measures or economic reforms. It was also agreed that a single supervisory body for euro-zone banks, housed under the European Central Bank, would be created by year’s end — much faster than previously discussed.

In essence, what the EU agreed to (after Spain and Italy withheld their support for previous measures that did include requirements for austerity measures and debt-level reductions), is to remove any need for austerity measures to qualify for bailout funds. More to the point, the rules regarding membership in the European Union, among them the requirement that countries maintain debt levels not to exceed a maximum of 60 percent of gross-domestic product and budget deficits not to exceed 3 percent of GDP.

Most troubled countries in the EU are running sovereign debt levels at more than twice this ceiling, and budget deficits in the double digits. Greece completely lied to the EU about its debt levels and budget deficits until they became so large that the country had to beg for outside assistance (a bailout). To get the bailout, Greece agreed to austerity measures, including cutting its budget deficit and also (eventually) reducing its national debt as a percentage of GDP. These austerity measures included cuts in government entitlements, an increase in the retirement age, a reduction in guaranteed benefits, government wages, job cuts, etc.

With this new “agreement,” these requirements are off the table. In other words, these countries took money and will take even more money from the bailout fund, and will not be required to stop the excessive spending that got them into trouble in the first place.

As I always say: You cannot borrow your way out of debt, which is exactly what these countries are trying to do. They will eventually default, and countries like Germany, which is relatively stronger economically, and which is providing the bulk of the bailout money, will be left holding IOUs that are worthless.

This will be a tough deal for German Chancellor Angela Merkel to sell to the German people. Germany’s economy is relatively good compared to EU-member countries in southern Europe. The German people have a conservative culture that favors fiscal responsibility. But Germans are becoming disenchanted with membership in the EU, as they are being asked to foot the bill at increasing cost for the mistakes of these other countries.

The positive for world financial markets is that some of the short-term pressure has been alleviated, but the underlying problems remain, and with this agreement, will only get worse in time. The United States currently has about $15 trillion in national debt, which represents roughly 100 percent of our total GDP. We have more debt than any other country on the planet. Italy, one of the EU countries with the most serious financial problems, has about $2.2 trillion in debt, which represents 120 percent of GDP, or about $1.8 trillion each year. Spain, another major problem country in the EU, has about $1 trillion in national debt, which represents 69 percent of GDP, or about $1.4 trillion. Greece is relatively small in terms of national debt and GDP, with about $480 billion in national debt, which represents 160 percent of GDP, or about $300 billion each year.

Greece has been at the forefront of the news coverage relating to the EU debt crisis, but ironically, it is one of the smallest economies in the union. Spain and Italy are much more troublesome because their economies are about five and six times the size of the Greek economy, respectively. Greece has had more immediate bailout needs, so it has dominated news coverage and has received the most attention in terms of bailout funding. Spain and Italy are a much larger, more complicated problem for the EU and for world financial markets (and you and me). I am not convinced that enough money can be contributed by the other EU countries (read Germany) to keep Spain and Germany afloat. EU leaders seem to be having trouble supporting Greece alone.

Beyond Greece, Italy and Spain, there are other countries within the EU and outside it that will need major help in the near future. On AM 1290, I discuss the financial markets and economies each weekday morning. We call the troubled countries in the EU PIIGS — Portugal, Ireland, Italy, Greece and Spain. Those countries all need major help and all individually represent a serious threat to the stability of the EU and the euro as a currency. By extension, they represent a significant threat to the stability of the entire world economy.

But it’s not just the EU. I already stated the size of the U.S. national debt at $15 trillion. Not only is this a mind-blowingly large number, but we are adding to it at an increasing rate. Even more disturbing is that the government, through operation twist — selling short-term debt to buy long-term debt, to reduce long-term interest rates, and QE (quantitative easing in which the government essentially prints money to buy long-term debt, again to force long-term rates down) — is not only weakening the dollar, which will eventually lead to inflation, but is also growing the national debt even faster than our out-of-control spending.

More to the point, they are doing the exact opposite of what they should be doing. Interest rates are at historic lows (they were at historic lows before the government started artificially pushing long rates down with operation twist and QE). The government should be refinancing our national debt with long-term bonds at these low interest rates to reduce our borrowing costs. They are doing the exact opposite! They are buying long-term bonds when they should be selling them!

When interest rates go back up, which they must, our borrowing costs will skyrocket from current levels. Since we don’t have the money to pay the interest, much less any principal on our debt, we will have to borrow even more money through selling even more bonds, to pay that interest. Additionally, we still have a massive budget deficit each year, which continues to add to our national debt. Even the most optimistic estimates show it taking many years before we can balance the budget.

Beyond the United States, there are many other countries that are also in trouble. Just last week, Cyprus asked for a bailout. If we look at total external debt, which includes money owed not just by the government of the country, but by its companies and individuals, Australia’s external debt represents 140 percent of its GDP. Even Germany, which has a relatively good economy in terms of growth, has external debt representing 184 percent of its GDP! Austria’s external debt-to-GDP ratio is an incredible 241 percent, Finland’s is 245 percent, Norway’s is 247 percent, France’s is 254 percent, Sweden’s is 262 percent, Hong Kong’s is 266 percent, Denmark’s is 283 percent, Belgium’s is 354 percent, the Netherlands’ is 367 percent, Switzerland’s is 391 percent, the United Kingdom’s is 451 percent and Ireland’s is an incomprehensible 1,239 percent!

The world is awash in debt! When currencies begin to suffer the effects of inflation, governments will be forced to raise interest rates, and the cost of borrowing for all — governments, companies and individuals will increase dramatically. Countries like Germany, that are being asked to bail out weaker countries in the near-term, may find themselves in need of a bailout in the not-too-distant future. The problem is that there will be no one standing by to provide that bailout. The people of Germany are certainly smart enough to realize this, so it will be interesting to see if Merkel can sell this latest agreement to her constituents.

For the rest of the world, the ramifications of the ongoing problems in the European Union will continue to plague financial markets, so investors need to stay focused on developments across the EU and make appropriate changes to investments. Hope for the best and plan for the worst seems like a good strategy at this point.

Craig Allen, CFA, CFP, CIMA, is president of Montecito Private Asset Management LLC and founder of Dump Your Debt. He has been managing assets for foundations, corporations and high-net worth individuals for more than 20 years and is a Chartered Financial Analyst (CFA charter holder), a Certified Financial Planner (CFP) and holds the Certified Investment Management Analyst (CIMA) certification. He blogs at Finance With Craig Allen and can be contacted at .(JavaScript must be enabled to view this email address) or 805.898.1400. Click here for previous Craig Allen columns. Follow Craig on Twitter: @MPAMCraig.

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